IFRS for Private Entities: The current stance of the IASB

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This report focuses on the key issues in the debate relating to the International Financial Reporting Standards for Private Entities (IFRS for Private Entities) formally called IFRS for Small and Medium-sized entities (SMEs) and critically assesses the current stance of the International Accounting Standards Board (IASB) on this issue. The term Private Entities would be used throughout the report apart from instances where the ED [1] and its associated documents are referred to. This report starts by assessing whether there is a need to develop an IFRS for Private Entities. It considers reasons why a free market approach might be better. This is so because entities would provide information relevant to their users' needs so as to make funding readily available to them and reduce the costs of their operations. It also notes the reasons for regulation of such entities such as to aid comparability of the companies' financial information; make it easier to implement cross-border acquisition and also help in dealing with financial providers as it can result in more accurate risk evaluations (PWC, 2005).

The key issues in the debate relate to the following:

ï‚· Whether there should be a stand-alone document for the proposed IFRS for Private entities with cross references to full IFRSs;

ï‚· The use of the same principles for both IFRS for Private Entities and full IFRSs;

ï‚· The scope of a private entity. The IASB explains that a private entity is one that does not have public accountability. Below is the actual definition used by the IASB.

SMEs (now private entities) are entities that do not have public accountability and those that produce general purpose financial statements for external users. [2] Examples of such users include owners not involved in the day-to-day running of the business, existing and potential creditors, and credit rating agencies.

An entity is said to have public accountability if: [3] 

(a) it files, or it is in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; or

(b) it holds assets in a fiduciary capacity for a broad group of outsiders, such as a bank, insurance entity, securities broker/dealer, pension fund, mutual fund or investment banking entity.

In response to the invitation to comment on the ED, most commentators noted that the proposed standard should be fully-stand alone with no cross references to full IFRSs so as to avoid a situation whereby preparers of private entity financial statements refer to two different sets of standards whilst preparing accounts. A Board member however disagreed that there should be a stand alone document for private entities because the accounting decisions of such entities are straightforward and do not need references to full IFRSs. [4] 

Another issue relates to the IASB's approach in developing the proposed standard. The same Framework and principles of full IFRSs have been used but with appropriate modifications based on users' needs and cost-benefit considerations. Most commentators described this as a top down approach to standard setting and explained that the Board was not putting users' needs as its primary objective for the proposed standard. They also mentioned that the Board had not made enough recognition and measurement simplifications to make the standard usable and ease the burden on smaller private entities. The Board however, explains that the objective of financial statements for all entities is the same and thus the same principles can be used (BC27).

The other key issue in the debate is the scope of the proposed standard. The standard is applicable to non-publicly accountable entities and is intended to be for a small entity with about 50 employees. The scope of the entity means that it is applicable to a wide range of entities from the very small entities often described as micro-entities to large private entities. This contrasts with the sort of entities that the Board says the proposed standard is for (i.e. entities with 50 employees). Commentators proposed that the scope of the standard be tightly defined so as to make it more workable.

After deliberations, the IASB has decided that the proposed standard would be fully stand-alone with no cross references to full IFRSs. Complex options in full IFRSs would be included in the standard if they need to be referred to by private entities. Also, the same principles of full IFRSs and the IASB Framework still apply. This is reasonable because a conceptual framework should not evolve as standards develop (Lever, 2006). If we consider that the IASB developed the IFRS for Private Entities on the premise that full IFRSs were designed to meet the needs of equity investors in public markets and that these needs are different from that of private entities, it is reasonable to question why the same Framework is being used and that it might be better develop a separate framework so that the users' needs of private entities are met.

The reports concludes that unless the scope of the proposed standard is tightly defined and a separate framework based on private entities users' needs is developed and used for creating the proposed standard, it may better to let these entities provide the best information that they believe would meet their users' needs as not doing so may increase the costs of their operations (Deegan and Unerman, 2006). Hence, allowing a free market approach to regulation.

1 Introduction

Why regulate financial reporting for Private Entities? It can be said that private entities are mostly owner-managed. They also tend to have a close relationship with their banks who are the main suppliers of capital and can be considered as an important user of their financial statements. They also sometimes have outside investors such as venture capitalists who work closely with them so as to make sure that their investment in the entities can be recouped. For this reason, private entities would produce financial information to meet the needs of users so that funds can be readily obtained. Therefore, because such entities would produce relevant information for their users, they should not be regulated (i.e. a free market approach to regulation should be adopted).

An important assumption under the free market approach ''is that accounting information should be treated like other goods, and demand and supply forces should be allowed to operate so as to generate an optimal supply of information about an entity'' (Deegan and Unerman 2006, p. 57). Deegan and Unerman (2006) also explain that organisations would still have incentives to provide credible information in the absence of regulation and that not doing so would lead to an increase in the costs of the organisation's operations. This based on the work of authors like Watts and Zimmerman (1978).

Agency costs have been suggested as part of the reasons for accounting regulation. However, using the premise that most private entities are owner-managed means that agency costs that arise due to conflicting interests between owners and managers and information asymmetry which arises because managers have more information at hand about the business than the owners can be said to be eliminated. This can be justified by the works of Bolton (1971) and Carsberg et al. (1985) that noted that the agency relationship (Jensen and Meckling, 1976) between shareholder and manager that is present in large companies is seldom significant in small companies, the majority of which are owned and controlled by the same individuals (Collis and Jarvis, 2000).

The financial reporting requirements for private entities can be said to be straight forward and as such no regulation should be required. However, there are benefits in regulation of Private Entities, such as: it allows for comparability of companies' financial information; it would be easier to implement planned cross-border acquisitions; helps in dealing with financial providers as it can result in more accurate risk evaluations by lenders and, in many cases, to a lower risk premium (PWC 2005). This report now discusses the issues in the debate of the proposed standard, assesses the current stance of the IASB and would then consider if it is in agreement with the proposed standard or whether private entities should not be regulated since their reporting requirements are straight forward and it will be their own interests to provide information useful to their users' needs as already explained above.

2 Key Issues in the Debate

The key issues in the debate were arrived at by going through a number of comment letters from different organizations in response to the invitation to comment on the ED as well as research using textbooks and journal articles. These issues are discussed below:

2.1 Stand-alone document (with cross-references to full IFRSs)

IFRS for Private Entities is intended to be a stand-alone document with cross references to full IFRSs in specific circumstances. Most commentators agreed that there should be a stand-alone document for private entities with no cross references to full IFRSs and that it is necessary to distinguish on the basis of public and non-publicly accountable entities. It is argued that this would be less burdensome for the preparers of financial statements of private entities as there would be only one reference point for all financial reporting requirements that is applicable to them.

A Board member however disagreed about having a stand alone document. The Board explained that the accounting policy decisions of a Private Entity "are straightforward." [5] The CFA Institute for Centre for Financial Market Integrity also commented that, "different reporting standards will lead to the delivery of information that is not consistent with the requirements of Principle 1 of the CBRM." [6] It is their belief that investors should be able to compare the financial statements of all entities regardless of whether such entities are publicly accountable or not and the use of different standards would not make this achievable. This can be seen as a situation where the organisation is protecting its own private interests i.e. the principles in its CBRM.

A better criterion that can be used for differentiating financial reporting is according to users' information needs. BC21 explains that users of private entity financial statements and their information needs are different to those of larger, publicly accountable entities. Hence, different standards should be created to meet these 'different' needs. This criterion implies that a bottom-up approach should be used in the standard setting process where users and their information needs form the basis of creating the standards. ''If it is accepted that the users of financial statements should determine the objectives of financial reporting, their needs must ultimately govern the form and content of financial statements'' (Davies at al. 1999, p.42).

2.2 IFRS for Private Entities is based on the same principles as full IFRSs

The IFRS for Private Entities was developed by extracting the fundamental concepts from the IASB Framework for the Preparation and Presentation of Financial Statements (the 'Framework') and the principles of full IFRSs with appropriate modifications on the basis of users' needs and cost-benefit considerations (ED, p. 5). This approach was described by some commentators as a top-down approach to standard setting. Ernst & Young commented that by using principles of full IFRSs as the starting point, the Board put the objective of meeting users' needs as a secondary rather than a primary priority. This issue of using the same Framework raises two important questions: (a) is it appropriate to use the same conceptual framework for publicly and non-publicly accountable entities? And (b) if a distinction is to be made, is it more appropriate to devise a separate set of standards, or to use an adapted version of existing standards?

According to Drever et al. 2007, p. 68, a ''framework provides the consistency and flexibility inherent in a principles-based system.'' The IASB's approach in terms of using the Framework for both standards (and thus being consistent) can be justified on the grounds that the objective of financial statements for all entities is the same regardless of whether they are public or private (BC27). [7] 

The IASB explains that "full IFRSs were designed to meet the needs of equity investors in companies in public capital markets." If (as explained under Section 2.1 above) these needs are different from that of private entities, it is reasonable to ask why the same principles (i.e. the same Framework) are being used to deal with different situations and may be a separate conceptual framework should be developed for private entities. Conversely, it can be said that a conceptual framework is supposed to lay the foundation for which accounting standards should be set. The fact that the standards are being developed according to the type of entities for example public or private, does not justify any changes being made to the underlying principles. Lever (2006) stated that "the conceptual framework should be the framework for the development of standards; it should not evolve as standards develop." If a separate conceptual framework is created [8] on the basis of different users' needs, it may be better to create a separate set of standards and not use an adapted version of existing standards that were created to meet users' needs that are not the same as users' needs of the proposed standard. As already discussed above, users' information needs should be a criterion for differentiating financial reporting requirements. However, using an adapted version of existing standards (which is what the IASB has done) may be less burdensome and the modification based on user needs is reasonable. However, if this distinction is made and a completely separate standard is created, it may cause a difficult transition to full IFRSs for private entities that grow and go public.

This issue of using the same principles for both entities has also raised concerns regarding recognition and measurement simplifications made by the Board. Commentators noted that the recognition and measurement simplifications were not simple enough to be used by private entities especially the very small ones. The European Commissioner for Internal Market and Services Charlie McCreevy stated that the standard ''was not simple enough'' to be applicable to private entities in the EU (Hanney, 2007, p. 8). Another area of concern is that the proposed default accounting treatment for financial instruments would be fair value on the profit and loss statement which means that some private entities may end up applying more fair value measurements than public entities reporting under full IFRS (Epstein and Jermakowicz, 2007).

2.3 Scope of IFRS for Private Entities

IFRS for Private Entities is applicable to all entities without public accountability i.e. entities that are not listed and not holding assets in a fiduciary capacity for a broad group of outsiders .The definition implies that the standard would be applicable to a wide range of entities- from the large private companies to small and 'micro-sized' entities. The Institute of Chartered Accountants of Scotland (ICAS) commented that the scope of the standard should be "tightly defined" due to the different types of transactions undertaken by large private companies and micro-entities. Part of the IASB's goals in developing the standard is to "develop a standard that will be suitable for, and easily applied by, even the smallest of SMEs- the so-called 'micro-sized' entities with just a few employees'' (Practer, 2007, p. 76).

BC56 states that "IFRS for Private Entities is intended to be a stand-alone document for a typical small entity with about 50 employees." The board notes in the ED that the '50 employee' guide was not used as a size test but used to help it determine the types of transactions and events that should be addressed in the proposed standard. This is contradictory because part of the goal as described above is to make the standard usable by micro-entities with just a few employees and thus using a '50 employee' guide may not be taking into account the sort of transactions encountered by such entities. Can the board also cover all kinds of transactions by using the 50 employee guide, given the vast diversity of private entities? Is the proposed standard going to be easily usable by say a small restaurant with about 7 employees? The activities of the business can be said to be straight forward and as such the standard may be complex for such entities. In response to this issue, the Board explains that the topical organisation of the proposed standard would allow such micro entities to easily identify aspects of the standard that are relevant to them (BC48). In my opinion, it may be better to tightly define the scope of the standard (in line with ICAS's view above) and specify the sort of non-publicly accountable entities that should use the standard. Although as described above, the Board explains that the proposed standard is for a small entity with about 50 employees, it is not clear whether the Board is implying that an entity with say 7 employees would not be able to use the standard.

3 The Current stance of the IASB

The IASB's current stance on the proposed draft IFRS for Private Entities is listed below:

ï‚· The standard would be fully standard alone with no cross references to full IFRSs but still based on the principles of full IFRSs.

ï‚· The standard is applicable to all non-publicly accountable entities; there would be no size test. It would be up to national jurisdictions to decide on what entities adopt the standard.

These are now assessed below:

The IASB proposed that IFRS for Private Entities would be a stand alone document with no cross references to full IFRSs. The Board would bring in complex options into the document and drop all cross references. This would eliminate the possibility of preparers of private entity financial statements of having to refer to two sets of accounting standards when preparing their financial statements. The stand-alone document would therefore help reduce the burden on private entities through the simplification of full IFRSs that have been tailored to meet their needs. The standard can also help to provide easy transition to full IFRSs when the private entities grow and go public into capital markets. Some also explain that the standard would bring cost savings to their organisation. A Controller for Europe for one of the largest companies in the world noted that the newly proposed standard would provide a cost saving of approximately €30 million. This company has a lot of subsidiaries in Europe and currently has to comply with about 22 different national GAAPs. (IFRS for Private Entities September 2008 Webcast). However, given the diversity of private entities and differences in developing and developed countries around the world the stand alone document may still not be suitable for such entities. Private entities that operate on small margins may also find it costly to adopt the proposed standard especially if local standards are really different from the international approach (Drever et al, 2007).

IFRS for Private Entities would still be based on the principles of full IFRSs. This is reasonable because as already mentioned above, the Framework should not evolve with the development of new standards and the underlying principles should stay the same and also because the objective of financial statements is the same for all entities. However, as it has been highlighted that the users' needs of private entities are different from that of publicly accountable entities, it may not be reasonable to use the same principles as the basis for both standards. Drever et al (2007) explain that a different conceptual framework may be required because objectives, strategies and accountability relationships can change rapidly in the private entities and therefore the objectives and concepts underlying full IFRSs may not be suitable for private entities. The European Financial Reporting Advisory Group (EFRAG) also commented that ''We agreed that a top-down approach from full IFRS was a good start for the project, but believe that there is still a need for freedom from full IFRS in order to meet the objectives of an IFRS for SMEs." EFRAG suggested that an analysis of private entities users' needs should be carried before any final decisions are made.

There is no size test as to what entities use the standard. This is a sensible approach on the grounds that if a size test were implemented, what is considered a private entity in a developed economy like the UK may be different to that of a developing economy like Nigeria for example. It is up to the legislators and regulators of national jurisdictions to decide on what entities apply the standard (BC50). This seems reasonable within a principles-based system. However, given the complexity (in terms of recognition and measurement principles) of the standard it may not be usable by micro entities (Shearer 2007). This contrasts part of the goals of the IASB in developing the standard, which is to make it suitable and easily applied by even micro-entities (Practer 2007). According to Tom Jones, Vice Chairman of the IASB, the proposed standard "is designed to appeal to every size of company other than the very smallest" (IFRS for Private Entities September 2008 Webcast). Does this mean that regulation is not required for the smallest of entities? This is another reason why a tightly defined scope for the type of entities that this standard is applicable to is needed.

4 Conclusion

The IASB should carry out an analysis of private entities users' needs (as suggested by EFRAG) in order to develop a conceptual framework and thus a standard to meet those needs. Using the same Framework for both standards after it has been said that the users' needs of publicly and non-publicly accountable entities are different is ineffective. The IASB also needs to tighten the scope of the proposed standard. The non-publicly accountable concept is too broad and may not be usable by the smallest of entities as some commentators argued that there were not enough recognition and measurement simplifications. Until the IASB carries out the above, it may be better to leave these entities to provide information to their users' in a way they believe would meet their needs and thus adopt a free market approach to regulation. Also in support of this view, it can be said that a global reporting standard is not needed due to the diversity and differences that exist in private entities around the world.

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