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ACC307 Accounting Theory Assignment
Case Study 1
Explain why principles-based standards require a conceptual framework.
The principles based standard setting approach needs a conceptual framework because of the reason that the members of the standards setting body need a proper guidance for the framing of standards. If there will be no standard framework for defining the concepts the standards so set by the members will be based upon their individual perception about the subject matter. Each person has his own opinion and thoughts for a particular topic and his ideas and suggestions will reflect his opinion. Therefore due to variety of opinions in the principles of different team members of the standard setting body the conflicts would arise among them and the situation may arise in which they will not be able to reach up to a conclusion or agreement of opinions. Thus the principles based standards if framed in this will not be uniform and will not have an identical base for each one of them. The conceptual framework creates a base for the standards on an overall basis. The FASB faced many difficulties during its first project of standard setting due to these reasons therefore it emphasize on the need of a pre-determined conceptual framework so that the issues arising at the time of standard setting among the members may be resolved by considering the guidance of such conceptual framework. The membership of standard setting body also changes with the time an as a result of this the principles set by the past members may not be considered relevant by the forthcoming members leading to amendments in the principles based standards. Due to these reasons a conceptual framework is quite essential for principles based standards. (Kaminski, 2011)
Why is it important that the IASB and FASB share a common conceptual framework?
The standard setting bodies FASB and IASB aim at the goal of convergence of their standards for uniformity. This goal can only be achieved by the two boards if and only if a common conceptual framework is shared by them while setting the standards which will be issued by them. Apart from this the members of the two boards differ in the level of their knowledge and intellectual thought process resulting in difference of opinions among them. As a result the standards that will be framed by them will be based on different concepts as per the consideration of relevancy by the members individually. Therefore the users of standards seeking guidance from these standards will get confused and will not be able to decide about the compliance of any one of the standards on same subject issued by the two boards in two different contexts. The IASB framework adopts concepts which are sound, comprehensive and internally consistent whereas FASB framework do not consider it relevant to change the generally accepted Accounting principles, reporting practices or interpretation. Due to this contradiction is existing in both the frameworks which need to be removed by sharing of a common conceptual framework between the two. (Satin, 2015)
It is suggested that several parties can benefit from a conceptual framework. Do you consider that a conceptual framework is more important for some parties than others? Explain your reasoning.
There are many parties who use the conceptual framework of accounting standards which are issued and developed by standard setting bodies such as IASB and FASB, for interpretation and application of those standards. These parties include the following:
1. Standards setters
2. Preparers of financial statements
4. Users of financial statements
The standard setters need the conceptual framework to develop accounting standards based on a uniform approach or to refine, update, complete or converge the existing concept statements and framework. The preparers of financial statements need the conceptual framework in effective application of accounting standards that may be applicable on them while preparing their financial statements. The auditors need the conceptual framework in order to make accurate judgement about the compliance of applicable standards on financial statements being audited through proper interpretation of standards. The users of financial statements need the conceptual framework to properly understand the financial information which is presented to them in the financial statements in accordance with applicable standards in context of the relevant areas in which the financial information will be used by them. It can be concluded that the conceptual framework is not only useful for the standard setters but also other parties equally. On the basis of above mentioned uses of conceptual framework for different parties and conclusion drawn it cannot be considered that it is important for some parties more than others. (James, 2012)
What is meant by a 'cross-cutting' issue? Suggest some possible examples of cross-cutting issues.
A cross cutting issue refers to an issue which cannot be ignore because of the reason that if it takes place it creates a very strong and never ending impact on the project. These issues directly harm the objectives and purpose of the project and may lead to the increase in requirements and cost of the project for its completion in an efficient and timely manner. The cross-cutting issues require special attention and consideration in order to reduce the risks of not achieving the targets and goals by the project.
The possible examples of cross-cutting issues harming the joint project of IASB and FASB which aims at convergence of standards by sharing a common conceptual framework are as follows:
Old concepts in the existing framework – The existing FASS concept statements and IASB framework documents require updating, refinement, completion and convergence. They articulate the concepts developed during 1970’s and 1980 are which lack far behind to lay an adequate foundation for setting principles based standards.
Difference in approach of both Boards – The IASB framework focus on adoption of concepts which are sound, comprehensive and internally consistent whereas FASB do not justify changing the generally accepted accounting principles and reporting practices. Thus they both contradict to each other.
Individual perception of members – The members of the Board whether past, present of forthcoming frame their opinions on the basis of personal ideas and concepts which result in the difficulties in arriving at conclusion by agreement of opinions.
Large number of projects – The Boards are pursuing many projects jointly and in tandem aiming at convergence together resulting in increase of burden. (Biondi, 2011)
Case Study 2
What you think is the fundamental problem with financial statements based upon the historic cost measurement principle used under US GAAP?
The fundamental problem with the financial statements that are based upon the principle of historical cost measurement which is used under US GAAP is that this principle do not render the financial statements made in accordance with this relevant and useful for the users and do not give a clear picture of the economic state of a company. The market value of publicly traded firms on New York Stock Exchange preparing their financial statements as per historic cost measurement principle is an average of five times their asset value serves in direction of the deficiency of relevance. As a result it makes the financial statements completely irrelevant for the financial information analyst community. The historical cost measurement principle focus more on reliability. The accounting information aims at creating information which may be useful for the investors, creditors and other stakeholders and users of financial information. This purpose cannot be achieved by the principle of historic cost measurement of US GAAP since it includes accounting of asset at a price for which it was purchased without making adjustments for appreciation and decrease in value of asset arising due to fluctuations and volatility in the market which leads to producing irrelevant information for the users. In this way the users are deviated from the economic reality and correct value of the assets of companies and thus defeating the objective of US GAAP of using accounting principles for preparation of financial statements which are free from errors and are not misleading. In this way the principle issued under US GAAP itself contradicts the objectives and purpose of US GAAP. (Pinto, 2015)
What do you think of the principle' ... accounts must reflect economic reality' as a core principle of measurement in accounting?
The principles of measurement in accounting whether it is historical cost measurement principle which focuses more on reliability of accounting information or principle of fair value accounting which emphasize the relevance of accounting information for users, both aim at producing the accounting information which reflects a true picture of the economic affairs and financial position of the company. This refers to as the reflection of economic reality by the financial statements. Economic reality indicates the financial position of the company in true sense. The aim of reflection of economic reality can only be achieved if the accounting information is able to show true value of its assets. This value shall be the value which is relevant in present context and is derived after making all the adjustments in the value for impairment and appreciation arising dare to uncertainties and market factors influencing the value of assets. For this purpose the producing of accounting information shall be relied upon fair value accounting. When assets are measured at fair value after providing for all the adjustments the financial information represents the correct value of the business of the company which creates faith in the minds of investors and other stakeholders for the company. Thus it can be said that the principle stating that the accounts must reflect economic reality is a core principle of measurement in accounting. (Lax, 2010)
How would you measure economic reality?
The economic reality of the financial and accounting information can be measured by the concept of Economic Value added (EVA). It is used to measure the economic value which the business adds to the economy. This value is calculated by using the overall cost of capital of the company arrived at on the basis of weights being assigned to cost of equity and cost of debt and then applying this overall cost on the operating capital. The value so arrived is deducted from the net operating profit after tax to get the economic value added. In this way the economic value is obtained which can be compared with the value of the company to measure the economic reality. If the investors are satisfied with the relevancy of the accounting information produced in the financial statements then it can be said that the accounting information provides a true picture of the economic state of the company and hence the accounting information reflects the economic reality. However this is only an estimation of economic reality. The appropriate measurement of economic reality can be made by calculating the economic value added by the company. When a company earns profits exceeding the normal profits they are called as the super profits or economic profits of the company. This concept is used to measure the economic value of the company so that the economic reality can be measured. (Hsu, 2016)
What is reliability in accounting?
Reliability is the tool used in accounting to measure that whether the information is free from errors and is not biased and the information is representing what it purports to represent. In this way reliability is based on two components viz. Faithful representation of information and the potential of verification. It assures the users about the representation quality and such assurance being the result of verification. However the precision or certainty of information is not covered within the measures of reliability. Sometimes the measurement of reliability is largely based on the estimates which are sufficiently reliable. Due to this reliability does not imply precision but if the measure of precision do not exist in the verification of information the existence of reliability is denied. In other words it can be said that precision is the measure of reliability in accounting but not an essential component which is assured in case of existence of reliability as stated by the Concept Statement 2 of FASB. The reliability in context of accounting is used to distinguish better information, i.e. more useful information from inferior one. (Rashid, 2010)
Case Study 3
The article states that the US standard setter FASB requires companies to record a provision in relation to environmental costs of retiring an asset ('to reserve environmental liabilities') if it’s fair value could be reasonably estimated. How do you think companies would go about estimating such a provision?
The US standard setting body FASB requires that the companies shall record a provision related to the environmental costs while retiring an asset which is the reserve of environmental liabilities in case the fair value of the liability can be reasonably estimated. If the fair value estimation could not be made on a reasonable basis in the period when asset retirement obligation incurs for the company then the recognition of liability shall be done in the period in which the estimation of such liability could be made reasonably by the company. The companies go for estimating such amount by using risk adjusted discounting rate technique for the estimation of fair value of liability. The appropriate discount rate taken by the companies for calculation is the observable rate of interest in the market applied on the cash flows which have the characteristics which are similar to the characteristics of the cash flows of the liability arising at the time of retirement of asset by the company. In some cases the liability for environmental costs relate to more than one period therefore in these cases liabilities occurring in subsequent reporting periods shall also be recorded by the company in addition to the original liability. In this way the changes in the liability will also be recognised. The changes that take place in the costs related to liability shall beer recorded as an increase in carrying amount of the liability or an expense categorised as Accretion expense related to the environmental liabilities cost. (Komatsu, 2012)
What aspects of the requirements were used by US companies to defer recognition of a liability?
The companies in US used to defer the liability of environmental costs related to the retired assets indefinitely by mothballing a contaminated property. The provisions of FASB require to recognise the liability in case the fair value of liability could be reasonably estimated and if could not be estimated to recognise in the subsequent period in which estimation could be made. This provision was used by the company to defer the liability by the reason of absence of market conditions to fairly value the liability being the conditional nature of this aspect. Another aspect used by the companies to postpone the recognition of liability is absence of pending litigation or obligation on the companies. There was no legal obligation due to which the companies postponed their recognition of liability to subsequent periods and not recording the same in the period of retirement of asset, its parts or facilities. The uncertainty in the timing and method of settlement of liability creating hurdle in the estimat6ion of fair value which was an essential condition was used as a tool by the companies against the requirement of recording the liability based on fair value estimation at the time of retirement of asset. (Chen, 2014)
In what ways does the recognition of the liability in relation to future restoration activity affect (a) net profit in the current year and future years; and (b) cash flow in the current and future years?
The recognition of liability in relation to activity of future restoration of asset which is retired by the company on the basis of fair value estimation of such liability shall be added to the carrying amount of such asset and shall be amortized over the remaining life of the asset starting from the year of restoration of the asset to be continued to the end of remaining life. Apart from this an allowance for estimated costs of restoration in future such as cost dismantling, cleaning up, abandoning etc. shall be recorded as a liability in the current year by the company. The recognition of liability will affect the current and future years’ net profits and cash flows alas follows: of
Net Profit – When the future restoration liability cost will be recognised as an allowance in the current year this will not affect the profit of current year. The capitalization of amount to the carrying amount of asset will also not affect profit but when the amount will be amortized over the remaining useful life of the asset the profit will be reduced for all the respective years.
Cash flows – In the similar sense the recognition of liability as an allowance and capitalization of asset will not result in inflow and outflow of cash but when the costs of restoration will be incurred in the future the cash outflow will be done as and when the cost is incurred. (Starc-Meclejan, 2013)
The article refers to changes in disclosure requirements relating to environmental liabilities in many countries around the world. How important is it that companies recognise the liability? To what extent is disclosure about the liability sufficient?
Around the world countries such as United States, Canada, and Europe changed the disclosure requirements for the companies so that the disclosure of environmental liabilities could be included in their regulations related to disclosure. These include guidance provided by European Commission in 2001 for the disclosure of environmental costs and other liabilities related you such costs as a result of which many European countries were bound to make additional disclosures. Similarly the Canadian Institute of Chartered Accountants issued guidance for the importance of disclosure of material risks related to environmental liabilities in 2002 to be disclosed in the annual reports of companies. Apart from these technical re-interpretations were made by the US FASB of the provisions issued by it earlier that required the disclosure of environmental liability related to retiring assets.
It is important that companies record the liability not only in context of legal obligation but also for the proper disclosure of accounting information which is relevant for the users of such accounting information which determine the faithful representation of financial statements. The disclosure about the liability is sufficient to the extent up to which it can affect the net profit and cash flow of the company in the current year as well as future years. (Hunsader, 2012)
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