The Development of Accounting Standards - Case Study Example

Case Study By: Foundation Course- Tutor: University of: Department of: 22rd May 2016 Case Study 1 Why principles-based standards require a conceptual framework Introduction According to Peecher, Solomon and Trotman (2013), many components of a financial statements are based on judgment, estimates as well as model rather than exact positions. Therefore, there is always I need for conceptual framework so as to outline the concepts underlying those judgment, estimates and models related to those specific financial statement. In this case, conceptual framework is often seen as an attempt to outline the nature and purpose behind accounting practices. It tends to consider the theoretical and conceptual issues related to financial reporting thus eventually formulating a coherent and steady platform that will underpin the development of accounting standards. Purpose: Although, conceptual framework can be applicable to a number of disciples, when it is specifically related to financial reporting, conceptual framework can be considered to be a statement of generally accepted accounting principles (GAAP) that produces a structure of locus for the evaluation of the existing accounting practices as well as the development of new ones to (Peecher, Solomon and Trotman 2013). Based on the fact that the main aim of the financial reporting is to provide some form of principle-based useful information as a basis for economic decision making, conceptual framework often comes in handy to form a theoretical strategy to evaluate how an entity’s business transactions can be measured and reported, that is, how they should be made presentable and easily understandable to the users of the information such as the shareholders, consumers, suppliers, the employees, management and even the government. Despite having been an unending debate regarding the usefulness of conceptual framework in ensuring that reliable financial information is produced, scholars have argued that without incorporation of the conceptual framework in any of the financial reporting, any of the accounting standards that will be produced will have serious defects and thus will end up not portraying the true financial status of the entity in question (Murphy and O’Connell 2013). Therefore, in order to ensure that principle-based financial position of an entity is reported, conceptual framework will be useful in the following ways:- It ensures each of the components of the financial statements are dependable on each other more so in the role of prudence versus accruals or matching principle (Wenger and Babb 2013). It maintains the internal consistency and ensures that the effects of the transaction on the statement of the financial position as well as the effects on the income statement are all taken into consideration. They are ever proactive in determination of the best financial reporting policies thus ensuring that standards of financial reporting are not based on a “fire-fighting approach,” that tends to mislead the information users (Wenger and Babb 2013). It ensures that all the standard setting parameters are fair in representing all the user groups, that is, composition of all the information as realized in an entity’s business operation. Importance of IASB and FASB sharing a common conceptual framework It has always been reported that lack of conceptual framework in any of the financial reporting standards lead to proliferation of important information related to ‘rules-based’ accounting systems whose main purpose is to ensure that accounting transactions are recorded as per some detailed specific rules or requirements (Wenger and Babb 2013). Therefore, it is encouraged to have IASB and FASB developed from an agreed conceptual basis so as to be helpful in the following ways:- To support in the building of future IFRS and the review of the current accounting standards through setting up of the underlying accounting concepts. To give assist in the preparation of the financial statements as per the applications of the IFRS which basically incorporates dealing with accounting transactions where there tend to be no an accounting standard in place (Wenger and Babb 2013). It would help to promote harmonization of accounting principle-based rules and standards through minimizing the count of alternative accounting treatments that is often permitted. Importance of conceptual framework to some parties over others As stated by Peecher, Solomon and Trotman (2013), the conceptual framework can be useful to any party that employs it in their financial reporting in a number of ways. Although there are those entities that it would prove to be quite of great importance in case they decide to incorporate it in their accounting reporting systems, for instance:- Firms that own foreign subsidiaries will benefit from the simplification of the process of consolidation if they decide to use IFRS across all its subsidiaries. Entities that uses IFRS while having their financial statements audited in accordance with the required International Auditing Standards (IAS) tend to realize enhanced status and reputation Firms that uses IFRS always find their results easily comparable to those of other companies also uses IFRS. This will hence curb the need for undertaking any form of reconciliation from local GAAP to IFRS whenever the analysts are assessing comparative performance of such firms (Peecher, Solomon and Trotman 2013). Bodies such as The International Organization of Securities Commissions (IOSCO) tend recognize usage of IFRS with conceptual framework for their listing purposes, that is, firms that uses IFRS and are members of the IOSCO will have to provide them with only one of their financial statements so as to determine their securities’ listing. This process tend to make it even easier and cheaper to generate funds in the international market (Peecher, Solomon and Trotman 2013). Cross Cutting Issue Cross cutting issue is basically development initiative or a measure related to a positive outcome of an activity or a project being undertaken, that is, positive virtues or even addition injection of raw materials that would work towards realization of the desired outcome of a project or an activity. Cross Cuttings would include the following:- Sustainable development; these are growth oriented practices that tend to achieve the present needs without necessarily interfering with the ability of the future generations to achieve similar results, that is, a company while desiring to increase its investment in the industry, should no rely so much on the debt financing to an extend that the future operations of the company will be compromised due to huge debt obligations that shall have been accrued then (Murphy and O’Connell 2013). Good governance; In order for a company to realize positive growth, the management should work towards ensuring that decision-making is participatory and inclusive, adheres to the stipulated rule of law, efficient and efficient, transparent and accountable(Murphy and O’Connell 2013).. Case Study 2 The fundamental problem with financial statements based upon the historic cost measurement principle used under US GAAP? Introduction The historical cost is basically the measurement of values used in accounting whereby the price of an asset on the balance sheet is based on its nominal or original cost when purchased by the company. Under US GAAP, where historical-cost principle is mostly applicable, a number of assets held on the balance sheet are often recorded at the historical cost regardless of whether they have changed in values over time (Liang and Riedl 2013). Although historical cost is normally criticized for its inaccuracy, it is still used in most accounting systems during low and high inflation as well as deflation periods. As a matter of fact, historical cost does not generally show any reflection of the current market value of items in the financial statement. Therefore, many accounting practitioners prefers alternative measurement bases to the historical cost measurement basis for some type of assets where the market values are readily available, that is, where the carrying value of an asset or a liability can be updated to the prevailing market price, also known as mark-to-market valuation or even consideration of some other value estimates that can approximate the real value of an asset or liability (Liang and Riedl 2013). Fundamental problems associated with usage of Historical Cost Measurements As outlined above, historical cost measurement basis often pose the following challenges when used under US GAAP:- There tend to be insufficient provision for Depreciation; Depreciation is considered as a framework of generating finances to be utilized in the replacement of the depleted fixed asset when they are rendered obsolete. In historical cost accounting method, depreciation is charged based on the historical cost of such fixed assets instead of the real price at which such assets where acquired, hence the provision that will be made through the depreciation based on the original cost will less than the replacement cost of such worn out fixed assets (Braun and Taylor 2015). Failure to take into consideration the subsequent changes in the price level; ideally, financial statement prepared based on the historical cost accounting are simply statement of historical facts thus it does not take into account the changes in the value of money which is often brought about by the fluctuations in the general level of prices. As a result, historical costing method does not seem to give the true position as well as state of affairs of the entity reporting its data (Braun and Taylor 2015). Presentation of unrealistic profit realization; in normal circumstances, the income statements prepared under historical cost accounting method fails to reveal the true profit realized by the entity in question. Since the revenues are recorded based on the current value basis while expenses recorded at historical costs, the resultant profit reported tend to be over-stated especially during periods that the economy suffers inflation (Persons 2014) Failure to present a fair value of the entity’s financial position; any given entity’s balance sheet normally comprises of both monetary as well as non-monetary items. During financial statement reporting, monetary items such as cash, loan, creditors and debtors among others tend to be reported based on their current money value while non-monetary items such as land, inventory, building, equipment and machineries among others on the other hand, are recorded on the basis of their historical costs and not at their current value, this would therefore not give the true fair value of the financial position of entities especially during period of inflation since such non-monetary items tend to be understated. Therefore reliability on the historical costing would mislead in this scenario(Persons 2014). Misappropriation of the holding and operating gain in the business operations; in the event of historical cost accounting method, any gain or loss realized on the account of holding inventories may end up being mixed up with the operating gain or losses. Therefore, it would be significant to make use of revaluation model so as to have the holding gain or losses separated from the operating gain or losses in order to determine the true operating performance of an organization (Braun and Taylor 2015). . Financial Accounts as a reflection of the economic reality In order for any given financial information to be useful for decision making, it must be economically reliable in the sense that it is accurate, true and fair (Collier 2015). Therefore, there is need to have the reported information that can always be verified and used consistently by both the entity’s shareholders as well as creditors while getting similar results so as to make important economic decision. Where the reported financial information cannot be trusted by the end users, it would often considered usefulness thus not economically reliable. Measurement of economic reality Economic reality can estimated through making use of the information and comparing the end results, for instance whenever shareholders of a company and its creditor uses the reported financial information and gets a similar results, the information would be considered economically reliable and thus shareholders may decide to invest more in the company as creditors agree to lend more as well. On the contrary, when usage of information results to different opinions, it should be considered economically unreliable thus not dependable in decision making (Collier 2015). Reliability in Accounting As discussed in relation to economic reliability, reliability in accounting basically refers to the trustworthiness of the reported financial information, that is, whether the users of the information such as the investors, suppliers, employers, customers, government and the surrounding community have confidence in the reported information(Collier 2015). Reliability is often attributed with representational faithfulness whereby the reported financial information adequately represents what really transpired during an organizations financial period. For instance, if an organization reports a profit of $152,000 whereas it made a loss of $32,000, the information reported in this case would be considered unreliable and thus cannot be used to make decisions pertaining to the future operations of the company. Case Study 3 Companies’ provision for reservation of environmental liabilities While a number of organizations have their goals focused on extinguishing their obligations and thus able to have much of their liabilities in control, there are some other companies that are still faced with challenges pertaining to accountability of these liabilities (Leonhardt, Coelho and Mation 2015). Therefore, companies should consider the following ways to estimate their provision related to such liabilities:- According analysts, once an organization has determined that there seems to be likelihood that liability has been incurred, the organization should estimate the remediation liability on the basis of available information and recognition of certain amount of liability in the event that estimate would be necessary(Leonhardt, Coelho and Mation 2015). While estimating their allocable share of costs, an organization should take into consideration the incremental direct costs of the remediation effort as well as post-remediation monitoring costs that are often expected to be incurred upon the completion of the remediation. Likewise, an organization’s estimate should include costs of compensations as well and related benefits costs for those staff that are often expected to devote quite significant amount of their time to the remediation related activities. However, organizations are not encouraged to estimate and capture data on those staff expected to devote incidental time on the remediation effort. In addition, the accrual of expected legal defense costs that are related to the remediation are normally excluded from the accounting of the liabilities’ costs (Leonhardt, Coelho and Mation 2015). Given the fact that in the early stages of remediation project, it is normally difficult to estimate liabilities’ costs because of the inherent uncertainties that are involved in the remediation process, it has been noted that estimates developed in the early stages of remediation normally vary significantly from the actual results(Leonhardt, Coelho and Mation 2015). Therefore, it is recommended that the following factors should be considered as integral components while carrying out cost estimates of environmental liabilities:- The existing range of technologies that can be used for remediation The extent as well as types of hazardous substances that are believed to be in the site and thus can be harmful The evolving standards of what constitutes an acceptable remediation. The potential number and financial condition of other potentially responsible parties (PRPs) and the extent of their responsibility for the remediation, that is, the quantity of hazardous substances that they can contribute to the environment Aspects of the requirements used by US companies to defer recognition of a liability Despite the fact that many of the US companies have the desire to recognize their liability within a stipulated timeframe, there tend to be some aspects that derail their effort in achieving this hence forcing some of these companies to defer recognition of their liabilities, among these aspects includes:- Impact of unexpected future events and developments; It has been reported that the remediation technology has been changing constantly, thus in many scenarios, new technologies have resulted in modified costs of environmental remediation. As a result of these anticipated changes in technology, it has been noted that information related to potential advances in remediation technologies has to be routinely considered by the environmental engineers when evaluating other alternative remediation strategies. Therefore such realistic advances should never be ignored whatsoever since failure to incorporate them might lead to misquoted of the most likely amount to be paid, hence the need for US companies to defer recognition of their liability until when all the changes have been incorporated (Clor‐Proell and Maines 2014). Effects of potential recoveries; potential recoveries are normally claimed from different parties such as insurers, PRPs, governmental or even third –party fund. Therefore, it is recommended that the environmental remediation liability should be determined independently from any of such potential claims, and thus US companies find it inappropriate to recognize their environmental liabilities before such potential claims are recovered (Clor‐Proell and Maines 2014). Ways in which the recognition of the liability in relation to future restoration activity affect Net Profit in current year and future years The recognition of liability tends to be a little bit contradictory based on the fact a liability is a “present obligation” that has risen from past events. As stated in paragraph 19 of the IAS 37, a liability is only obligation that “exists independently of an entity’s future actions thus recognized as provisions.” This statement is often interpreted to mean that liabilities must always be unconditional, that is, an entity does not always have a liability for obligations that it could avoid through future actions regardless of whether those actions are realistic or not (Harris 2014). Therefore, recognition of liabilities based on expenses that had been incurred a while back affects present net profit whereas expenses incurred now and will be recognized in future will implicate the net profit of the future years. Cash flow in the current and future years In order for a liability to meet the requirements for recognition, there must always be probability of flow of resources in form of cash (Harris 2014). If expenses are incurred and the liability recognized within the same period, there would be cash outflow in the current period hence less resources for re-investment. On the other hand when expenses are incurred and the liability recognized in future, the entity will have retain its cash flow which it would probably re-invest and realize additional profit before recognizing the liability (Harris 2014). The importance that companies recognize liabilities Based on the nature of the liabilities, there is always presumption that an outcome is bound to be unfavorable in case a claim, litigation or an assessment has been asserted or faces likelihood of assertion. Therefore, it advisable that a company accrues at least the minimum amount that can be reasonably estimated (Harris 2014). The extent to which disclosure about the liability sufficient According to Clor‐Proell and Maines (2014), whenever the financial statement disclosure provided can adequately state that a probable loss was incurred during a given financial period but cannot subject such a loss to reasonable estimation, possibly due to the following factors:- The nature and extent of the probable contingency, that is, the description of the environmental remediation obligation The fact that considerable estimate cannot be made within the available time References Braun, G.P., Haynes, C.M., Lewis, T.D. and Taylor, M.H., 2015. Principles-based vs. rules-based accounting standards: The effects of auditee proposed accounting treatment and regulatory enforcement on auditor judgments and confidence. Research in Accounting Regulation, 27(1), pp.45-50. CLOR‐PROELL, S.M. and Maines, L.A., 2014. The impact of recognition versus disclosure on financial information: A preparer's perspective. Journal of Accounting Research, 52(3), pp.671-701. Collier, P.M., 2015. Accounting for managers: Interpreting accounting information for decision making. John Wiley & Sons. Harris, S.C., D. Wall Foundation Limited Liability Company, 2014. Videoconferencing systems with recognition ability. U.S. Patent 8,704,869. Leonhardt, R.D., Coelho, G.M., Stump, D. and Mation, G.F., 2015. Expanding environmental liability in insolvency cases: risks for shareholders, managers and practitioners under Brazilian law. Insolvency & Restructuring International, 9(2). Liang, L. and Riedl, E.J., 2013. The effect of fair value versus historical cost reporting model on analyst forecast accuracy. The Accounting Review, 89(3), pp.1151-1177. Murphy, T. and O’Connell, V., 2013. Discourses surrounding the evolution of the IASB/FASB Conceptual Framework: What they reveal about the “living law” of accounting. Accounting, Organizations and Society, 38(1), pp.72-91. Peecher, M.E., Solomon, I. and Trotman, K.T., 2013. An accountability framework for financial statement auditors and related research questions. Accounting, Organizations and Society, 38(8), pp.596-620. Persons, O., 2014. A principles-based approach to teaching International Financial Reporting Standards (IFRS). Journal of Instructional Pedagogies, 13, p.1. Wenger, M.R., Thomas, M.A. and Babb, J.S., 2013. Financial reporting comparability: toward an XBRL ontology of the FASB/IFRS conceptual framework. International Journal of Electronic Finance, 7(1), pp.15-32. Read More