The economic investment decisions” (Elliot & Elliot, 2017). The

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 identifies 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 decisions. Relevant information has predictive value.
The financial statements show 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 timeliness 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 extent to
which they are imbued with 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 prevailing 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 as management are not able to rearrange
asset sales to increase or decrease net income whenever they can. It prevents
entities from manipulating their reported net income. Management 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 stops this from happening 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 that an entity 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 inform users about obligations
to pay cash in the future and of 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 that accounting
standards must meet.

 

However, the
conceptual framework has been criticized due to the inconsistencies and lack of
guidance in 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 the balance sheet 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 mandates 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 the financial statement. 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
used as much 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 fulfilled 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 which will increase the relevance and
faithful representation of the financial report. Stewardship helps to accurately
record, assess
managements performance, and provide information to optimise
firm value, thus 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 stem from the potential tension between the interests of management and
those of owners (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
as they have 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, it is possible
for a manager to not 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) shows 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
managers benefit when shareholders 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, they have 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, historical cost method to value assets and
liabilities is seen as a more relevant measure for the purposes of financial
statements.

 

Different opinions continue to exist about
whether providing information about management stewardship should be stated as
an objective of financial reporting. I believe that 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 prospective 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 add nothing substantive to the objective (Whittington, 2008).

To
conclude, it is evident that there are many opportunities and limitations by
using the conceptual framework and accounting standards. Despite limitations
such as its inadequacy in certain situations, the contributions of the
conceptual framework and accounting standards far outweigh the shortcomings. Continued
development and enhancement is therefore recommended. With a well formulated
conceptual framework there is an expectation that information will be generated
that is one or more relevant to report users, as well as being more faithfully
represented. The conceptual framework has shown the importance of comparability
within financial statements whilst also showing how stewardship can develop
over time which helps to compliment users reviewing financial statements.