'Micro, small and medium-sized enterprises (SMEs) are the engine of the European economy. They are an essential source of jobs, create entrepreneurial spirit and innovation in the EU and are thus crucial for fostering competitiveness and employment'
Günter Verheugen (Member of the European Commission).
'A literature review is a critical evaluation of the existing body of knowledge on a topic, which guides the research and demonstrates that relevant literature has been located and analysed' (Collis and Hussey, 2009; pg.100). Therefore the literature review must present the up to date state of the topic, and should present the major questions and issues in the field of the study (Collis and Hussey, 2009).
In the recent year standards of financial reporting have been improved enormously, as result of national and international influences throughout the world. And because of the increasing complexity of company accounts and accounting standards, accountants and practitioners i.e. preparers of accounts, argue about the validity and fairness of the ever increasing regulations and legislation (Mayes, 1994).
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Recently in August 2009, The ASB consultation paper on The future of UK GAAP proposes a three tier financial reporting structure as follows:
All entities that are publicly accountable should use full IFRS for their consolidated and individual accounts, this tier include listed companies, banks, investment funds and insurance entities (O'Keefe and Hackett, 2009).
Non-publicly accountable entities above the small threshold would use the IFRS for SMEs. Tier (2) entities could elect to prepare their financial statements using IFRS for SMEs, of full IFRS (O'Keefe and Hackett, 2009).
Small companies that are not publicly accountable would be entitled to use the ASB's FRSSE. They could elect to use full IFRS or Financial Reporting Standards for Smaller Entities (FRSSE), IFRS for SMEs (O'Keefe and Hackett, 2009).
This paper will discuss the characteristics of entities which qualifies for IFRS for SMEs and FRSSE; entities that:
- Do not have Public accountability and
- Publish general purpose financial statements for external users.
For this research purposes, it is very important to have a common definition of SMEs in order to improve their consistency and effectiveness, and to limit distortions of competition. (Enterprise and Industry Publications, 2003). For the purpose of this research the definition of SME's will be adopted from the European commission definition which is: 'The category of micro, small and medium-sized enterprises (SMEs) is made up of enterprises which employ fewer than 250 persons and which have an annual turnover not exceeding 50 million euro, and/or an annual balance sheet total not exceeding 43 million euro.' ''Extract of Article 2 of the Annex of Recommendation 2003/361/EC'', (Enterprise and Industry Publications, 2003)
The world wide acceptance and the imposition of International Accounting Standards (IASs) have reinforced the debate on differential financial reporting, and especially since the International Accounting Standards Board (IASB) released a discussion document in June 2004 on SME reporting (Bakerville and Cordey, 2006).
Practitioners have recognized the fact that financial reporting is a huge burden on small companies, and therefore progress has been made in order to reduce the reporting demands on SMEs with varying success.
This research is basically concerned with the accounts of small and medium-sized companies, the aim is to explain and clarify a lot of the company accounting requirements that affect such companies and the exemptions that are available for SMEs.
The study will examine whether the increasing reporting costs are necessary for Small and medium-sized companies whose financial statements have limited and potentially less demanding users (Barmaky and Leng, 2008).
Differential reporting is the idea that different entities should be subject to different accounting rules (Harvey and Walton, 1996). A different set of accounting standards and regulations has been discussed widely. The discussion mainly concentrates on whether smaller companies should be given simplifications and exemptions in financial reporting or not. And this has caused the start of the controversial debate known as the big GAAP/little GAAP debate (Collis and Jarvis, 2003).
The debate became more controversial because of the fast increase and development of financial regulations in the early 1990s, which lead, as previously mentioned, compliance with the complex regulations causing a huge burden on SMEs compared to larger corporations, and the introduction of International Financial Reporting Standards (IFRS) by the International Accounting Standards Board (IASB) have shifted the debate to become even more controversial. IFRSs are only designed to meet only the needs of listed companies and nothing was made to the appropriateness of IFRSs to SMEs (Collis, Jarvis 2003).
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Consequently the Association of Chartered Certified Accountants (ACCA) recognized 'that SMEs are likely to be disproportionately burdened by the regulatory requirement and, as a consequence, it actively campaigns for fairness in regulation, recognising the issue as a significant factor in the success, productivity and growth of small businesses' (Leung, 2008).
The IASB's project on IFRS for SMEs has been discussed widely and for a long time, hence this indicates the challenges in getting consensus on how SME differential financial reporting standards should be set; for example which areas of the full IFRS standards should be simplified or omitted?( Barmaky and Leng, 2008).
In order to understand differential accounting and how to implement it, the principle issues of differential reporting must be discussed, (Jarvis and Collis, 2003) argues that differential reporting mainly rests in 7 foundations:
Users, and users need: there is a difference between the main users of the financial statements of large companies and the main users of the financial statements for smaller companies. The large companies have a much bigger number of users than smaller companies.
Stewardship and agency relationships: the evaluation of the management by the owners of an enterprise in assessing their success in achieving organisational objectives (Arnold, Hope, Southworth and Kirkham, 1994). Even though large corporations the ownership and management are separate, smaller entities are often not separated.
Complexity: one of the most common arguments found while searching the literature was that large corporations have complex transactions and they provide highly aggregated information, in the other hand such complexity is mostly irrelevant to smaller entities.
Costs and benefits: the size of the entity is a very important factor in calculating the costs of preparing financial statements, larger companies have more complex transactions, this leads for higher costs (Walton and Harvey, 1996).
Decision usefulness: the statements of large entities are used for a much wider set of decisions compared to smaller entities.
Understand ability: users of smaller entities have a less knowledge in accounting therefore their statements must be understandable for such users; on the other hand users of larger corporation statements usually have more knowledge in accounting standards and procedures.
(Jarvis and Collis, 2003)
This paper will discuss the different models and approaches to differential accounting reporting; this includes the discussion of the top-down approach which is used by the IASB and the 'bottom-up' approach (Baskerville and Cordery, 2006).
Top-down approach: a regulatory system in which it may provide a base set of standards with exemptions for companies that does not meet certain criteria' size of influence (Baskerville and Cordery, 2006).
Bottom-up approach: On the other hand, a new set of standards with a more simple measurement and disclosure requirements can be developed only for SMEs (Baskerville and Simpkins, 1997).
The paper will further examine the three elements of differential reporting in the UK for SMEs which are; (1) abbreviated accounts, (2) Financial Reporting Standard for Smaller Entities (FRSE), and (3) the exemption of statutory audit (Collis and Jarvis, 2003).
This study also aims to analyze previous comments and research made on the differential financial reporting for SMEs, throughout this analysis the research aims to answer questions on (1) whether differential reporting for SMEs is effective? As well as the different types of models, (2) the key user group of SMEs financial statements, (3) To what extent has worldwide harmonisation in financial reporting by SMEs been achieved? (4) What impact do national financial reporting differences have on IFRS for SMEs? And last but not least, (5) should audit exemption be extended to medium-sized unlisted companies?
On the other hand, Bakersville and Cordey (2006) describes the prevalent view that SMEs are small entities on the way of becoming large entities to be unsustainable, and it also overshadows the argument on how SMEs must be offered relief from highly technical IAS. (Bakersivlle and Cordey, 2006). Therefore O'Keeffe and Hackett concluded that an entity is deemed to have public accountability if:
'If it has debt of equity instruments traded in a public market.
It is in the process of issuing debt or equity instruments for trading in a public market.
It is a deposit-taker and holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses, typically banks, credit unions, insurance companies, investment banks and mutual fun.' (O'Keeffe and Hackett, 2009, pg1).
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A predominant concern of standard setters is whether the standards should be a simplification of current IFRS or, alternatively, whether SME standards should represent a whole new set of Generally Accepted Accounting Principles (GAAP).
Standards setters have a predominant concern on whether the current IFRS standards should be simplified for SMEs or alternatively standards setter should represent a whole new set of Generally Accepted Accounting Principles (GAAP) (Baskerville and Cordery, 2006). In order to resolve this issue this paper will discuss a summary of learning of the past, along with provisional predictions of the possible outcomes of differential financial reporting by SMEs.
In order to fully understand financial reporting by SMEs, the paper will also compare full IFRS and IFRS for SMEs. It is estimated that there is up to 80% fewer disclosure requirements in the IFRS for SMEs. IFRS for SMEs consists of about 300 pages, compared to about 3000 pages in full IFRS. (O'Keeffe and Hackett, 2009)
Previous literature in this topic discussed the IASB project for SMEs financial reporting, but a question arises logically; is the IASB moving toward the correct track for SMEs financial reporting? as Robin Jarvis addressed this topic further in the accountancy magazine, Jarvis noted that even though the IASB promoted its SME projects up its agenda, the IASB must also address other complex issues, such as the definition of SMEs and how unlisted companies that are not SMEs will be incorporated in the standards (Jarvis, 2003).