Critically evaluate the need for accounting standards and the need for a set of principles on which they are based.
Accounting standards contain a set of rules and governing practices for the treatment of all financial transactions. The main objective of accounting standards is to establish recognition, measurement, presentation and disclosure requirements dealing with financial transactions and key events which are important in the financial statements of companies. These financial statements give end-users important information, as well as an in depth understanding about an organization’s performance, position and cash flow. Some examples of users of financial statements include potential investors, employees, suppliers and government agencies. As such, accounting standards provide the basic framework for financial statements to be presented in a fair and credible manner, such that it reflects the true overview of the financial status of an organization. These standards also help to present financial statements in a standardized and coherent manner, so that end-users worldwide are able to extract information and make decisions based on them.
Advantages of Accounting Standards
One advantage of having accounting standards is that it helps to ease the understanding of financial statements. What this means is that with accounting standards, financial statements reflect the financial position and status of an organization in a clear and coherent manner. With the need to publish financial statements in accordance to accounting standards, it also improves the credibility and reliability of the information present in the financial statements. End users, such as potential investors, top management and stakeholders, are able to make more informed decisions with greater confidence based on the information extracted.
Accounting standards also provides guidance for accountants in their line of work. When financial reporting issues arise, accountants may refer to published accounting standards to determine how to publish an event. Some examples of these issues include new accounting transactions and new actions incorporated by an organization. Since accounting standards serve both as a reference and a guideline to accountants, this reiterates the transparency, reliability and credibility of financial statements when they are published based on a common accounting framework.
Disadvantages of Accounting Standards
A disadvantage of using accounting standards is in its inflexibility. For example, an accountant working in an organization which complies with accounting standards might find himself having a hard time in his line of work. This is because he has to make the organization’s unique experience fit into the guidelines laid out in published accounting standards. Another disadvantage of accounting standards is in its cost to comply with the standard. When a company decides to comply with the new standard, it must first consider the requirements of the standard, and what actions the company must take to implement the standard and the cost to do so. In many cases, this proves to be very costly as implementing and complying with a new standard would require system upgrades and employee training.
Principle-based standards (PBS) is a framework of generally accepted accounting principles (GAAP) which accountants use for financial reporting. Some examples of the guidelines found in PBS include regularity, consistency, sincerity, prudence, continuity, periodicity and good faith. In PBS, an accountant follows these simple key objectives which help to ensure good reporting. The rules and guidelines set out in PBS only serves as reference and guide the accountant when he is doing his financial reporting.
* Flexible, its broad guidelines allows it to be used in various circumstances * Allows companies to produce financial report using a method that best suit them Disadvantage
* Lack of guidelines could lead to variation in financial reporting, making it difficult in terms of comparability
Rule-based standard (RBS) refers to a list of detailed rules that must be followed when preparing financial statements. The list of rules serves as a checklist when accountants prepare financial statements at the end of a company’s fiscal year. This approach is more favoured by accountants because in preparing the financial reports by following the RBS checklist, it reduces the possibility of being brought to court if their judgements of financial statements are found to be incorrect.
* Having a defined list of rules in preparing financial statement allows standardization, improving consistency which allows comparability between different companies * Easier to audit for compliance purposes
* Having to follow a detailed set of rules results in rigidity, each transaction is accounted with respect to each rule. * Accountants have to comply to the rules set forth in RBS or face penalties for non-compliance.
In conclusion, there is a necessity for accounting standards when companies prepare their financial reports. Financial statements prepared based on accepted accounting standards not only gives users a detailed overview of the financial position of a company, but also assures users that the information they had obtained is reliable, credible and transparent.
The International Accounting Standards Board’s Framework for the Preparation and Presentation of Financial Statements requires financial statements to be prepared on the basis that they comply with certain accounting concepts, underlying assumptions and (qualitative) characteristics. Five of these are: Matching/accruals, substance over form, prudence, comparability and materiality. Briefly explain the mean of each of the above concepts/assumptions.
The International Accounting Standards Board (IASB) framework is drawn up and used in preparing and presenting financial statements. The framework was drawn up and approved in April 1989 and published in July 1989. It was adopted by the IASB in April 2001 and later in September 2010; the Conceptual Framework for Financial Reporting 2010 was approved by the ISAB. (Deloitte, 2012) The purpose of the framework is to lay down guidelines to help ISAB shape the preparation and presentation of financial statements for end users.
The IASB Framework acts as a guideline to the Board in establishing future frameworks and as well as a guide to solving accounting issues that are not addressed directly in an International Accounting Standard or International Financial Reporting Standard or Interpretation. The scope of the framework includes the objective of financial report, the qualitative characteristic of useful financial information, the elements of financial statements and the measurement of the elements of financial statements. The focus would be on five of the many qualitative characteristics present in the IASB Framework. The five qualitative characteristics, namely matching/accruals, substances over form, prudence, comparability and materiality would be further discussed in detail as follows:
Accruals concept is an accounting method that measures the performance and position of a company by journaling economic events regardless of when cash transactions occur. According to this concept, the revenues and expenses are recognized when they are earned or incurred and not when actual money is received or paid. The matching concept is an extension of the accruals concept, whereby revenue earned by the company and the expenses incurred by a company to earn that revenue has to be accounted in the same accounting period. For example, a business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignores the date when the payment will be made.
Substance over Form
Substance over form is the concept that the information shown in the financial statements and accompanying disclosures of a business should reflect the underlying realities of accounting transactions, rather than the legal form in which they appear. This would result in a true view of the affairs of the entity to be presented. Substance over form is critical for reliable financial reporting, particularly in cases of revenue recognition, sales and purchase agreements. For example, a lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly equal to the fair value of the asset, etc. Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset.
The prudence concept, also known as the concept of conservatism, refers to be cautious when it comes to the recording of business transactions. It is stated that under the prudence concept, the amount of revenues recorded should not be overestimated; neither should the amount of expenses be underestimated. One should be conservative in recording the amount of assets, and not underestimate liabilities. (Steven Bragg, 2011) In terms of profit and loss, anticipated profits cannot be recorded down as profits until they materialize. Some examples of exercising prudence is when company’s inventory should be valued ‘at cost or market price, which is less’, and a provision should set up for an allowance for doubtful accounts.
Comparability is one of the key qualities which accounting information must possess. Accounting information is comparable when accounting standards and policies are applied consistently from one period to another and from one region to another. The characteristic of comparability of financial statements is important because it allows us to compare a set of financial statements with those of prior periods and those of other companies. Financial statements of one entity must also be consistent with other entities within the same line of business.
This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice. For example, a company which sells mobiles phones values its inventory based on First In First Out (FIFO) method previously, it must continue to do so in the future so as to preserve consistency in the reported inventory balance. A switch to other methods may cause a shift in the value in the inventory, which results in lack of basis of comparability.
It is stated that information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements (IASB Framework) Materiality therefore relates to the significance of transactions, balances and errors contained in the financial statements. Materiality defines the threshold or cutoff point after which financial information becomes relevant to the decision making needs of the users.
Information contained in the financial statements must therefore be complete in all material respects in order for them to present a true and fair view of the affairs of the entity. For example, the government of the country in which a company operates in working on a new legislation which would seriously impair the company’s operations in future. Although there are no figures involved, but the implication on the company would be so great that it would be material for this information to be made known to parties it may concern.
IASB Framework, 2012, http://www.ifrs.org/current-projects/iasb-projects/conceptual-framework/Pages/Conceptual-Framework-Summary.aspx (Cited 23 December 2012) Deloitte IAS Plus, History of IASB Framework, http://www.iasplus.com/en/standards/standard4 (Cited 23 December 2012) Steven Bragg, 13 March 2011, What is the prudence concept in accounting, http://www.accountingtools.com/questions-and-answers/what-is-the-prudence-concept-in-accounting.html (Cited 23 December 2012)