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Case study 1- Revisiting the conceptual frameworks
In the given case study the FASB and IASB are coming together to reframe their conceptual framework for accounting and financial statements. Previously their principles are based on personal framework of each of these regulatory authorities. But now they are considering framing these frameworks on the basis of fundamental concepts. These principle were framed and developed during 1980’s, there these principle requires revaluation and updating.
Question 1- Explain why principles-based standards require a conceptual framework
According to Financial Accounting Standards Board (2010), Conceptual frameworks can be defined as set of assumption and principle which guides the organisation in preparation of financial accounts and statements. If an organisation does not preparation of financial accounts, then the financial statements of each organisation may differ from the applicable legislature. In a principle based standards, management tries to apply their own treatment of different accounting situations. Conceptual frameworks help an organisation to deal with such situations and align the accounts with the legislature requirements. These frameworks help the external user of the financial statements to acquire accurate and relevant information from these financial statements.
Purpose of conceptual frameworks
Principle based standards are generally accepted accounting principles (GAAP) which are issued by Financial accounting finance board (FASB). There has been various debates after the cases of fraud like Enron and WorldCom that rule based accounting should be replaced and principle based accounting must be used. Conceptual frameworks help in evaluation and development of current accounting standards. It also helps harmonising the accounting treatments and mitigating the alternative treatments adopted by management of an organisation. These conceptual frameworks are not only important for the organisation but are also important to the auditors. Harmonisation of accounting of the entire organisations will bring uniformity in audit policies and procedures.
Advantages of conceptual frameworks
Conceptual frameworks have various advantages to the organisation, auditors and external and internal users of such financial statements. Following are some of the advantages of using conceptual frameworks based principles in accounting-
1. Evaluation of the current standards will make these standards more logical to use for an organisation. This will enable standardisation of accounting standards which will help organisation in globalisation of business.
2. These frames are based on accounting concept and no specific guidelines are provided, hence it enables the organisation to deal with different situations faced during business.
3. These conceptual frameworks bring transparency in operations of the organisation.
Question 2- Why is it important that the IASB and FASB share a common conceptual framework.
According to Wang (2014), in recent times there has been a push for all the organisations to use harmonised accounting standards. This is due to the fact that there are various organisations that are working globally and they have to use different accounting standards according to the law applicable on such organisation. This makes compilation and comparison of financial statements very difficult.
It is very important that IASB and FASB jointly work on the conceptual frameworks as these are two of the biggest organisations who prepare standards of accounting. Difference in these accounting standards can affect the working of global as well as local organisations Murphy and O’Connell, 2013). We have evaluated how different accounting standards can effect a global organisation. Local organisation also has to compete with these organisations and hence they have to compare their financial standing with them. This can be difficult if different rules are adopted by both organisations.
According to De Franco et al (2011), main objective of harmonisation of accounting standards is to enable organisations to compare their financial statements with that of organisations working in other part of the world. This will enable an organisation in more accurate and cost effective strategic planning of the business of an organisation.
Question 3- Benefit from a conceptual framework to various parties
In the previous part of the case study we have evaluated that these are various advantages to various parties like organisation, auditors, external parties etc. Application of conceptual frameworks in accounting practices will be most beneficial to two party’s i.e. global organisation and auditors. These benefits are discussed as under-
These are the organisation which have subsidiaries in various countries and managed by a central head office. Strategies and development plan of the subsidiaries are prepared by the holding companies for the subsidiaries located at different locations over the world. Main objective of conceptual framework for these organisations is evaluation and comparison of financial statements of their subsidiaries. With the help of uniformity in the accounting standards, these functions can be done by these efficiently and effectively (Barth et. al., 2012).
There are various audit firms which are working at a global level like KPMG, PwC, Deloitte and EY. Different accounting standard followed in different part of the world has also created barriers in working for these Audit firms. With the introduction of conceptual frameworks, these firms can perform their function more efficiently as they have to study and follow a particular set of standards.
Question 4- Cross cutting issues
In the joint project of development and refining of conceptual frameworks, there were many issues on with both the regulatory authorities disagreed. These issues of disagreement are called as cross cutting issues. Therefore cross cutting issues can be defined as the factors of disagreement during development of the conceptual frameworks. In a report issued to evaluate the development of conceptual frameworks, both these authorities have also issued various cross cutting issues. Some of these issues are as follows-
Asset definition-It was conflicted that whether the assets should be valued in terms of rights or resources. For example an asset is purchased by an organisation and values at its purchased cost. The future benefits to be gained from these assets are not taken into consideration.
Measurement of assets and liabilities-In this subject matter it was conflicted that whether there should be specific criteria for measurement of an asset. for example whether the assets should be revalued or not and if revalued then whether there should be an specific method of revaluation
Uncertainly evaluation- In this matter disagreement arises in the subject that whether effect of an uncertain and probable event should be included in the financial statement of not. For example it expected that an organisation will increase its sales with recent introduction of new technology. Whether this should be evaluated and presented in monetary terms or not.
Case Study 2- The trend toward fair value accounting
There have been various comparisons over the period of time between the historical cost method and fair value methods for valuation of the asset. Adoption of appropriate method for valuation of asset is very important as it represents the accurate financial standing of an organisation. In the given case study also comparisons have been made between these two methods to evaluate the economic reality of organisation and market. Many professional have criticised the fair vale method as in this method assets can go up to five times of cost of the asset.
Question 1- Fundamental problems with historical cost method
According to Greenberg et al (2013), in case of historical cost method, assets of the organisation are valued at the purchasing price of the asset. These purchase cost includes any expense incurred by the organisation in relation of the asset like installation cost, taxes paid, labour paid etc. In this method of valuation depreciation and impairment loss on the asset is properly recorded to account for wear and tear in asset over its life. This method of valuation is heavily criticised by various accounting professional as it does not represent the actual economic value of such asset. For example assume a situation in which after three months of purchase of an asset the product which was produced from such machine becomes out dated. In such case the book value of the asset very high whereas it would have no future economic benefit.
Following are some of the disadvantages of adopting this method of valuation of asset –
1. In this method no treatment is given to the fluctuations in the price level of the acquired assets after of purchase. Due to this actual position of the assets are not presented in the balance sheet.
2. Depreciation method is used by an organisation to decrease the value of the asset to determine its actual value. This method only considers the loss incurred due to wear and tear of the asset whereas there are various other factors which can depreciate the value of asset.
3. Replacement reserves are not considered in such method which will be required to replace the asset at some point of time.
4. This method lowers the actual values of the asset which could be used by the management of organisation in window-dressing of the balance sheet.
Question 2- What do you think of the principle' ... accounts must reflect economic reality' as a core principle of measurement in accounting?
There have been many criticisms by various accounting authors regarding level of reliability which a stakeholder can implement on the financial statements of an organisation. This question has challenged the credibility of an accounting auditor and auditor. Hence the principle “accounts must reflect economic reality” should be included by every organisation in its core accounting principles. Not only organisations, various regulatory authorities issuing and maintaining these accounting principles should also include this principle in their framework. Main purpose of preparation of financial statements is true presentation true and fair value of the assets and liabilities. This purpose cannot be achieved by adopting historical method for valuation of asset.
One of the methods that can help organisation in presenting economic reality of the organisation is fair value method of valuation in which the assets of the organisation are revalued at the end of every financial year. Proper valuation of the asset is very important as business valuation in various organisations is based on asset valuation approach (Power, 2010). Hence we can conclude that determining economic value of the business should be made core accounting principle.
Question 3- Measurement of economic reality of organisation.
Every organisation prepares their financial accounts on the basis of GAAP and other principles issued by the relevant authority. These methods are unable to represent the true and fair standing of the company in market. Therefore various business valuation methods are used by organisations to evaluate the actual economic reality of the company. Some of these methods are explained as under (Abrams, 2010).
In this method of business valuation, organisations are valued on the basis of assets and liabilities acquired by such assets in business. This is based on the concept that the income generating power of an organisation is based on the assets employed by such organisation. In this method the net worth of the company is calculated by deducting all the liabilities from its aggregate assets. All the assets in this method are valued on the market price to determine its true economic value.
A true economic value of an organisation can be evaluated on the basis of market value of the organisation in the market. In this method the business of an organisation can be valued on the basis of prevailing market price of company on stock market. This is one of the best methods to compare the organisation with other competitor in market.
This method of business valuation in based of the concept that main objective of organisation is making profits. Hence in this method business of an organisation are valued on the basis of potential income generating capacity.
Question 4- Reliability in accounting
According to Abdullah et al (2015), reliability and transparency in financial statement is very important for stakeholders and management of an organisation. Stakeholders of the organisation take investment decision on the basis of these financial statement whereas decision making process of management is also based on these financial statements. Financial statement of any organisation can be called as reliable if while preparation of these all the concepts and principles of accounting are followed.
A financial accounts of an organisation will be considered as reliable if such accounts are prepare free from material misstatements and a user can faithfully use such information. Following principles and concepts should be followed by an organisation to bring reliability and transparency in accounts-
1. Clear representation
3. Completeness and accuracy of information
4. Separate legal entity concept
Case study 3- Disclosure of environment liability
Environment liability of an organisation referred to the potential cost which could occur in an organisation due to its operations or any other contingent events. This liability also includes potential damages which may occur in an organisation due to purchase of another business unit of asset. Over the period of time regulatory authority of various countries are establishing compulsory rules and regulations regarding disclosure of these liabilities.
Question 1- How do you think companies would go about estimating such a provision
From the given case study we can analyse that various countries are establishing the compulsory requirements for disclosing environmental liability. FASB standard requires every organisation to disclose environmental cost of an asset if its fair market can be estimated reasonably. Environmental obligations of an organisation are specified in “ASC 410-30 Environment Obligations”. In this section various areas are discussed like Environmental remediation liability laws, potentially responsible parties, joint and several liability, environmental loss contingencies etc. (Rose, R.R. 2010).
As this is a compulsory requirement therefore an organisation should determine proper method for determining such fair value estimate. It is very difficult such liability which has not occurred, hence best option for the organisation would be to adopt probabilistic method.
This method can be used by an organisation by assigning a particular probability to every possible outcome which could adversely affect environment. For assignment of such probability an organisation should do proper research and analysis of the event under consideration. Before purchasing an asset an organisation should evaluate the factors which could affect the business environment. If an organisation purchases a manufacturing asset then it should evaluate how much pollution it would create and assign a probability (Borgwardt, 2012). According to this a provision should be created by the organisation and disclose such provision in the financial statements.
Question 2- What aspects of the requirements were used by US companies to defer recognition of a liability
During the introduction of this provision, a company was required to recognise a provision for environmental cost incurred in disposing of a certain asset. But this was compulsory only when asset was actually disposed. Due to leniency of this provision companies in US started to take advantage of this loophole in this provision. Companies postponed the disposal of the unused assets so that they do not have to provide for environmental liability in case of termination of the asset. These unused assets were showed at book value in the balance sheets which also effected the true financial position of the company. To cope up with this problem, FASB stated that every organisation have to recognise environmental liability in case of termination of unused asset. FASB further clarified that timing of recognition and settlement of payment of such asset will not affect recognition of environmental liability.
Question 3- In what ways does the recognition of the liability in relation to future restoration activity affect business
We have discussed above that it is important for an organisation to recognise the environmental liability in the financial statements. Due to this compulsion an organisation will required to estimate and recognise the cost of environment damage at the time of purchasing a business or assets. Company has to prepare a provision of such estimated cost which will affect cash flow and profit of the organisation.
Estimates cost of environment damage will be provided in financial statement over the life of the asset. For example if estimated cost is 10000 and life of asset is 10 year then provision of 1000 will be made every year. Hence every year profits of the organisation will reduce by the amount of provision. And when actual cost will be incurred then such cost will be adjusted with the amount of provision.
This recognition of environmental cost will also affect the cash flows of the organisation. In the initial years of purchase of the asset there will be no effect on the cash flows of the organisation as this reserve will be created from free reserve of the organisation. Cash flows of the organisation will get affection when actual cost will be incurred by the organisation. Any penalty applied by the regulatory authority will also have to be paid by the organisation. Hence it can be said that environment liability will affect future cash flows.
Question 4- Importance of recognition of environment liability
We have discussed that it is compulsory for organisations to recognise environmental liabilities. But an organisation should voluntarily recognise these liabilities due to its importance and advantages to organisation. Some of these advantages are stated below-
Protection from Legal obligations
If all the requirements regarding recognition of environmental liabilities are properly followed by the organisation then it could prevent it from various penalties and law suits. Law suits can be initiated by various environmental charities can be initiated which could result in high financial loss for the company.
This would also create good reputation of the company in the market and among the consumers. This could result in increased sales or market share price of the company.
Estimation of environmental factors that can damage the company will enable organisation to obtain insurance policies against environmental hazards.
It is social obligation of every person in the society for protection and preservation of the environment. An organisation is also a part of the society; hence it should also perform its obligation toward environment.
Organisation should recognise environment liability on an annual basis. Company should also regularly evaluate the emergence of new factors which could affect the provisions created in such respect. These provisions should be included in the financial statements of the organisation and presented before the shareholders in annual general meetings. An organisation can also present such information in the notes to accounts of the financial statements to maintain transparency with the stakeholders.
Abdullah, Z.I.B., Almsafir, M.K. and Al-Smadi, A.A.M., 2015, “Transparency and Reliability in Financial Statement: Do They Exist? Evidence from Malaysia, Open Journal of Accounting, 4(04), p.29.
Abrams, J.B., 2010, “Quantitative business valuation: a mathematical approach for today's professionals”, John Wiley & Sons.
Barth, M.E., Landsman, W.R., Lang, M. and Williams, C. 2012, “Are IFRS-based and US GAAP-based accounting amounts comparable?”, Journal of Accounting and Economics, 54(1), pp.68-93.
Borgwardt, K.H., 2012, “The Simplex Method: a probabilistic analysis”, Springer Science & Business Media.
De Franco, G., Kothari, S.P. and Verdi, R.S., 2011, “The benefits of financial statement comparability”, Journal of Accounting Research, 49(4), pp.895-931.
Financial Accounting Standards Board (FASB), 2010, “Conceptual Framework for Financial Reporting”, Statement of Financial Accounting Concepts.
Greenberg, M.D., Helland, E., Clancy, N. and Dertouzos, J.N., 2013, “Fair Value Accounting, Historical Cost Accounting, and Systemic Risk”, Rand Corporation.
Marcel, F. and Cristina, F. 2012, “Environmental Liabilities Accounting: A Review Of Some Standards And Guidelines”, Journal of Public Administration, Finance and Law.
Murphy, T. and O’Connell, V., 2013. “Discourses surrounding the evolution of the IASB/FASB Conceptual Framework: What they reveal about the “living law” of accounting”, Accounting, Organizations and Society, 38(1), pp.72-91.
Power, M., 2010, “Fair value accounting, financial economics and the transformation of reliability”, Accounting and Business Research, 40(3), pp.197-210.
Rose, R.R. 2010, “Environmental Liabilities with the Codification—Is It Simpler? Better?”, Corporate Environmental Disclosure Column.
Wang, C., 2014, “Accounting standards harmonization and financial statement comparability: Evidence from transnational information transfer”. Journal of Accounting Research, 52(4), pp.955-992.