Why is a conceptual framework necessary
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Introduction
International
Accounting Standards Board (IASB) has begun a mutual project with US Financial
Accounting Standards Board (FASB) to rebuild the existing frameworks and
converge them into a common framework. First, some background. The US
Securities and Exchange Commission (SEC) has proposed that companies required
to file financial statements with the SEC begin replacing U.S General Accepted
Accounting Principles (US GAAP) with International Financial Reporting
Standards (IFRS) beginning in 2014. For all practical purposes this means the
eventual adoption of IFRS (principles-based) for all companies in the United
States(U.S. accounting standards are considered to be rule-based model). The
shift aims to harmonize US accounting standards to an international one in
tandem with the globalization of capital markets.‘Norwalk’ agreement between
the FASB and the IASB was signed paving the way for the creation of more
principles-based accounting standards for global financial reporting
(Wikipedia, 2010).
What is Conceptual Framework?
International
Conceptual Framework of Financial Reporting is a system of interactive
objectives and fundamentals which lays out a set of consistent standards in
preparing financial reports.A conceptual framework is akin to a constitution
that prescribes the nature, function and limits of financial accounting and
financial statements.ed to us by a student in order
to help you with your studies. This is not an example of the work written by
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Why is a conceptual framework necessary?
First, to be
useful, standard setting should build on and relate to an established body of
concepts and objectives. A soundly developed conceptual framework should enable
the IASB or FASB to issue more useful and consistent standards over time. A
coherent set of standards and rules should be theresult, because they would be
built upon the same foundation. The framework should increase financial
statement users’ understanding of and confidence in financial reporting, and it
should enhance comparability among companies’ financial statements. Second, new
and emerging practical problems should be more quickly solved byreference to an
existing framework of basic theory. For example, PandaCorporation sold two
issues of bonds that it would redeem either with $1,000 in cash or with 50
ounces of silver, whichever was worth more at maturity. Both bond issues had a
stated interest rate of 9 percent. At what amounts should the bondshave been
recorded by Panda or the buyers of the bonds? What is the amount ofpremium or
discount on the bonds and how should it be amortized, if the bond
redemptionpayments are to be made in silver (the future value of which was
unknownat the date of issuance)?It is difficult, if not impossible, for the
FASB or IASB to prescribe the proper accountingtreatment quickly for situations
like this. Practising accountants, however, must resolvesuch problems on a
day-to-day basis. Through the exercise of good judgment and withthe help of a
universally-accepted conceptual framework, practitioners can dismiss
certainalternatives quickly and then focus on an acceptable treatment.
Harmonization
of accounting standards is very important. For instance, Multinational
companies doing business in more than one country will find that it is
difficult to comply with more than one set of accounting standards established
by authorities in different nations.
Harmonization
of accounting standards will help the world economy in the following ways: by
facilitating international transactions and minimizing exchange costs by
providing increasingly "perfect" information; by standardizing
information to world-wide economic policy-makers; by improving financial
markets information; and by improving government accountability. International
investment decisions and financial-based management decisions are then made
with less risk.
Furthermore,
harmonization of accounting policy would help provide a "level playing
field" globally. Regulators and auditors will be receiving the same
information, facilitating the evaluation process.
In today’s
accounting environment, there are two formats of accounting systems, namely
principles-based system and rules-based system.Almost all companies are
required to prepare their financial statements according to one of the two
standards. Recently, there has been much debate on whether principle-based
accounting would be more efficient than the popular rules-based accounting, in
the wake of accounting scandals, such as Enron. As a result of the Enron
saga, the current way of accounting has been come under a great deal of
scrutiny.
Rules-based Accounting
Rules-based
accounting such as US GAAP is basically a list of detailed rules that must be
followed when preparing financial statements. Many accountants favor the
prospect of using rules-based standards, because in the absence of rules they
could be brought to court if their judgments of the financial statements were
incorrect. When there are strict rules that need to be adhered to, the
possibility of lawsuits is diminished (Investopedia, 2009). Having a set of
rules can increase accuracy and reduce the ambiguity that can trigger
aggressive reporting decisions by management. The matrix of rules, however, can
cause unnecessary complexity in the preparation of financial statement
Principles-based Accounting
Principles-based
accounting such asIFRS is adopted as a conceptual basis for accountants. A
simple set of key objectives are set out to ensure good reporting, e.g.
qualitative characteristics, faithful representation. Common examples are
provided as guidelines and explain the objectives. Although some rules are
unavoidable, the guidelines are not meant to be used for every situation
(Investopedia, 2009). Precise requirements can sometimes compel managers to
manipulate the statements to fit what is compulsory. The problem with
principles-based accounting is that lack of guidelines can yield unreliable and
inconsistent information that makes it difficult to compare one organization
with another.
When
contemplating which accounting method is best, it must be made
certain that the information provided in the financial statements is
relevant, reliable and comparable across reporting periods and entities.
Increased discussion has pushed accountants towards principle-based
accounting, but it is recognized that the method needs to be
modified to make it more effective and efficient.is essay is an example of a student's work
Disclaimer
To illustrate
thecomparison, for example, depreciation expense for all fixed assets is to be
set at 10 percent per annum of the original cost of the asset until the asset
is fully depreciated.Such a rule leaves no room for judgment or argument about
the amount of depreciation expense to be recognized. Comparability and
consistency across firms and through time is virtually assured under such a
rule. This is a rules-based system.In contrast, under the principles-based
system, depreciation expense for the reporting period should reflect the
decline in the economic value of the asset over the period. Such a standard
requires the application of judgment and evaluation by both managers and
auditors. The goal is to register the realistic value of the asset according to
“as is” basis.
Differences between IFRS and U.S. GAAP
Statement of
Income — Under IFRS, extraordinary items are not segregated in the income
statement, while, under US GAAP, they are shown below the net income.
Consolidation
— IFRS favors 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.
Inventory —
Under IFRS, LIFO (Last In, First out) cannot be used while under U.S.
GAAP,companies have the choice between LIFO and FIFO (First In, First Out).
Using the LIFO method results in lower gross profit, which allows a company
tobe taxed less.
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.
Development
Costs — These costs can be capitalized under IFRS if certain criteria are met,
while it is considered as “expenses” under U.S. GAAP(Remi Forgeas, 2008).
Advantages
Rules-based
System
Increasedaccuracy,
reduced ambiguity and a diminished possibility of lawsuits.
Rule-based
standards are generally considered easier to audit for compliance purposes, and
may produce more consistent and comparable financial reports across entities.
Auditor
display higher confident in decision making because they have a bright-light
guidelines.
Principles-based
System
The
fundamental advantage of principles-based accounting is that its broad guidelines
can be practical for a variety of circumstances
Potentially
very flexible with regard to new and changing products and environments. As
such, they should also require less maintenance.
Another
advantage of a principles-based system is that it would result in simpler
standards. Principles-based system would lead to standards that would be less
than 12 pages long, instead of over 100 pages.
Accountants
are afforded the flexibility to input their expertise and judgment more freely
in line with the professional code in producing the financial statements. Such
deployment of their skills and experience will enhance their professionalism.
Disadvantages
Rules-based
System
Lack of
transparency of disclosure. In the wake of recent accounting scandals, such as
Enron and Worldcom, investors are becominghypersensitive to the reliability of
published accounts and suspicious of the possibility of inflated earnings.
The major
drawback to a rules-based system is the complexity in the preparation of
financial statements
May include a
lack of flexibility with regard to changing conditions and new products, hence
requiring almost continual maintenance at times.
Frequently
subjectto manipulation as entities may search for loopholes that meet the
literal wording of the standard but violate the intent of the standard.
Principles-based
System
Critics of a
principles-based approach argue that financial statements are more difficult to
audit andwould likely lose their comparability and consistency across
industries and issues regarding income measurement and recognition would remain
controversial. For example, how much income will General Electric actually
recognize on a multi-year defense contract under the percentage of completion
method of accounting? Will this be comparable to the income reported by its
competitors?
To the extent
that they rely on individual judgment to interpret and implement the standards,
there is a danger that they can be used to manipulate financial results. For
example, what ifthe auditors behaving badly? Abuse their trust and fail to
apply the principles in "good faith consistent with the intent and spirit
of the standards."
Auditors
display less confidence in their decisions.
Between the
rules-based and principles-based modules, it is felt that the latter will be
more practical and preferred by the global community, given its universal
appeal based on ethics, sound judgment, transparency, credibility and even
downright common sense factors. Moreover, in the globalised business arena,
this system would be easier to adopt, comprehendThis essay is an example of a student's work
Disclaimer
This
essay has been submitted to us by a student in order to help you with your
studies. This is not an example of the work written by our professional essay
writers.
and acceptable
as against rigid rules that may be interpreted differently from one country to
another.
Example Cases
Enron Case
U.S.
accounting standards are considered to be rule-based model. For example, we
look at the Enron scandal, which broke in October 2001 and eventually led to
the collapse of the Enron Corporation. Through the use of accounting loopholes,
special purpose entities (SPE), and poor financial reporting, Enron was able to
cover up billions of dollars in debt from failed deals and projects.In the U.S,
Accounting law allows a company to exclude a SPE from its own financial
statements if an independent party has control of the SPE, and if this
independent party owns at least 3 percent of the SPE.
Enron needed
to find a way to hide the debt since high debt levels would lower the
investment grade and trigger banks to recall lendings. Using the Enron’s stock
as collateral, the SPE, which was headed by the CFO Fastow, borrowed large sums
of money. And this money wasused to balance Enron’s overvalued contracts. Thus,
the SPE enabled Enron to convert loans and assets burdened with debt
obligations into income. In addition, the taking over by the SPE made Enron
transfer more stock to SPE. However, the debt and assets purchased by the SPE,
which was actually burdened with large amount of debts, were not reported on
Enron’s financial accounts.
Enron was
also guilty of using a dubious mark-to-market accounting system in its forward
gas contract sales whereby income was estimated as the present value of net
future cashflows to indicate “true economic value”. When these projects
faltered, income was still recorded based on the initial value which of course
was incorrect. As a result more projects had to be “created” to sustain a
steady income inflow to appease the shareholders.
Conclusion
Personally, I
do notfavor relying on either principles. Without credible principles, the
rules are meaningless. Without rules the accountants are not protected.
We had
principle-based rules up until the IASB/FASB was created. The more specific
rules or guidance were issued following lawsuits against auditors or
accountants, questioning their professional judgment. The profession felt that
to issue specific rules would reduce the likelihood of lawsuits against the
accountant’s professional judgment. Interestingly, we are now coming full
circle and looking to simplify how accounting is interpreted. We will make this
switch and then in another 10-20 years, if another accounting scandal arises
and everyone will ask for more rules again?
However, we may be well served by
acknowledging that neither a purely rules-based nor a purely principles-based
system will be the best option on its own. Perhaps a largely principles-based
system policed by a simple rules code could be the ideal solution.Any set of
rules will be subject to someone's interpretation. The rules will only be as
good as those who use them.
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