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This assignment is to evaluate how the qualitative characteristics in the Framework contribute to the decisions made by investors. At the same time, we will summarize the purpose of the International Financial Reporting Standards Framework for the Preparation and Presentation of Financial Statements. Furthermore, examples will be given along the discussion and evaluation of the need of develops an agreed international conceptual framework. By the way, the IASB's principles-based international accounting standards and the US FASB's rules-based standards also will be evaluate to see whether which one is more acceptable for global users of financial statements. The advantages and disadvantages of each system also will be discussed. This assignment will be done and analyzed based on the secondary resources such as Financial Reporting Standards textbook and the information gathered from the internet as well as the idea given by the senior lecturer.
Summarize the purpose of the IFRS Framework for the Preparation and Presentation of Financial Statements and evaluate how the qualitative characteristics in the Framework contribute to the decisions made by investors.
The IFRS framework describes the basic concepts that underlie the preparation and presentation of financial statements for external users. This framework deals with the objective of financial statements, qualitative characteristics, definition, recognition and measurement of the elements from which financial statements are constructed as well as the concepts of capital and capital maintenance. The purpose of this framework is to assist the Board of International Accounting Standard Committee (IASC) in the development of future International Accounting Standards and in its review of existing International Accounting Standards.(IFRS-portal.com, 2010). Besides, it also helps the Board of IASC in promoting the harmonization of regulations, accounting standards and procedures that are related to the presentation of financial statements.(IFRS-portal.com, 2010). At the same time, it provides a basis for reducing the number of alternative accounting treatments permitted by International Accounting Standards. By the way, it also assists the people who are preparing for the financial statements to apply the International Accounting Standards.(IFRS-portal.com, 2010). In addition, the auditors also can get an opinion whether the financial statements conform to the International Accounting Standards through this framework. (L.T. Tan, 2010). The users of financial statements also can use this framework to help them to interpret the information that is contained inside the financial statement in order to conformity with the International Accounting Standards. Lastly, this Framework also provides information about its approach to the formulation of International Accounting Standards for those who are interested in the work of IASC with information. (L.T. Tan, 2010). These purposes will help the users in their preparation and presentation of financial statements.
Qualitative characteristics are the attributes that make the information provided in financial statements useful to users. Basically, the four principal qualitative characteristics are understandability, relevance, reliability and comparability.(A., Melville, 2008). For the understandability, there are many different users and decisions makers. The level of accounting and business knowledge they process, the methods of decision-making they employ, the ability to process the information, the information they already process and their ability to obtain additional information differ among various decision makers. It is assumed that users of financial information have a reasonable knowledge of business, accounting and economic activities and, with due diligence, will be able to analyze the information provided.(Iasplus.com, 2011). Next, the relevance is the information that can influence the economic decision of users. The useful information on present and future events can be derived by evaluating from the past. For information to be useful, it has to be relevant to the decisions that are being made.(Iasplus.com, 2011). The reliability indicates that the financial information is reliable if it is free from error and bias, and represents faithfully the events and transactions that have occurred. Reliable information reflects the events or transactions that have taken place. If the financial statements are prepared under conditions of uncertainty, then caution is advised in exercising judgment and in making any estimates. In other words, prudence is to be applied. (B., Elliot, 2009). For the comparability, users need to compare information between entities and over a period of time. The information from different entities is comparability if there is consistency in the accounting treatment of the economic events and transactions over time and in the disclosure of accounting policies. In absence of any of the above-mentioned characteristics, it will cast doubt on the information supplied by the entity. (B., Elliot, 2009)
Besides, there are some other characteristics that may add some value. There other characteristics are timeliness, verifiability, prudence and faithful representation.(A., Melville, 2008). The timeliness indicates that information is available to decision-makers in time to be capable of influencing their decisions.(A., Melville, 2008). Besides, the verifiability measures that the information is reliable if it can be verified by various means. Transactions are always recorded by examining source documents that will form the evidence for the transactions.(A., Melville, 2008). Next, the prudence requires prepares of financial statements to be cautions in the exercise of judgment to ensure that income and assets are not overstated and expenses and liabilities are not understated. For example, if the net realizable value of inventory falls below cost, the loss is recognized immediately and the inventory will be valued at the lower value.(Iasplus.com, 2011). In additional, the faithful representation purposes the financial reports represent economic phenomena in words and numbers. To be useful, financial information must consists of relevant and also represent faithfully the phenomena it purports to represent. For example, a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the enterprise at the reporting date which meet the recognition criteria.(Iasplus.com, 2011).
Investors are made up with the present investors, prospective investors and their advisors from a large group of users of financial reports. The investors are the providers of risk capital and their advisers are concerned with the risk inherent in and return provided by their investments.(L.T. Tan, 2010). Therefore, they are interested in the performance of the entity and the stewardship of the resources and the ability of the entity to pay the dividend. Under normal circumstances, investors will need information to determine whether they should buy, sell, or hold their shares in the entity. So, all of the qualitative characteristics as stated above should be carefully analyze by the investors before they invest or make any decisions. If they found that the information is not relevance or is not suit one of the principal as stated above, they should reconsider before make any decision. (L.T. Tan, 2010)
Using examples to illustrate your answer, critically evaluate and discuss the need to develop an agreed international conceptual framework and whether the IASB's principles-based international accounting standards are more acceptable for global users of financial statements than the US FASB's rules-based standards.
The objective of the international conceptual framework is to develop in the public interest with a single set of high quality, understandable and enforceable global accounting standards. It requires transparent and comparable information in financial statements and other financial reporting to help participants in the world's capital markets and other users make economic decisions. Furthermore, it promotes the use and rigorous application of those standards. Moreover, it provides information which helps users in terms of their evaluations and decisions. At the same time, it brings about convergence of national accounting standards and International Accounting Standards and International Financial Reporting Standards to high quality solutions.
As we known, the needs of an agreed international conceptual framework are very important and had been discussed above. But the problem is which standard is more acceptable for the global user. First of all, the worldwide accounting is governed by either one of the governing bodies which is International Accounting Standard Board (IASB) or Financial Accounting Standard Board (FASB) (Vitez, 2010). IASB governs accounting in 150 countries worldwide including England and the members of European Union by referring to the official website of IASB. By the way, the IFRS is a set of accounting standards for formal financial reporting which were developed by the International Accounting Standards Board (Vitez, 2010). However, FASB is a non-organization whose primary purpose is to develop, adopt, and issue the US GAAP (Generally Accepted Accounting Principles). (Trusty, 2011). US GAAP covers all accounting in the US. According to the article from the Wharton Business School at the University of Pennsylvania, it written that "For example, while U.S. GAAP is based on rules and specific details, International Financial Reporting Standards tend to be more broadly based on principles." This sentence simply means that US GAAP is largely rule-based while the IFRS are principles-based international accounting standards (Adam, 2007).
The rule-based accounting standards require accountants to follow a listed of specific rules when preparing the financial statements. Rule-based accounting standards have very widely and intact detailed explain in concerning what is or is not allowed. For example, if a factory leases a machine, the company must follow the specific rules to determine whether the transaction is an operating lease or a capital lease (Alexander and Jermakowicz, 2006). The characteristics of rule based accounting standards consists of bright-line thresholds, scope and legacy exceptions, large number of implementation guidance, and a high level in detail (Mergenthaler 2009). In case, many accountants are favour in using the rule based system because if there is an absence of rule, accountants need to judge and prepare the financial statements based on their perceptive. By the way, if their judgment of financial statements is wrong, they might be brought to court. In addition, when there are strict rules need to be followed, the possibility of lawsuit will decrease or even didn't exist.(Togeeze, 2008).
The advantages of this standard are generally easier to audit for compliance purposes, and may produce more consistent and comparable financial reports across entities. Because of this rule, the format of financial statements of all the public companies is the same. Thus, their financial reports are more comparability.(Schipper, 2003). For example, the directors or other users can compare their financial reports with other companies easily. The disadvantage of this standard is frequently easier to "Game", as accountants may search for loopholes of the standard to violate the intent of the standard. A "bright-lines" tests which is provided by rule-based accounting standard can easily be avoided. Hence, accountants can play around the rule, and manipulated the result. Another disadvantage is lack of flexibility with regard to changing conditions, trend and new products. Besides, it also limited the use of judgement of accountants in their implementation, just because of this standard had a rule to follow. By the way, it will require almost continual maintenance at times. It is because the rule was fixed but the real-world environment is keep changing. So, the bodies need to keep continual maintenance, develop, and adopted the accounting standard in order to meet the demands (Basiccollegeaccounting.com, 2006).
On the other hand, the IASB's principles-based international accounting standards is based on the conceptual framework of accounting which includes decision usefulness, true and fair view, going concern, substance over form. This standard takes the form of general principles, and requires largely interpretation and judgment by the accountants before they can be implemented. The principles-based accounting not only increases the potential for different interpretation, but also provides guidance in other areas.(Adam, 2007). Although some of the rule is unavoidable, but the guidelines and rules set are not meant to be applied in every situation.(Togeeze, 2008). The characteristics of principles-based accounting standards including faithful presentation of economic reality, responsive to user's needs for clarity and transparency, based on an appropriately-defined scope that addresses a broad area of accounting and the use of reasonable judgment (A. DiPiazza, Jr., 2008).
The advantage of principles-based accounting indicates that its broad guidelines can be practical and applied to variety circumstances. Broad principles avoid the pitfalls associated with precise requirements that allow contracts to be written specifically to manipulate their intent. A relevant case is 'A 1981 study sponsored by FASB found evidence that accountants purposefully try to structure leases as operating leases to avoid incurring additional liabilities.' Therefore, providing broad guidelines may improve the representational faithfulness of financial statements. Another advantage is it would result in simple and clear standards. The principles-based accounting system would lead to standard that would be less than 12 pages, rather than over 100 pages.(Herz, 2002). The principles would be easy to understand and can be implemented to a broad range of transactions. Harvey Pitt, who is a former SEC chairman, claimed that 'Because standards are developed based on rules, they are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent' (Pitt, 2002).
In addition, principles-based accounting standards allow the accountants to apply professional judgement in assessing the substance of a transaction. Chairman of FASB (Herz) stated that the professionalism of financial statements would be enhanced if accountants are required to using their judgment rather than relying on detailed rules (Herz, 2002). Furthermore, this type of accounting standard reflects the actual performance of company's financial statement accurately. In case, Australian Securities and Investments Commission Chairman David Knott has stated, an increase in principles-based accounting standards would reduce manipulations of the rules (Nationwide News, 2002).
The disadvantage of principles-based accounting standard is lack of precise guidelines which could lead to inconsistencies in the application of standards across organizations. For example, companies are required to recognize both an expense and a liability for a contingent liability that is probable and estimable. On the other hand, a contingent liability that is reasonably possible is only reported in the footnotes. With no precise guidelines, how should companies determine if liabilities are probable or only reasonably possible? The lack of bright-light standards may reduce comparability and consistency which is basic perceptive of financial accounting (Trogulj, 2008). Another disadvantage of this accounting standard is because of the extent that they rely on individual judgment to interpret and implement the standards. It produces the unreliable and inconsistent information that make it difficult to compare.(Basiccollegeaccounting.com, 2006).
After the evaluation and discussion of these 2 systems, it shows that they are purely different. There are some examples of impacts between this two systems on the financial statements and therefore on the conduct of businesses.
First one is Consolidation. IFRS favours a control model whereas U.S. GAAP prefers a risks-and-rewards model. Some entities consolidated in accordance with FIN 46(R) may have to be shown separately under IFRS.
Second is Measurement of Inventory. Under IFRS, LIFO cannot be used while under U.S. GAAP, companies have the choice between LIFO and FIFO.
Third is Income statement. Under IFRS, extraordinary items are not segregated in the income statement, while, under US GAAP, they are shown below the net income.
Fourth is Improvement costs. The improvement costs can be capitalized under IFRS if certain criteria are met, however the development, improvement cost is recognised as 'expenses 'under U.S. GAAP (Forgeas, 2008).
'Without principles the rules are meaningless' (Estiben, 2006). After looking at the both characteristics, we think that the IASB's principles-based accounting standards are more acceptable for global users of financial statements because a principle is more open to interpretation as compare to a rule. We conclude such a way because the current rules-based system is too complex and not transparent enough for users of financial statements. However, the principles-based approach is supported by the International Accounting Standards Board and proponents of the principles-based approach believe a change is necessary in a global economy. Besides, the global users of financial statements are always tried to see the company actual performance and other relevant information of the company. The principles-based accounting standards provide more minimal guidance, greater use of professional judgments and other advantages which are global users of financial statements wanted.(Sdriscoll, 2006). Therefore, the global users of financial statements will be more acceptable principles based system as compare to the rule-based system.
From the evaluation and discussion above, it shows that the purpose of the IFRS framework plays an important role in the Preparation and Presentation of Financial Statements. Moreover, the qualitative characteristics such as understandability, relevance, reliability and comparability are very important and useful to the investors as it might influence their decisions. Besides, the principles-based is overall good enough as compare to the ruled-based. The principles-based can be practical and applied to variety circumstances and it may improve the representational faithfulness of financial statements. However, the ruled-based sometimes might lead to inconsistencies in the application of standards across organizations and make it difficult to compare. As a result, we can conclude that principles-based is better and should be preferable to the financial statements' users.