The Importance of Faithful Representation
Questions:
1.Conceptual frameworks have identified a number of qualitative criteria that financial information should possess if it is to be useful to decision making?
2.Identify the weaknesses of historical cost accounting. In light of these weaknesses, why do you think historical cost accounting remains the most popular method of accounting measurement?
3.The Conceptual Framework Chapter 1 OB2 states that “the objective of general purpose financialvreporting is to provide financial information about the reportingventity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity?
1. Financial statement is one of the most important factors in the financial aspects of business organization. Financial statement refers to the formal records of all the financial activities and transactions of a business (Kim, Kraft & Ryan, 2013). One of the most important factors in the preparation of financial statements for the organizations is the faithful representation of those financial statements. Faithful representation of the financial statements refers to a concept that states that all the financial statements of the business organizations must reflect the actual financial condition of the organizations (Barth, 2013). Faithful representation of the financial statements is necessary for every business organizations irrespective of size and type of the organization. There are three major attributes of the process of faithful representation; all the business organizations must follow these three attributes at the time of the preparation of the financial statements. They are completeness, error free and unbiased (Abeysekera, 2013).
The first attribute states that all the financial information provided in the financial statements of the companies must be complete in nature. It implies that the financial information of the organizations must reflect the actual financial position of the organization (Palea, 2013). As per the second attribute, the financial statements of the business organizations should not have any kind of errors in them. Financial statements containing a series of errors lead to the misinterpretation of the actual financial position of the business organizations (Kadous, Koonce & Thayer, 2012). The third attribute suggest that the financial statements of the business organizations must not have any kind of biasness in them. Biasness happens when the financial statements of the organizations are being manipulated to provide a different financial picture of the organization. The accountants must not be biased at the time of making the financial statements (Weil, Schipper & Francis, 2013). These are the three major attributes of the faithful representation of the financial statements.
The Australian Accounting Standard Board, commonly known as AASB, has a significant role to play in the faithful representation of the financial statements of the business organizations (Henderson et al., 2015). As per the AASB Framework Chapter 3 QC 12-16, the financial statements of the organizations include economic phenomena in words and numbers. In order to be useful for the readers of the financial statements, these financial phenomena must be represented correctly and they must be faithfully represented to the users of them. Another important concept in the faithful representation in the AASB framework is neutrality (Luttermann, 2012). As per the AASB framework, neutrality in the financial statements implies that the financial statements of the organizations must be free from any kind of biasness. Hence, it can be observed that the concept of neutrality is a crucial aspect in the process of faithful representation of the financial statements. In the process of faithful representation, one of the major concerns is that is it possible to present the financial information faithfully and neutrally. After considering the conceptual framework of AASB, it can be said that the faithful and neutral presentation of the financial statement of the business organizations is possible. As per the conceptual framework of AASB, the empirical accounting researchers have found some major evidences that it is possible to present the financial statements faithfully and neutrally (Quadackers, Groot & Wright 2014).
Concepts of Faithful Representation
It can be seen that there is not any kind of specific measure for the purpose of faithfully and neutral representation of the financial statement. However, there are many ways to do this. The decision making process of the organizations does not depend on the faithful or unfaithful representation of the financial statement. Some major aspects need to be there in the process of faithful representation. The first aspect is comparability. All the financial information in the process of faithful representation must be comparable. The reliability of the financial information in the financial statements increases when they can be compared to the same kind of information from any other financial statement (Bodie, 2013). The compared financial information may not be useful for the business organization, but they will sure be faithful for the business organization along with the users of them. The next important aspect in faithful representation is verifiability. It is a fact the verified information can be used with confidence (Ball, Jayaraman & Shivakumar, 2012). In today’s world, the investors take greater risks by depending on the provided financial information in the financial statements. Hence, the information is desired to be verified. The verified information may not be always useful for the users, but the faithfulness and neutrality makes them precious to the users of the financial information. Another important aspect is timeliness of the provided information.
The concept of timelines states that the financial information in the financial statements must be recent. In addition, the financial statements must be used in a quick period. The inclusion old or expired information in the financial statements of the business organizations may falsify the true financial position of the organizations. The most important aspect is understandability. It is desired that the information provided in the financial statements must be understandable for the users of them. Understandability implies that the presented information in the financial statements of the organizations must be clear to the users; in addition, they must be fundamentally correct. From above discussion, it can be said that with the help of these aspects, it is actually possible to represent the financial information faithfully and naturally. In this regard, the financial standard makers need to take some initiatives. In the conceptual framework, the financial standard setter should include some examples or references of the process of faithful representation of financial data so that the accountants can follow this. This will provide them a clearer picture about the process of faithful and neutral representation of financial information in the financial statements of the companies.
2. Historical cost is a process of measuring the value of the asses. In the process of historical cost, the value of an asset in the balance sheet is taken based on the nominal cost or original cost when acquired by the company or organization. There are both weaknesses and merits of HCA. In order to analyze the popularity of this process, it is necessary to evaluate both weakness and metros of this process.
It can be seen that there are some major weakness of historical cost accosting (HCA). In the HCA, the recent changes in the price level are not taken into consideration. Due to this reason, the financial statements under HCA fail to show the true financial image of the organization (DRURY, 2013). Another weakness is the unrealistic value of assets in the balance sheet. Due to not taken into consideration the recent changes in prices, the amount of the assets of the organizations show unrealistic values. Insufficient provision for depreciation is another weakness of HCA. The depreciation is charged based on historical cots that are not sufficient. Another major disadvantage of the HCA is unrealistic profit (Carmona, Ezzamel & Gutiérrez, 2016). The major problem is that the revenues are taken based on current value and the expenses are taken based on historical value. Hence, it can be said that the HCA process fails present the fair or actual value of the financial position of the organizations.
The Role of AASB in Ensuring Faithful Representation
Along with the above-discussed weaknesses, the HCA has some major merits or benefits. The HCA maintains the objectivity of the financial position of the organization. HCA is considered as the simplest method of the valuation of the assets (Demski, 2013). Apart from this, the process of charging depreciation is a simple process in HCA. The conservative approach of HCA makes it more innovative to the accountants. It creates the scope of creative accounting. It can be seen that the HCA process is consistent with the broader goals and objectives of the accounting process (Hall, 2012). These are the major advantages of HCA.
Due to the presence of the weaknesses in the process of HCA, there are some alternative methods of HCA. One of the alternatives of HCA is current cost accounting process. In this process, the amount of cash that needs to be paid at the time of the acquisition of any asset is taken into consideration. Realizable value method is another alternative of the HCA. In this process, the current amount of cash that could be obtained after the disposal of the assets is taken into consideration. Present value method is another alternative asset valuation process of HCA. In this process, the future cash flow that can be generated due to the disposal of the assets is taken into consideration. The most popular alternative of HCA is the current purchasing power accounting (Jolliffe & Prydz, 2015). In this form of accounting, the profit after allowing the maintenance cost of the purchasing power is taken into consideration. These are the major alternatives of HCA.
From the above analysis, it can be seen that there are both demerits and alternative methods of HCA. In spite of the presence of both demerits and alternatives, the HCA is widely popular among the accountants of all over the world. There are specific reasons behind this. One of the major reasons is that the accountants are very mush reluctant to value the assets based on the current market price. The reasons behind this are creative accounting and various accounting malpractices. It has been seen that under the process of HCA, there is not any scope for accounting manipulation as all the accounting information is supported by evidences. This is another reason for choosing HCA by most of the accountants. The financial managers can apply various kinds of alternatives in recognizing, measuring and reporting the economic information with the help of HCA. As per the empirical evidences, the financial statements based on the process of HCA are very much useful for the financial managers. Apart from these, there are various other reason that are responsible for the widespread popularity of HCA all over the world. It can be observed that these reasons are to powerful too surpass the demerits of HCA.
3. As per International Accounting Standard Board’s (IASB) conceptual framework chapter 2, the main objective of financial reporting is to provide financial information to the various users of the financial statements for financial decision-making. The various users of financial statements are the potential investors, lenders, creditors and others. It is important that these various users of financial statement must be provided with the necessary information in order to make effective decisions. It is important that these financial information is necessary for the assessment of the future cash flow of the organizations along with to assess the stewardship of the accounting process. This information has its utmost importance at the time of decision making of the business organizations. It can be seen that IASB has give more emphasis on describing the term stewardship rather to use them (Zhang & Andrew, 2014).
Attributes of Faithful Representation
The main purpose of financial statement forms the base of conceptual framework. In addition, there are various other elements of conceptual framework like the idea of treatment of business entity, the various elements of financial statements, disclosure and presentation of various measurement and others. The main objective of general principles of financial treatment is to provide financial information to the various users of the financial statements. The various users of financial statements are the investors, creditors and others (Gebhardt, Mora & Wagenhofer, 2014).
In this regard, the measurement process under historical cost and fair value is an important aspect. These two measurement processes are used by the business organizations to measure the financial assets of the organizations. In the process of fair value method, at the time of valuing any asset of the organization, the current market prices of that asset is taken into consideration. On the other hand, in the process of HCA, the market prices of the asset is considered at the time of the acquisition of the asset by the business organization. hence, it can be seen that some major differences are there between the measurement process of these two methods. Fair value accounting is taken into consideration when the present value of an asset cannot be determined. On a more precise note, fair value can be described as the agreed upon sales price of an assets between two parties. It can be observed that, among these two measurement processes, the historical cost value of measuring the cost of an asset is more popular all over the world. One of the major reasons is that the process of measurement is very easy and convenient in HCA (ifrs.org, 2017). In addition, the HCA diminishes the scope of manipulation from the accounting process. Hence, from the above discussion, it can be concluded that among these two measurement methods, the HCA method is more relevant in the accounting conceptual framework.
References
Abeysekera, I. (2013). A template for integrated reporting. Journal of Intellectual Capital, 14(2), 227-245.
Ball, R., Jayaraman, S., & Shivakumar, L. (2012). Audited financial reporting and voluntary disclosure as complements: A test of the confirmation hypothesis. Journal of Accounting and Economics, 53(1), 136-166.
Barth, M. E. (2013). Measurement in financial reporting: the need for concepts. Accounting Horizons, 28(2), 331-352.
Bodie, Z. (2013). Investments. McGraw-Hill.
Carmona, S., Ezzamel, M., & Gutiérrez, F. (2016). Accounting history research: traditional and new accounting history perspectives. De Computis-Revista Española de Historia de la Contabilidad, 1(1), 24-53.
Conceptual Framework for Financial Reporting 2010. (2017). ifrs.org. Retrieved 9 April 2017, from https://www.ifrs.org/News/Press-Releases/Documents/ConceptualFW2010vb.pdf
Demski, J. (2013). Managerial uses of accounting information. Springer Science & Business Media.
DRURY, C. M. (2013). Management and cost accounting. Springer.
Gebhardt, G., Mora, A., & Wagenhofer, A. (2014). Revisiting the fundamental concepts of IFRS. Abacus, 50(1), 107-116.
Hall, J. A. (2012). Accounting information systems. Cengage Learning.
Henderson, S., Peirson, G., Herbohn, K., & Howieson, B. (2015). Issues in financial accounting. Pearson Higher Education AU.
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Kim, S., Kraft, P., & Ryan, S. G. (2013). Financial statement comparability and credit risk. Review of Accounting Studies, 18(3), 783-823.
Luttermann, C. (2012). Accounting as the Documentary Proof of Good Corporate Governance. In German Corporate Governance in International and European Context (pp. 275-328). Springer Berlin Heidelberg.
Palea, V. (2013). IAS/IFRS and financial reporting quality: lessons from the European experience. China Journal of Accounting Research, 6(4), 247-263.
Quadackers, L., Groot, T., & Wright, A. (2014). Auditors’ professional skepticism: Neutrality versus presumptive doubt. Contemporary Accounting Research, 31(3), 639-657.
Weil, R. L., Schipper, K., & Francis, J. (2013). Financial accounting: an introduction to concepts, methods and uses. Cengage Learning.
Zhang, Y., & Andrew, J. (2014). Financialisation and the conceptual framework. Critical perspectives on accounting, 25(1), 17-26.
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