Iasb’s Conceptual Framework Essay
This report is intended to discuss the significance of the IASB’s Conceptual Framework. It will layout the basis of the Conceptual Framework and then discuss its significance and relevance with regards to previous and future accounting industry standards.
The IASB’s (International Accounting Standards Board) Conceptual Framework is a set of rules and standards that the accountancy industry, within the Global market, adheres to in order to produce clarity across the board when producing financial statements and information for users of those statements.
IASB will replace the standards set by the FASB (Financial Accounting Standards Board) in which the UK accountancy industry required companies to comply with generally accepted accounting practice (GAAP). GAAP offers a certain amount of legal backing to the accounting standards produced by the FASB, however problems occurred when direct comparisons were made between the financial statements of companies from different countries using a variety of methods.
This difficulties arose as a result of these countries using different reporting standards to those set by the FASB. This problem was not just between UK and other countries, but also between financial statements produced in any differing countries. As such, like for like comparisons between entities based in different countries was time consuming and complicated.
The accounting standards with the biggest international widespread use, before the change in reporting, was the United States (US) GAAP (generally accepted accounting practice), as at the time this was mandatory reporting for all American companies and all foreign companies wishing to be listed on the American stock exchange.
However, because of the international differences in reporting, this lead to a huge amount of both confusion and differences in the reporting details and styles. This also meant that any UK based companies with US parents, listed on the stock exchange, were required to provide two sets of financial statements, one conforming to UK GAAP and one conforming to US GAAP. This, in turn, had it’s own financial ramifications because of the extra cost involved in both preparation and audit. Moreover, one of the biggest problems may be seen as the possibility of conflicting audit opinions, as well as the difficulties faced by the company in the appointment of auditors, as they would need to have experience in both the UK and US standards.
With increased globalisation of industries and multi national companies and the financing of such companies becoming worldwide, there became an apparent need for standardisation of accounting standards. The intention being that all financial statements would be comparable regardless of the country of origin. This would then enable users of these statements to more easily evaluate the statements when considering the company for investment, lending and trade.
Once this need was identified the original standards committee, IASC (International Accounting Standards Committee) was tasked with establishing the standards required in order to facilitate this. The IASC later went onto become the IASB because of a deemed restructure due to its agreement with the IOSCO (International Organisation of Securities Commission) which had endorsed the reporting regime for the global marketplace of raising of finance and trading of shares. (Utopian Global Stock Exchange).
The IASB conceptual framework has set the new IFRS (International Financial Reporting Standards) in order that the preparation and presentation of financial statements for external users are all of the same concept and that all statements are presented in the same way for companies listed across the European and American market. This will aide those users of the financial statements namely Lenders, Investors, Government Agencies, Creditors, etc, in reaching the decisions required for their particular segment of business. It will also give shareholders the ability to rely upon globally standardised audits to ensure that the management of the company is dealing with the activities of the company to the best of their abilities and not misleading the shareholders in any way.
The significance of this is that all companies listed on stock exchanges will now be working towards identical standards in that their treatment of certain items within the financial statements will be all the same, which in itself leads to greater clarity, understanding and the avoidance of ‘creative accounting’.
For example, there are now certain basic assumptions within the financial statements. For example, statements will be detailed in the same manner, and that all statements will take into account the various accounting assumptions of going concern, prudence, matching concept, etc. Previously under the FASB there was no hard and fast rules as to how statements should be laid out or indeed which assumptions had been used. These were all generally ‘notes to the accounts’ which could, invariable, run into hundreds of pages and make the understanding of such for non financial individuals or companies, very difficult and unclear.
The significance of the framework has meant that each individual country no longer has control of its own accounting standards. Accounting bodies in all countries have had to make significant changes to their own working practices some of which have been in existence for a great many years, due to the changes. The retraining of qualified individuals within the industry has increased costs hugely within practices and companies alike.
Audits are now performed on a new set of financial statements which again requires training and changes to audit techniques. In the short term this could potentially lead to incorrect audit opinions being given as experienced auditors with enough knowledge to work in this area, will no longer be able to deliver to such a high level.
Further, areas of significance of the exposure draft include the fact that changes to the preparation of financial statements are likely to impact against company statute for any country. In the UK, UK GAAP conforms to the companies act. Any changes that occur in the make up of the financial statements in the UK may mean that it fails to conform to the Act.
If this occurred the decision would need to be made as to whether to re visit changes to the exposure draft or push through a change to the Act. Both these solutions would be costly, the second involving parliamentary change. This shows how the conceptual framework was significant in that it forces all the individual accounting bodies to reach compromise with each other so that it takes the best of all area’s with minimum change and so cost. This has never happened before to this extent.
This can also be seen as each individual country may have had accounting standards that were relevant to their own taxation legislation. Changes in the way the accounts are produced and laid out may require further working cost to be completed in order to ensure the adjustments are in line with tax legislation, alternatively tax legislation may need to be changed. Again some form of compromise would be needed. As it is highly unlikely that tax legislation would be changed to fit in with a change in accounting standards any change that affected this area would undoubtedly lead to high tax consultancy fees for businesses.
There are standards in lots of areas coming into practice. For example, IAS 1 is the Presentation of Financial Statements, which ensures that all financial statements are presented in the same way and all have the same headings. This aids the user again to be able to understand statements from companies of all different types, backgrounds and countries. Being aware that the statements are presented in the same way enables a quicker and clearer understanding.
It also has a greater clarity for statements from different periods, in that users are able to compare ‘like with like’ and not be concerned that statements may have been issued with different standards period on period. For example, that the depreciation calculation basis has remained the same.
The overall significance of the Conceptual Framework will produce a clearer understanding for both the Accountancy industry, in that accountants will prepare all their financial information in the same manner using the same assumptions and guidelines, and for users of those financial statements. The accounting industry will be seen as a more authoritative and respected industry in the way it conducts itself rather than the recent negative perils of its history. This is a huge positive step forward for the industry as a whole as for the first time bodies all over the world are coming together as opposed to ensuring their longevity by having small but significant differences. It should be noted however that this will not come without increased cost in the short term.
On 11 March 2010, the International Accounting Standards Board published an Exposure Draft – ‘Conceptual Framework for Financial Reporting – The Reporting Entity’. We will discuss and evaluate the impact on the financial statements of reporting entities.
It’s purpose and objective is to ‘provide financial information about the reporting entity that is useful in making decisions about providing resources to the entity and in assessing whether the management and the governing board of that entity have made efficient and effective use of the resources provided. The reporting entity concept is intended to further this objective.’
This draft paper has been brought in to enable the clarity of the company that is reporting its accounts along with its sister companies. It is proposed in order to enable the users of the statements to obtain a clearer understanding of the financial standing of the parent/holding company.
In order to be able to do this the user must first be able to establish what conjugates a ‘reporting entity’.
RE3 in the draft states that a ‘reporting entity’ has three features;
a) Economic activities of an entity are being conducted, have been conducted or will be conducted. b) Those economic activities can be objectively distinguished from those of the other entities and from the economic environment in which the entity exists. c) Financial information about the economic activities of that entity has the potential to be useful in making decisions about providing resources to the entity and in assessing whether the management and the governing board have made efficient and effective use of the resources provided.
The reporting company of the financial statements must be able to confirm that it is a company trading in financial activities, or that it intends to within a period of time. It cannot be a holding dormant company that is not trading and therefore unable to ‘pay its own way’. It has to also trade in differing activities or at least be able to show that it is trading in a different activity. The reporting entity must also be able to provide useful information to users and be able to show that its management has run the company beneficially and correctly.
The purpose of this would be to enable users to see that the company is indeed a true ‘company’ and is not using itself to ‘hide’ the disparities that may have been going on behind the scenes of the group. It would also be considered an unfair advantage if the parent company should be trading in the same activity as the group as whole, as it could possibly be able to obtain better rates, revenue, lower expenses, because of the size and thus inflate/reduce its profit unfairly.
There is also the question of what constitutes a ‘separate reporting entity’. Can a sole trader report for itself… this is not particularly relevant however, because of the guidelines of the whole framework. It is primarily for the governance of listed companies and hence the small independent company would use the guidelines literally as a guide but not be governed by them.
Defining a reporting entity is probably not required as most of the time it is determined by internal or external regulation or the tax authorities or those providing the capital of a business. Therefore, whether an area of financial activity determines the reporting entity is irrelevant but it should probably be whether the financial activities determine the status of the entity.
RE4 and RE5 discuss the ways in which to identify a reporting entity in a specific situation taking into account the activities of the entity that are being conducted and whether this relies upon the reporting entity being a separate legal entity. It also talks about whether ‘commingling’ equates to a financial relationship between separate legal entities.
It discusses whether the reporting entity can include more than one entity in its status. Looking at an example for this may logically explain. Company A makes parts specific to a car manufacturer, those parts cannot be used in any other car whatsoever. What this draft is implying is that Company A should then be included in the reporting entity of the car manufacturer’s financial statements because it solely makes parts that cannot be used for anything else. The ‘commingling of economic activities and the fact that there is no basis for objectively distinguishing their activities’
This leads to the obvious point of misrepresentation. The aim of the whole change in International standards is that the users of the statements gain greater clarity; it would be financially incorrect to include separate legal entities in those statements, giving the readers a false account of what those statements imply.
RE6 talks about the ‘portion of an entity qualifying as a reporting entity if the economic activities can be distinguished objectively from the rest of the entity and financial information about that portion of the entity having the potential to be useful in making decisions about providing resources to that portion’. This point appears to clarify how the separate legal entities could also be separate reporting entities.
The possibility of a large conglomerate company reporting all it’s activities and hence separate entities individually leading again to misrepresentation. It would appear this would only be useful if say one of those separate entities were to fail and the potential users of the information were looking to ‘pick up the pieces’ of that particular part at an unrealistic price because of the circumstances.
It doesn’t appear that the majority of users would benefit from this. In fact it would only aid in ‘hiding’ the true picture of the legal entity.
RE7 to RE10 discuss the consolidation of the financial statements for reporting purposes. They talk about the relationship between ‘controlling entities’ and how this is distinguished by ‘control’. RE7 mentions the details of the controlling entity in that it has ‘control when it has the power to direct the activities to generate benefits for itself’. RE8 & 9 goes on to discuss the sharing of this power if two or more entities are involved in the control.
These points on the consolidation appear to contradict the previous identification of a reporting entity and how it is recognised. Talking about the cash flows and the other benefits to its equity investors. The separate cash flows of the individual legal entities if not included in the reporting entity, would of course have an impact on the financial statements of the legal entity, namely in the parent. It would be financially incorrect not to include all entities, in effect, ‘hiding’ the true financial picture of the whole of the entity. The draft also talks about the ‘sharing of the power’ and that in these circumstances, none of the entities would present information about itself and the other on a consolidated basis. Again a clear misrepresentation of the factual information relating to sister and parent companies. Contradicting itself with regards to the earlier points of identifying reporting entities and being able to show separation of economic activities.
RE11, Parent–only financial statements is suggesting that controlling entities need only report on it’s equity and investments and not the financial activities if indeed there are any. This could lead to incorrect assumptions being made in that interpretation of the financial statements, using say, ratio analysis, could give a completely different scope if the other entities within the group are not taken into account. It could potentially lead to investment being taken without the investor knowing the whole of the circumstances. The suggestion that these are presented together with the consolidated financial statements must be seen as a ‘given’ rather than an exception.
RE12, Combined financial statements discusses the need for the statements to include information about the more commonly controlled entities. There is an argument that the holding company could just hold the debt of the sister companies within its financial statements and that the profits of these other companies will merely be used to service this debt. Surely the significance of this would be huge in the users providing more investment or indeed creditors seeking to build relationships.
The exposure draft appears to try and give guidance into the financial statements within business and how to identify reporting entities and under what capacity these entities should produce their financial information. However, it seems that this draft goes some way to not only contradicting itself but also to confuse the reader in trying to establish what specifics it should be aiming for in order to correctly produce financial statements for the wider market.