Financial Reporting and its Functions
Conceptual framework that has been set out in relation to the financial reporting function is the complete set of interrelated objectives as well as fundamentals of financial reporting. These frameworks facilitate the accounting standards setters in their process of setting sound standards in the areas of financial accounting. CF deals with financial information users and their information demands. Along with it, it describes in details the qualitative features that the financial information must possess.
The basic objective of financial reporting is to communicate necessary and relevant financial information to the interest parties i.e. the stakeholders of the entity so as to enable them to take sound economic decisions. Therefore, the financial reporting embraces two prime objectives i.e. the decision usefulness and the stewardship function (ACCA, 2018).
Decision useful information can be defined as the information related to the reporting entity and is of use to the existing as well potential investors, the creditors and other providers of finance in their decision making function in their capacity of capital providers. The decision usefulness is considered as the principal objective of the function of financial reporting. It involves preparation and presentation of financial reports considering the key decision makers so as to provide them better information (Shagari & Dandago, 2013).
Stewards literally refer to the persons who look after another’s property. The stewardship function imposes the responsibility on the management of the reporting entity to provide reliable and necessary information to its stakeholders in regards to the use of economic resources made by such entity in its business.
The concept of decision usefulness has originated from U.S. which is a developed exchange economy. The decision usefulness feature was further taken by Efficient Market Hypothesis which assumes that share prices of the entity incorporate all the relevant information which enhances the market efficiency. Hence, the accounting standard setters must take into consideration the needs of capital market participants when making rules for disclosure of information. The decision usefulness objective plays the forward looking view, whereas, the stewardship function emphasises on the earnings from past transactions. Decision useful information must enable the users to analyse the impact of information regarding future cash flows on capital prices so that they can take decisions in regards to providing further capital to such entities. The stewardship concept merely required the report in regards to management’s honesty in dealing with company’s resources. However, it later advanced to reporting on the efficiency of management and now it encompasses analysis of ability of management in generating sustainable return from the resources employed. The stewardship feature of information enhances the decision usefulness of the information.
Historical Cost Accounting and its Weaknesses
Relevance and reliability are the major qualitative features of financial information contained in the financial statements of the reporting entity. Relevance of the information is achieved when it is able to influence the user’s decision (Barth, Beaver & Landsman, 2001). In order to change the user’s decision, information has to offer predictive or confirmatory value. Reliability means the quality of the information that is achieved when the information is does not contain any type of error or bias and also represents faithfully what it is supposed to represent. The information must also possess verifiability feature in order to be called as reliable (Johnson, 2005).
Qualitative features of the financial information are the essential ingredients to render the information usefulness purpose for the decision making. The relevance and reliability of the information is greatly influenced by the decision usefulness and stewardship objective. In order to be used in decision making, the information must meet the common needs of the key users of financial reports. In the recent era, the attribute of usefulness is more emphasised by IASB and this has caused extreme focus on the cash flows related to the future and less focus on maintaining the reliability feature of the information (Draft, 2015). The negligence towards stewardship function as the separate objective of financial reporting will affect the relevance as it will result in exclusion of such information that is necessary to serve the purpose of stewardship (EUROPE, 2007).
In conclusion it can be said that the approach of IASB of treating decision usefulness as a principal objective of financial reporting and to include the information necessary from stewardship perspective in the decision usefulness objective will not satisfy the reliability and relevance requirement of the financial reports. The said approach will also affect the verifiability feature of information (IASB, 2005).
Normative theories are those theories that aim to inform about what should be the best and normal practice to be adopted in a particular situation. These theories do not lay emphasis on what is actually happening or will be happening in future. Rather, they are concerned about what should have happened in the existing situation (Tresch, 2014). The conceptual framework of financial reporting and its resulted accounting standards are the classical examples of normative theory as they all prescribes what should actually be done by the professional accountants. Normative theory in accounting is developed through complex and logical reasoning. These theories define opinion of a group of people in dealing with various areas of accounting.
Key Building Blocks of Conceptual Frameworks
Definition: The term historical cost accounting involves the recognition of the major assets and expenses of the financial statements on the values at which they were acquired or incurred. The values at which such items are recorded in the financial statements are called the historical costs. HCA works on the realisation principle where revenues are recognised only when they are realised (Ellul, Jotikasthira, Lundblad, & Wang, 2015). This type of accounting has its own strengths and weaknesses that will be discussed below:
- Bias free data:
The accounting information depicted under HCA is generally bias-free and hence it possesses the capability of being verified independently. Therefore, it promotes dissemination of more reliable information to the external parties of reporting entity (Zeff, 2007).
- No involvement of personal judgement:
There is no room for personal judgements of the management of the reporting entity. As transactions are recorded at their original prices, there are low chances of disputes.
- Legal recognition:
The historical cost accounting has the capacity of being legally recognised as it forms basis for taxation purposes and dividend declaration purposes.
- Unrealistic profits:
When income statements are prepared under HCA, they do not reveal the true profits of the entity. When HCA is followed, the expenses are recorded at their historical values however the revenue items are recorded at the current values. In inflationary periods, profits are over-stated.
- Ignorance of current price levels:
When financial statements of a company are prepared and presented on the basis of HCA, they ignore the effect of the changes in the levels of prices of various relevant items of the financial statements. HCA proves to be unsuitable practice particularly in inflationary periods.
- Unrealistic fixed asset records:
When HCA is followed for the accounting purpose the fixed assets values does not involve the effect of changing economic factors which affects their current value in the market. The ignorance of increase or decrease in the asset’s current realisable value deters the true financial position of the business in the market. It also affects the amount of depreciation that is supposed to be charged to the assets. When incorrect depreciation is charged to the entity’s income statement, the financial statements fail to depict the true profitability of the reporting entity.
There are various alternatives to the historical cost accounting method such as Current Purchasing Power Accounting (C.P.P.A), Current Cost Accounting (C.C.A)
This method also requires the firms to maintain the books of accounts on the conventional approach i.e. historical costing but certain items of financial statements are adjusted for the general price index. The main purpose of this approach is to take into account the impact of change in the levels of prices.
- CPPA provides reliable accounting information to the relevant decision makers from the management team so that they can formulate requisite plans and policies.
- This method helps in ensuring that the purchasing power of the capital contributors is kept intact.
- The comparative study under this method is easy as it makes use of common purchasing power as the measuring unit.
- This method only focuses on the changes in the customer’s purchasing power and not in the value of the particular items in the market.
- The selection of appropriate price index is quite difficult in this method.
- It fails to deal with the pitfalls of historical cost accounting.
Current cost accounting recognises the price level changes in regards to an individual item due to the general price level variations. This method involves the preparation of financial statements on the basis of current market values of non-current assets and not on the basis of historical costing.
- This type of accounting provides with more reliable information regarding the financial position of the business.
- It provides up dated data and information about the reporting entity which helps in identifying its current financial health.
- It also takes into account the inflationary effects of the economy on the financial statements.
- The determination of value of assets is quite difficult in case of real assets.
- It is highly volatile in nature.
- The element of subjectivity is involved in CCA
- It is not suitable in periods of depression (Laux & Leuz, 2009).
Conclusion:
The current cost accounting method has actually proved to be adequate to deal with the failures of HCA as well as CPPA as it involves consideration of inflationary accounting. Moreover, the financial results under CCA are more easily interpretable as it differentiates the business gains and capital gains arising from increase in the value.
The conceptual frameworks aim to define the nature, subject, objectives and purpose as well as the major contents of general purpose financial statements. The conceptual framework facilitates the provision of structured theory for the financial accounting by explaining clearly its fundamentals. These frameworks set out various building blocks in the area of financial reporting. Following are the main building blocks of conceptual framework:
- Definition of the term financial reporting: this is the first and foremost aspect that is addressed by the framework for general purpose financial reporting. It sets the boundaries of financial reporting system. It also involves determination of such activities and events that must be included in the financial reporting discipline. Also, it deals with the skills that are requisite for the accounting profession.
- Definition of the term reporting entity: This part establishes the criteria to identify the reporting entities which are supposed to prepare the financial reports. SAC 1 governs this part of conceptual framework.
- Objectives- Financial Reporting: This block of financial reporting conceptual framework specifies the broad objectives of the function of financial reporting. Further, it deals with identification of primary users of financial reports prepared within the general purpose framework and the type of financial information needs of such users (AASB, 2001). Furthermore, it also deals with the type of financial reporting that is suitable in the given situation. This part of conceptual framework is dealt by SAC 2.
- Qualitative characteristics: This block addresses the key qualitative characteristics of the financial information. Such characteristics must be possessed by every part of information in the financial statements to achieve the basic purpose of financial reporting. Conceptual framework covers reliability, relevance, usefulness, timeliness, fair representation etc. This part is dealt by SAC 3.
- Elements of financial statements: This part of the framework provides for the identification and definition of elements of the financial statements like assets and liabilities, revenues and expenses, its equity. Each of these components is defined in details in the conceptual framework. This part of the said framework is dealt by SAC 4.
- Basis of recognition: This part deals with the recognition criteria for the transactions in the financial statements. The items must be recognised in the financial statements only when there is a probability of movement of cash in and out of business and when the value of such items can be measured reliably. This part is also dealt with SAC 4. The recognition of elements that must be incorporate in the financial statements, are to meet:
- Main objectives of GPFR
- Qualitative characteristics of accounting information
- Measurement Basis and Techniques to measure the items: This part sets out different measurement attributes for different elements of financial statements. The main attributes are historical cost, current cost equivalent, current cost and several other objectives. It also set pit the measurement units such as normal or constant purchasing power dollars. Moreover, the concept of capital such as financial or physical (Schipper & Trombetta, 2010).
The above building blocks are interconnected to each other as they all deal with the reporting of necessary and relevant information by a way of financial reports to the stakeholders of the company so as to allow them to undertake informed decision making (Schroeder, Clark & Cathey, 2001).
Yes there is an optimal structure of conceptual framework of financial reporting which cannot be disturbed in order to achieve its core purpose. The framework is designed by the accounting standard board to provide the guidance to the accounting standard setters about the process of formulation of accounting standards. If the order of the building blocks of conceptual framework is disturbed, it will create difficulty for the accounting standard setters to create a logical set of accounting standard. Also, the users of financial reporting function to conceptually understand the accounting standards applicable on them (Schroeder, Clark & Cathey, 2001).
The normative theory of accounting is the theory which is not based on the observations but on the way the accounting process must be undertaken. This theory is concerned with the identification of best decision to be taken keeping in mind an ideal decision maker who is completely informed and can act rationally. The measurement aspect is the weakest section of the entire conceptual framework due to various factors. The framework given by IASB sets out various measurement attributes but does not prescribe the criteria of selection of the most appropriate alternative attribute, measuring unit. The conceptual frameworks as provided by FASB and IASB are based on the similar theories but there are certain variations in the way both measures and defines the key components of financial statements. Such uniformity of the ways of treating the main elements creates confusion and hence both the accounting standard boards are required to be synchronised so as to improve the consistency of the conceptual framework of financial reporting. Moreover, the measurement bases that have been prescribed in the conceptual framework are not justified as it recognises historical costing and current costing (Xuyue, 2006). There are other alternatives also available in the market such as Current Purchasing Power Accounting, Replacement Cost Accounting Technique, Current Value Accounting etc.
References:
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