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Accounting standard is the detail rules that drawn out to regulate the accounting treatment of transaction and other items shown in financial statement by organization. The main purpose of accounting standards (whether national or international) is to reduce variation in accounting practice and to introduce an extent of uniformity into financial reporting.
Both International Accounting Standard Board (IASB)'s IFRS and Financial Accounting Standard Board (FASB)'s GAAP list out requirements related to financial statements that are essential to economic decision makers. Both sets of standards address notes to the financial statements, supplementary schedules as well as the underlying assumptions, and qualitative characteristics of the financial statements.
Qualitative characteristics are the attributes that make the information provided in financial statements useful to users such as investors, employees, lenders, suppliers, creditors, customers, government agencies and public.
The Framework lists four main qualitative characteristics of useful financial information as followings:
The information provided in financial statement must be understandable. Different users will obviously have different levels of ability as regards understanding accounting information. However, the framework assumes that the users have "a reasonable knowledge of business, accounting and economic activities and are willing to study or analyze the information provided with reasonable diligence" (Jane L. & Huang C.C., 2008). For instance, this applies to the format or layout of the statement, the terms used in the statement and the policies, methods and assumptions utilized in preparing the statement. Relevant information should not be excluded merely on the grounds that it may be too difficult for some users to understand.
To be useful, information must be relevant to the users' decision making needs. The information is relevant when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations. The relevant information has predictive, or conformity value and maybe used as the basis for predicting future financial performance of entity. The same information plays a confirmatory role in respect of past predictions about, for example, the way in which the entity would be structured or the outcome of planned operations (MASB, 2011).
The relevance of information is affected by its nature and materiality. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial reporting. An item which is so small and has not significant effect is considered immaterial to be relevant to users' needs.
The reliable information can be depended upon by users to present a faithful representation and is neutral, error free, complete and prudent.
The information must represent faithfully what it either purports to represent or could reasonably be expected to represent.
Substance over form
To be reliable, financial information must be accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The legal form of a transaction may sometimes be very different from its substance and this situation might be deliberately contrived.
Financial information is reliable when it is free from deliberate or systematic bias (that is neutral). Furthermore, the information must be complete and free from error within the bounds of materiality. A material error or an omission can cause the financial statements to be false or misleading and thus unreliable and deficient in terms of their relevance.
Prudence refers to exercising a degree of caution in making judgements about estimates required under conditions of uncertainty, such that gains and assets are not overstated and expenses and liabilities are not understated. The existence of assets and gains requires more confirmatory evidence and reliably measurement than are required for liabilities and losses. However, it is not appropriate to use prudence as a reason for, for instance, creating hidden reserves or exercise provisions, deliberately understating assets or gains, or deliberately overstating liabilities or losses. It would cause the financial statements are not neutral and therefore unreliable (ACCA Study Test, 2008).
To be reliable, financial information must be complete within the bounds of materiality and cost. Omission of information may mislead the users' of financial statements.
The users must be able to compare the financial statements between entities and over a time period. An important implication of comparability is that users are informed of the accounting policies adopted by entity, any changes in those policies and the effects of such changes. The entity should adopt consistent accounting policies over time. Compliance with accounting standards, including the disclosure of the accounting policies used by the entity, helps to achieve comparability.
The purpose of International Conceptual Framework
The IFRS Framework describes the basic concepts that underlie the preparation and presentation of financial statement for external users.
The purpose of the Framework is to:
Help the IASB in their role of developing future accounting standards and in reviewing existing IFRSs.
Help the IASB by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs.
Help international standard-setting bodies in developing national standards.
Help those preparing financial statements to apply IFRSs and also to deal with areas where there is no relevant standard.
Help auditors when they are forming an opinion as to whether financial statements conform to IFRSs.
Help users of financial statements when they are trying to interpret the information in financial statements which have been prepared in accordance with IFRSs.
Provide information to other parties that are interested in the work of the IASB.
Many of the developed countries of the world have their own standard-setting bodies. In recent years, the increasing globalization of business has urged for a single set of accounting standard. The IASB and FASB are in the process of converged. The most predominant accounting models are International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP). Most countries over the world embrace the IFRS such as European Union, Australia, Singapore, and Malaysia and so on.
One of the major differences between two conceptual approaches: IFRS is principle-based, whereas U.S. GAAP is rule-based.
The IFRS is a principle-based standard that focus on fundamental principle, drawn clearly in the IASB's conceptual framework, rather than on detail rules. It is adopted by IASB in 1989. This approach requires accountants to exercise professional judgment in the public interest to ensure that their financial statements fairly and faithfully representation of all transactions. Principles-based standards provide a comprehensive basis and have the flexibility to deal with new and different situations. The inherent characteristic of a principle-based framework is the potential of different interpretations for similar transactions that would create uncertainty requires extensive disclosures in the financial statements.
In a principle-based accounting system, the areas of discussion or interpretation can be clarified by the IASB, and provides fewer exceptions than U.S. rules-based system. However, critics believe it is too much leeway allowed by principle-based approach for organizations, because they generally do not have to follow specific rules, only wide range principles.
On the other hand, the FASB's GAAP focuses on providing a list of detailed rules that must be followed when preparing financial statements. It is believed that many accountants favor using rules-based standards, because in the absence of rules they could be facing lawsuits if their judgments in the financial statements were incorrect. Having a set of detailed rules can increase accuracy and reduce the ambiguity that can trigger aggressive reporting decisions by management. However, the complexity of rules can cause unnecessary complexity in the preparation of financial statements. So far, the U.S. FASB has developed 148 accounting standards as compare with IFRS which has been published only 41 standards.
The U.S. rules-based accounting standard has came under fire since the Enron accounting fraud scandals where in Arthur Andersen was seen as designing and accepting client-originated financial instruments that met the technical requirements of GAAP while violent the intent. As the international accounting standards is more simple, applicable, accounting principles under which a certain extent, it is believed it is being more able than the U.S. accounting standards. Well-known at home George Soros stated: 'the rules alone is not enough, you will need to principle'. He added: 'the U.S. accounting system to accounting rules-based. But only accounting rules is not enough, because it leads to avoidance behavior '. He also pointed out that although Europe will also appear like the U.S. accounting scandals, but 'would not have such a system problem'.
There are some differences between principle-based and rules-based standards, for example:
IFRS has a single model - control model (the notion of governance and risks and benefits) into the consolidation analysis. However, U.S. GAAP has two distinct models: a risk and rewards model under FIN 46(R) and a voting control model under ARB 51.
Further, uniform accounting policies are used for entities within a consolidated group under both approach, however, there is certain exceptions under US GAAP (for example, a subsidiary within a specialized industry may retain the specialized accounting policies in consolidation). Besides, the consolidated financial statements of the parent and its subsidiaries may be based on different reporting dates as long as the difference is not more than three months.
Measurement of PPE
IFRS may use either revalued model or cost model whereas US GAAP only allows PPE measure in cost model.
Under both standards, the cost of inventory includes all direct expenditures to ready inventory for sale (excludes general selling costs).
Under IFRS, LIFO (a historical method of recording the value of inventory, a firm records the last units purchased as the first units sold) cannot be used. However, under U.S. GAAP, companies have the choice between LIFO and FIFO.
Earning per share
Under IFRS, the earning-per-share calculation does not average the individual interim period calculations, whereas under U.S. GAAP the computation averages the individual interim period incremental shares.
Subsequent Reversal of impairment loss
It is required for all assets (except goodwill) in IFRS if certain criteria are met whereas it the reversal of impairment loss is prohibited in U.S. GAAP.
These costs can be capitalized under IFRS if certain criteria are met, while it is considered as "expenses" under U.S. GAAP except for certain website development costs or costs associated with developing internal use software).
Revaluation of tangible asset
Under IFRS, it is allowed if the intangible asset trades in active market, however, it is prohibited under U.S. GAAP.
Principles-Based Accounting Standards:
Principles-based standards have provided broad guidelines to be applied to numerous situations and help reduce manipulations of the rules by organizations or accountants. It can improve the representational faithfulness of financial statements. (Rebecca and Mark Myring, 2004)
It allows accountants to exercise professional judgment in assessing the substance of a transaction instead of relying on detailed rules. It is flexible to accommodate future development in these dynamic market environments.
A principles-based system would result in simpler standards that would be less than 12 pages long, instead of over 100 pages if compare to rules-based standards.
A lack of precise guidelines could produce unreliable and inconsistent information in the application of standards across organizations and make it difficult to compare one entity to another. For instance, organizations are required to recognize both probable expense and liability for a contingent liability. However, a reasonably possible contingent liability is only disclosed in the footnotes. With no precise guidelines, how should organizations determine if liabilities are probable or only reasonably possible?
Principles-based standards generally require preparers to apply professional judgment to implement and interpret the standards in the absence of sufficient guidance. This has allowed accountant to manipulate financial results since they can set low standards for themselves in this regard (even failing to meet those), it is a big question if they will rise to the occasion.
Rules-based Accounting Standards:
It produces more consistent and comparable financial reports across entities. The standards are set out in detail and compliance with the rules can be more easily monitored and enhance the comparable between entities.
The longer and complicated standards have lead the entities to look for loopholes that meet the literal wording of the rules but violate the intent of it.
For instance, lease accounting consists of hundreds of pages of rules and interpretations; however, there almost no leased assets appear on company's balance sheets. The system has enabled an industry of financial engineering and structured transactions designed to circumvent the rules. (Raymond Thompson, 2009)