The
conceptual framework and accounting standards for financial reporting provides
an agreed set of fundamental principles and concepts that leads to consistent
standards to ensure that these principles are met accordingly and the
information required by users are faithfully represented and relevant (FASB,
2010). These standards are required in order to ”assess managements stewardship
and make informed economic investment decisions” (Elliot & Elliot, 2017). The
purpose of this essay is to critically evaluate how the conceptual framework
and accounting standards are facilitating the reporting of ”relevant and
faithfully represented” information in the entities financial statements that
are useful in assessing the prospects for future net cash inflows to the
entity. Specifically, this essay will evaluate the objectives of financial
reporting, ‘valuation usefulness’ and
‘stewardship usefulness’. Also, the importance of reporting relevant and
faithfully represented information within the conceptual framework will be
discussed in depth.

 

The
conceptual framework and accounting standards state the qualitative
characteristics of financial information that is required to reflect truthfully
a company’s financial performance (IASB, 2010). Relevant information is capable
of making a difference to a user’s decision. Relevant information has
predictive value because it helps users to evaluate the potential effects of
past, present, or future transactions or other events on future cash flows (Nobes
and Stadler, 2015). In addition to predictive value, confirmatory value contributes
to the relevance of financial reporting information. If the information in the
financial report provides feedback to the users regarding previous transactions
or events, this will help them to confirm or change their expectations (Jonas
& Blanchet, 2000) (Christensen, 2010). Faithful representation is the
second fundamental qualitative. To faithfully represent economic phenomena that
information purports to represent, financial information must be neutral, complete,
and free from error (IASB, 2010).

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However, the quality of ‘transparency’ is not directly
mentioned in the Exposure Draft. In practice, it is often referred to in the
context of good financial reporting. A study from Nobes and Stadler (2015) regarding
the usefulness of qualitative characteristics, showed that preparers frequently
refer to transparency in the context of policy changes under IAS 8.

IAS 1 states
that the primary objective of financial reporting is to provide information
that is useful to those making investment decisions, such as buying, selling or
holding equity investments (Gore & Zimmerman 2007).  Given that valuation usefulness is seen as
the dominant role of contemporary financial reporting (Zeff, 2013), it is rather
unsurprising that financial statements are found to be very useful to investors
and other creditors when valuing a firm. The conceptual framework provides
accurate and timely financial information, relevant to the accounting standards
for investors and stakeholders (Ball,2006). This should lead to more-informed
valuation in the equity markets.

 

 

A major
feature of the conceptual framework and accounting standards that facilitates the
reporting of relevant and faithfully represented information is the concept of
fair value (IFRS 13). Hermann (2006) states that fair value is the most
relevant measure of financial reporting. IAS 16 provides a fair value option
for property, plant, and equipment and IAS 36 requires asset impairments and reversals
adjusted to fair value. Under the fair value measurement approach, assets and
liabilities are re-measured periodically to reflect changes in their value, resulting
a change in either net income or other comprehensive income for the period.

In addition,
fair value meets the conceptual framework criteria in terms of qualitative
characteristics of accounting information better than other measurement bases. Fair
value makes financial information relevant because current prices are reliable
measures of value as it reflects present economic conditions that is related to
economic resources and obligations (Barth, 2008). Also, according to Hermann
(2006), fair value is more relevant to decision makers. Fair value makes an
entity’s financial information faithfully represented because it accurately
reflects the condition of the business. Management and entities may sometimes
rearrange asset sales and use the gains or losses from the sales to over or
understate net income at a current time. Fair Value prevents entities from manipulating
their reported net income as gains or losses from price changes are reported in
the period in which they occur. As pointed out by Ball (2006), this results in
a balance sheet that better reflects the current value of assets and
liabilities. However, the use of fair values results in an unavoidable
trade-off between relevance and reliability of accounting standards and could
increase manipulation opportunities in highly liquid markets (Marra, 2016)
(Barth, 2008).

Moreover, IAS
1 requires entities to prepare its financial statements, except for cash flow
information, using the accrual basis of accounting (IASB 2010).  Accrual accounting is a method which measures
the performance of a company by recognizing economic events regardless if any
cash transaction occurs. The accruals concept gives entities a better assessment
and understanding of future net cash flows, thus enabling managers to make more
informed financial decisions. The accrual basis informs users about obligations
to pay cash in the future and of economic resources that represent cash to be
received in the future. Just like fair value, Accrual accounting also meets the
framework criteria of qualitative characteristics. Accrual accounting enables
predictability as it helps users evaluate the potential effects of past,
present or future transactions or future cash flows, and confirmatory value to
confirm or correct their previous evaluations. Accrual accounting produces more
faithfully represented financial statements as it constitutes better representations
of actual circumstances and the entities performance in any time period. There is
evidence that as a result of the accruals process, reported earnings tend to be
smoother than underlying cash flows and that earnings provide better
information about economic performance to investors than cash flows (Dechow
1994).

 

Overall,
both the accruals and fair value concept makes financial statements relevant
and faithfully represented, Therefore, making valuation more useful as
investors are able to accurately assess the prospects for future net cash flows.
In fact, it would be tough to identify better alternative methods in order to
meet the requirements of the qualitative characteristics from accounting
standards and the conceptual framework.

 

However, the
conceptual framework and accounting standards has been criticized due to being
inconsistent and its lack of guidance when defining and recognising assets and
liabilities. Most notably, IAS 38 Intangible Assets. Intangible assets are only
recognised if it is probable that the expected future economic benefits that
are attributable to the asset will flow to the entity. The general requirement
in IAS 38 is similar to the requirement for Property, Plant, and Equipment of IAS
16. Conversely, in the remainder of the standard, and interrelated requirements
in IFRS 3 Business Combinations, different requirements are included which
could result in the recognition of intangible assets that do not meet the recognition
and definition criteria of the Conceptual Framework as well as the exclusion of
intangible assets that do meet the definition of an asset (Brouwer, 2015). The
lack of recognising many intangible assets on financial statements due to this
problem has been criticised by Lev (2003), who holds that this information is
required to solve the issue of partial, inconsistent and confusing information regarding
non-current assets. Eckstein (2004) concludes that the objective of providing
relevant information must include the recognition of intangible assets. Disclosing
the true value of intangible assets in the financial statement is fundamental
in order to meet the objectives (Laux, J. (2011).

According to the recent
conceptual framework of IASB, the objectives of financial reporting has two
aspects. One is stewardship, which deals with management responsibility towards
the company, and another is decision-usefulness, which mainly deals with the
decision-making users of financial statements. The current Exposure
Draft gives more prominence to the role of stewardship, which is an improvement
on the existing 2010 framework (IASB 2015). This
issue concerns the very nature of financial reporting, and may hinge on whether
one believes that financial reports are utilized to such an extent or more for
control and evaluation of management as they are for resource allocation decisions
(Gore & Zimmerman 2007).

Andrew
Lennard (2007) argues that stewardship and decision usefulness should be
recognised as separate objectives. The assessment of how
management has satisfied its stewardship responsibilities may require more information
that is not necessarily provided to achieve the objective of financial
reporting. Stewardship helps to increase the decision
usefulness to the relevant decision maker by imposing responsibility for management
to take care of the entity’s resources, thus increasing the relevance and
faithful representation of the financial report. Stewardship helps to accurately
record, assess
managements performance, and provide information to optimise
firm value, therefore improve investment decisions. Management
stewardship is meaningful to financial reports users who are interested in
making resource allocation decisions because managements performance in
discharging its stewardship responsibilities significantly affects an entities
ability to generate net cash inflows (Kuhner and Pelger 2015).

However, assessing the performance of managements stewardship through financial
statements may prove difficult because of the agency problem. Some of the concern about stewardship being a separate objective seems
to arise from the potential conflict between the owners and managements
interest (Agrawel and
Koeber, 1996). Bebchuck and Fried (2003) state that managers have a lot of
influence and power over shareholders in different aspects, such as their own salary
because of the ability to reduce the link between their performance and their
salary. Managers have almost complete freedom allowing them plenty of
opportunities to benefit for their own private interests. For example, a
manager may not want to distribute excess cash when the firm does not have profitable
investment opportunities, therefore, making financial statements express an
inaccurate reflection of managerial allocation of resources. Boshkoska
(2014) states that
increasing managerial compensation will reduce the agency costs to shareholders
which would make financial statements more likely to represent accurate
information about a firm’s stewardship.  Also,
this will help support managerial and shareholder interests together, so that when
shareholders benefit, managers can also benefit.

Furthermore, Kuhner and Pelger (2015) show
that the concept of fair value has different impacts on the valuation and
stewardship usefulness of financial statements. To clarify, fair value can display
a negative impact on the ability of financial statement users to assess
stewardship of the managers of the company. Lennard (2007) argues that, to be
able to assess how the management discharged their responsibilities towards the
shareholders, a piece of information that is difficult to disagree with is
demanded. In other words, the historical cost method to value assets and
liabilities is seen as a more relevant and superior measure for the purpose of relevant
and faithful representative financial statements.

 

Different opinions continue to exist about
whether providing information about management stewardship should be stated as
an objective of financial reporting. A separate objective for stewardship is
not required because it is comprised within the decision usefulness objective. The decision usefulness objective is to
provide decision useful information to current and future providers of finance.
Additionally, the same information about economic resources and claims, and
changes in them, is the same information needed for assessing management
stewardship. Therefore, adding a discussion about the information that is
helpful in assessing stewardship would be impractical to the objective (Whittington, 2008).

To
conclude, it is evident that there are limitations by using the conceptual framework
and accounting standards. The limitations may make an
investors’ assessment of an entities net future cash flow inaccurate. However, the contributions far
outweigh the shortcomings. Without these regulations it would be
impossible to produce accurate, and unbiased financial statements. Even if
financial statements were slightly inaccurate, it would be impossible to
predict future net cash inflows without them. Faithful representative and
relevant financial information would not be possible without these accounting
standards. Continued development
and enhancement is recommended. With regards to stewardship, it would not be sufficient
to only use financial statements to measure management responsibilities of the
entity. Therefore, I believe that valuation should be considered as the main objective
of financial reporting.

 

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