Financial Reporting: Rethinking Approach

This assignment delves into the current state of financial reporting, questioning the effectiveness of traditional methods in capturing relevant financial information. It encourages students to examine the conceptual framework for financial reporting, considering trade-offs between qualitative characteristics like reliability and relevance. The discussion focuses on the role of revenue recognition in performance reporting and potential shifts towards alternative approaches in light of developments within the field.

ACCOUNTING THEORY

Accounting theory
Answer to 1
Relevance and faithful representation are considered the most fundamental qualities of reporting
financial information to the users and both characteristics are necessary in order to implement
good decisions. Besides, attainment of representational faithfulness and relevance is subject to
the advantages from such characteristics surpassing the costs of endeavoring to attain them.
Relevance is that qualitative characteristic that assists in identification which financial
phenomena must be reported. Besides, relevant information possesses confirmatory and
predictive value and once it becomes recognized, faithful representation occurs. Such
characteristic provides that financial information is useful if it not only depicts relevant financial
phenomena but also faithfully depicts then as neutrally, completely, and free from all errors
(Deegan, 2011). Relevance can be considered the most fundamental characteristic in conceptual
framework because faithful representation can prove to be of fundamental importance only when
it is expressed as a part of a wider fundamental characteristic that is based on reliability.
Regarding relevance, information can be regarded as relevant if it is capable of making a
variation in the decision-making process of users. In contrast to this, information is said to be
faithfully represented if financial information is complete, free, and neutral from errors. Both
characteristics are significant for users in decision-making (Northington, 2011). However, there
is a debate regarding the most significant characteristic among the two.
Based on the IASB, professional judgement is immensely necessary for ascertaining whether the
financial information forming part of financial statements align to faithful representation or not.
The current conceptual framework depicts faithful representation as an important condition of
reliability. However, there is a big risk that the financial information might be lesser than a
faithful representation of what it intends to portray (IASB, 2010). This is not because of biases,
but because of inherent complications in recognizing the transaction. This can be the reason why
often internally generated goodwill cannot be recognized in the financial statements. Particularly,
intensive utilization of accounting estimates plays a key role in diminishing the value of faithful
representation in the financial statements (ANZ, 2008). Besides, non-recurring estimates of
accounting like restructuring expenses, in-process research, etc hamper the faithful
representation concept. Furthermore, based on various surveys, it was found that low levels of
faithful representation in financial statements only marginally affected the relevance concept.
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Accounting theory
Based on the requirement of the conceptual framework, the financial information must be
completely free from errors in order to prove faithful representation but the International
Accounting Standards Board acknowledges that the same cannot be achieved in every aspect. In
simple words, information may be material in order to prove its relevance to the users but
faithful representation may not be truly achieved in all respects. Predictive value in the current
scenario is the most relevant indicator of relevance in relation to the usefulness of decision-
making and measurement of predictive value by using three different items. Firstly, the forward-
looking statements offered by annual reports of a company assist in explaining the
management’s expectations for the upcoming years of the company (Wagenhofer, 2014). This
information is relevant for capital providers and others because management has prior access to
private data to establish a forecast that cannot be attained by other stakeholders. If the
information is not relevant in nature, it cannot adhere to the fulfillment of faithful representation.
Moreover, in relation to annual reports, the faithful representation cannot be measured because
the data about the actual financial phenomenon is required to assure it. All these concerns clearly
justify the fact that relevance is more important than faithful representation.
Given the nature of accounting standard, it has become very difficult for preparers to achieve
faithful representation. For financial statements to be reliable and relevant, financial data must be
properly capable of consistent measurement and, based on the accounting standards, it must
faithfully represent what it intends to present. However, in the recent years, the corporate world
has to encounter immensely complicated transactions and relevant changes in how information
must be presented and prepared (ANZ, 2008). For instance, the rise of fair value technique
involves huge valuation methods that pose a challenge for the accountants to tackle. Besides,
they are under an obligation to evaluate the accuracies of such methods and consider whether
complicated valuations have been done properly and whether effective sources of information
have been taken into consideration. Further, changes in accounting standard setting may have
huge implications for an organization. Besides, it thus seems like such accounting standard
setting can interact with both management control system and strategies of an organization.
Hence, tension betwixt both of these may take on different forms that necessitate the requirement
of financial accounting regulations (Landsman et. al, 2014). If such accounting regulation
changes, the practices also change in a way that they cannot be easily tracked but can have major
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Accounting theory
implications on the financial statements. With constant variations in accounting regulations,
attainment of faithful representation becomes doubtful.
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Accounting theory
Answer to 2
A historical cost can be defined as a measure that is used in accounting where the price of the
asset on the balance sheet depends on the nominal or original cost when acquisition is done by
the company. It is a popular method used for assets under the GAAP module.
Historical cost accounting suffers from various criticisms and it is due to the fact that various
alternatives came to the forefront. In the case of historical costing, the assets are recorded at the
original cost and continue to utilize the historic figures throughout the life of the asset and the
time value is eliminated completely (Parrino et. al, 2012).
Moreover, there has been an instance of irrelevance that happens in times of a price rise. It is
even questioned whether is of utility to be intimated regarding the cost that was in the past years
and its comparison with the current year. As a matter of fact there appears a deficiency in terms
of additivtiy.
The Historical cost suffers from various shortfalls and hence, it is needed to refer to the
normative alternatives. The first alternative to Historical cost is the current cost accounting that
strives to provide book values that are realistic in nature by valuation of the assets at the present
level buying prices. The Historical costing have an assumption for the inventory cost flow like
the LIFO and weighted average. The business profit that is generated in the case of CCA reflects
how the entity has enriched itself in financial terms and the increment in the cost of resources
which is altogether ignored by the cost accounting (Melville, 2013). When it comes to the
historical costing, it can be stated that such a method do not take into consideration the changing
prices and hence, will overstate the profits in the case the price rises and the profit distribution
can lead to destruction of the operating capacity.
Secondly, the exit price accounting is an alternative that defines the assets that is valued at exit
prices and that the financial statements must perform to intimate the capacity of an organization
to adapt to the scenario. When it comes to the point of historical cost it suffers from the
disadvantage of relevance when it comes to the price rise. There is a difference in terms of
logical addition to the assets that is acquired over different point of time with the ones acquired
with dollars of various purchasing powers. The historical costing will fail to serve the decision
making process of the investor and therefore the financial statement will not serve the purpose. It
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Accounting theory
is needed that the accountant must showcase the profit and losses as computed in the competitive
market. The marketable assets must be valued at market price.
The third alternative being the positive accounting theory and the Efficient market hypothesis.
The min potency of the theory rests in the fact that it strives to provide an understanding of how
the world operates instead of telling how the world should work. On the other hand, PAT tries to
make an understanding of the link and connection between many accounting information, firms,
managers, etc (William, 2010).
Going by the overall discussion it can be said that the historical cost suffers from various
disadvantages and that the alternatives helps in providing adequate answers to the problem that
are unanswered. The current cost accounting is better placed and it provides meaningful
information to the investors. This concept takes into consideration the time value of money and
inflation which is altogether ignored by the historical cost.
Going by the concept of CCA it can be said that it provides information that is meaningful
however, all the qualities cannot be commented as correct. Therefore, getting a method which is
totally correct is a tedious task because ultimately there are various problems in the concept.
Success can be reaped if the organization follows the policy that suits the organization and its
operations (William, 2010). However, success ratio will depend upon the scenario and the
manner in which the implementation is being done.
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Accounting theory
Answer to 3
According to the IASB, a conceptual framework is not something that is found, instead, it is
constructed. It accommodates pieces that are borrowed from different places but the structure is
something that is built and not something, which prevails ready-made. The key building blocks
of the conceptual framework are a combination of prior theory, experiential knowledge, and
research (Seilber, 2015). On a whole, firstly, in relation to experiential knowledge, the same
offers evidence that the financial information in the financial statements has significant potential
for practice and is more likely to contribute towards the ongoing discourse associated with the
topic. The second key block of conceptual framework depicts the significant traditions that play
a key role in guiding the study (Ryan, 2001). The third block plays a key role in identifying the
loopholes that are known. This is done by implementing prior research processes or by
identifying various other policies and practices that are not operating properly.
The advantages of a conceptual framework comprising of concepts developments in a way that
can enhance financial reporting, maximize the overall communication, enhance the compatibility
of accounting standards, etc. With the assistance of a conceptual framework, accounting
standards can be well developed. Besides, the principles that are set in the Financial Accounting
Standards Board are appropriately established and can be applied to particular situations wherein
no relevant accounting standards prevail (Seilber, 2015). Various accounting advantages might
result from the development of conceptual frameworks. Firstly, the FASB have recommended a
new project namely the Revenue Recognition Project within the conceptual framework that may
enhance its usefulness. This project can play a key role in addressing any inaccuracies or
inappropriateness that forms part of the financial statements betwixt the earning procedures and
definition of various elements (IASB, 2011). The second accounting advantage that may result
from the development of conceptual framework is the fair value project that can play a key role
in considering the procedures of application of relevance and reliability so that an effective
measurement output can be selected. On a whole, with the development of conceptual
frameworks, development of accounting standards can be done in an easier way that is
economical as well in terms of cost (Graham & Smart, 2012). In the presence of a defined
conceptual framework, the standard-setters can be made more responsive to the users of financial
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Accounting theory
statements, and reporting with such users are made clearly aware so that they are able to identify
the departure from principles set out in the ASB (Tysiac, 2015).
Even though there are various advantages to a conceptual framework, yet there are various
limitations as well. Firstly, a conceptual framework can be more of a general nature in reality.
This is because the principles forming part of the framework highly depend on assumptions that
may not prove to be useful to the users (Davies & Crawford, 2012). This can be justified by the
fact that while preparation of financial statements; accounting standards may be proved
theoretical in nature, thereby resulting into frauds. Further, there are immense complications in
understanding the conceptual framework that may prove difficult for the users in making
decisions and preparers in preparing the reports as well. In addition, the basic accounting
principle within which the conceptual framework relies upon is directly attributed in monetary
terms. The justification behind such limitation is that both financial and non-financial
information must be prioritized by the accounting principle and only monetary concerns cannot
enable in enhancing the decision-making ability of users (Davies & Crawford, 2012). Besides,
there is a belief that other perspectives of operations like an organization’s influence on the
broader community and the natural environment also play a relevant role in investment decisions
on the part of investors. Therefore, since economic phenomena are given due preference, this
belief may not be fulfilled. On a whole, taking into account these issues in the conceptual
framework, a variety of standards is the need of the hour because a single standard cannot
address the requirements of every user. Moreover, in the search for simplicity and common
grounds, the conceptual framework must cover various generalizations that suffer from
inadequacies (Needles & Power, 2013). Corporate failures like Enron, Arthur Andersen occurred
even though they depicted financial reports accommodating good stewardship of management.
Hence, with too much reliance on the assumption of objectivity in the conceptual framework,
potential misuse of goodwill was done by these corporates and this sheds light on the criticisms
of the conceptual framework in the current scenario. Moreover, revision and developments have
been proposed by the FASB and IASB to address disparities in corporate reporting (Laux, 2014).
Such recommendation for alteration of approach comes alongside developments in the
conceptual framework that includes a trade-off betwixt other qualitative characteristics like
reliability, comparability, etc (Tysiac, 2015).
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References
ANZ 2008, The Objective Financial Reporting Qualitative Characteristics and Constraints of
Decision-useful Financial Reporting Information, viewed 28 August 2017
http://www.aasb.gov.au/admin/file/content106/c2/ED164sub4.pdf
Davies, T & Crawford, I 2012, Financial accounting, Harlow, England: Pearson.
Deegan, C. M 2011, In Financial accounting theory, North Ryde, N.S.W: McGraw-Hill
Graham, J & Smart, S 2012, Introduction to corporate finance, Australia: South-Western
Cengage Learning.
IASB 2010, The Conceptual Framework for Financial Reporting, viewed 28 August 2017
http://eifrs.ifrs.org.
IASB 2011, International Financial Reporting Standard 13. Fair Value Measurement, viewed
28 August 2017 http://eifrs.ifrs.org>
Landsman, W. R, Maydew, E. L & Thornock, J. R 2014, ‘The information content of annual
earnings announcements and mandatory adoption of IFRS’, Journal of Accounting and
Economics, vol.53, pp. 34-54.
Laux, B 2014, ‘Discussion of The role of revenue recognition in performance reporting’,
Accounting and Business Research,vol.44, no.4, pp. 380-382.
Melville, A 2013, International Financial Reporting – A Practical Guide, 4th edition, Pearson,
Education Limited, UK
Needles, B. E & Powers, M 2013, Principles of Financial Accounting. Financial Accounting
Series, Cengage Learning.
Northington, S 2011, Finance, New York, NY: Ferguson's.
Parrino, R, Kidwell, D & Bates, T 2012, Fundamentals of corporate finance, Hoboken, NJ:
Wiley
Ryan, J.B 2001, Measurement in financial accounting: critical support for historical cost,
viewed 28 August 2017 http://ro.uow.edu.au/cgi/viewcontent.cgi?article=2022&context=theses
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Seilber J 2015, FASB removes concept of extraordinary, retains guidance on unusual item,
viewed 27 August 2017, http://www.pwc.com/us/en/cfodirect/assets/pdf/in-brief/us2015-01-
fasb-extraordinary-unusual-items.pdf
Tysiac K 2015, No more extraordinary items: FASB simplifies GAAP, viewed 27 August 2017,
http://www.journalofaccountancy.com/news/2015/jan/gaap-extraordinary-items-201511630.html
Wagenhofer, A 2014, The role of revenue recognition in performance reporting,
OxfordUniversity Press
William, L 2010, Practical Financial Management, South-Western College.
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