Theconceptual framework and accounting standards for financial reporting providesan agreed set of fundamental principles and concepts that leads to consistentstandards to ensure that these principles are met accordingly and theinformation required by users are faithfully represented and relevant (FASB,2010). These standards are required in order to ”assess managements stewardshipand make informed economic investment decisions” (Elliot & Elliot, 2017).
Thepurpose of this essay is to critically evaluate how the conceptual frameworkand accounting standards are facilitating the reporting of ”relevant andfaithfully represented” information in the entities financial statements thatare useful in assessing the prospects for future net cash inflows to theentity. Specifically, this essay will evaluate the objectives of financialreporting, ‘valuation usefulness’ and’stewardship usefulness’. Also, the importance of reporting relevant andfaithfully represented information within the conceptual framework will bediscussed in depth.
Theconceptual framework identifies qualitative characteristics of financialinformation that is required to reflect truthfully a company’s financialperformance (IASB, 2010). Relevant information is capable of making adifference to a user’s decisions. Relevant information has predictive value.The financial statements show predictive value because it helps users toevaluate the potential effects of past, present, or future transactions or otherevents on future cash flows (Nobes and Stadler, 2015). In addition topredictive value, confirmatory value contributes to the relevance of financialreporting information. If the information in the financial report providesfeedback to the users regarding previous transactions or events, this will helpthem to confirm or change their expectations (Jonas & Blanchet, 2000) (Christensen,2010).
Faithful representation is the second fundamental qualitative. Tofaithfully represent economic phenomena that information purports to represent,financial information must be neutral, complete, and free from error (IASB,2010). However, the quality of ‘transparency’ is not directlymentioned in the Exposure Draft.
In practice, it is often referred to in thecontext of good financial reporting. A study from Nobes and Stadler (2015) regardingthe usefulness of qualitative characteristics, showed that preparers frequentlyrefer to transparency in the context of policy changes under IAS 8. IAS 1 statesthat the primary objective of financial reporting is to provide informationthat is useful to those making investment decisions, such as buying, selling orholding equity investments (Gore & Zimmerman 2007). Given that valuation usefulness is seen asthe dominant role of contemporary financial reporting (Zeff, 2013), it is ratherunsurprising that financial statements are found to be very useful to investorsand other creditors when valuing a firm. The conceptual framework providesaccurate and timeliness financial information, relevant to the accountingstandards for investors and stakeholders (Ball,2006).
This should lead tomore-informed valuation in the equity markets. A majorfeature of the conceptual framework and accounting standards that facilitates thereporting of relevant and faithfully represented information is the extent towhich they are imbued with fair value (IFRS 13). Hermann (2006) states that fairvalue is the most relevant measure of financial reporting. IAS 16 provides afair value option for property, plant, and equipment and IAS 36 requires assetimpairments and reversals adjusted to fair value. Under the fair valuemeasurement approach, assets and liabilities are re-measured periodically toreflect changes in their value, resulting a change in either net income orother comprehensive income for the period.
In addition,fair value meets the conceptual framework criteria in terms of qualitativecharacteristics of accounting information better than other measurement bases. Fairvalue makes financial information relevant because prevailing prices arereliable measures of value as it reflects present economic conditions that isrelated to economic resources and obligations (Barth, 2008). Also, according toHermann (2006), fair value is more relevant to decision makers. Fair value makesan entity’s financial information faithfully represented because it accuratelyreflects the condition of the business as management are not able to rearrangeasset sales to increase or decrease net income whenever they can. It preventsentities from manipulating their reported net income. Management may sometimesrearrange asset sales and use the gains or losses from the sales to over orunderstate net income at a current time.
Fair value stops this from happening asgains or losses from price changes are reported in the period in which theyoccur. As pointed out by Ball (2006), this results in a balance sheet thatbetter reflects the current value of assets and liabilities. However, the useof fair values results in an unavoidable trade-off between relevance and reliabilityof accounting standards and could increase manipulation opportunities in highlyliquid markets (Marra, 2016) (Barth, 2008).
Moreover, IAS1 requires that an entity prepare its financial statements, except for cashflow information, using the accrual basis of accounting (IASB 2010). Accrual accounting is a method which measuresthe performance of a company by recognizing economic events regardless if anycash transaction occurs. The accruals concept gives entities a better assessmentand understanding of future net cash flows, thus enabling managers to make moreinformed financial decisions.
The accrual basis inform users about obligationsto pay cash in the future and of resources that represent cash to be received inthe future. Just like fair value, Accrual accounting also meets the frameworkcriteria of qualitative characteristics. Accrual accounting enablespredictability as it helps users evaluate the potential effects of past,present or future transactions or future cash flows, and confirmatory value toconfirm or correct their previous evaluations. Accrual accounting produces morefaithfully represented financial statements as it constitutes better representationsof actual circumstances and the entities performance in any time period. There isevidence that as a result of the accruals process, reported earnings tend to besmoother than underlying cash flows and that earnings provide betterinformation about economic performance to investors than cash flows (Dechow1994). Overall,both the accruals and fair value concept makes financial statements relevantand faithfully represented, Therefore, making valuation more useful asinvestors 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 tomeet the requirements of the qualitative characteristics that accountingstandards must meet.
However, theconceptual framework has been criticized due to the inconsistencies and lack ofguidance in defining and recognising assets and liabilities. Most notably, IAS38 Intangible Assets. Intangible assets are only recognised if it is probablethat the expected future economic benefits that are attributable to the assetwill flow to the entity. The general requirement in IAS 38 is similar to therequirement for Property, Plant, and Equipment of IAS 16. Conversely, in the remainder of thestandard, and interrelated requirements in IFRS 3 Business Combinations, differentrequirements are included which could result in the recognition of intangibleassets that do not meet the recognition and definition criteria of the ConceptualFramework as well as the exclusion of intangible assets that do meet thedefinition of an asset (Brouwer, 2015).
The lack of recognising many intangibleassets 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 therecognition of intangible assets. Disclosing the true value of intangibleassets in the financial statement is fundamental in order to meet theobjectives (Laux,J.
(2011).According to the recentconceptual framework of IASB, the objectives of financial reporting has twoaspects. One is stewardship, which deals with management responsibility towardsthe company, and another is decision-usefulness, which mainly deals with thedecision-making users of the financial statement. Thecurrent Exposure Draft gives more prominence to the role of stewardship, whichis an improvement on the existing 2010 framework (IASB 2015).This issue concerns the very nature of financialreporting, and may hinge on whether one believes that financial reports areused as much or more for control and evaluation of management as they are forresource allocation decisions (Gore & Zimmerman 2007).
AndrewLennard (2007) argues that stewardship and decision usefulness should berecognised as separate objectives. The assessment of howmanagement has fulfilled its stewardship responsibilities may require more informationthat is not necessarily provided to achieve the objective of financialreporting. Stewardship helps to increase the decisionusefulness to the relevant decision maker by imposing responsibility for managementto take care of the entity’s resources which will increase the relevance andfaithful representation of the financial report. Stewardship helps to accuratelyrecord, assessmanagements performance, and provide information to optimisefirm value, thus improve investment decisions. Management stewardship ismeaningful to financial reports users who are interested in making resourceallocation decisions because managements performance in discharging itsstewardship responsibilities significantly affects an entities ability togenerate net cash inflows (Kuhnerand Pelger 2015).However, assessing the performance of managements stewardship through financialstatements may prove difficult because of the agency problem. Some of the concern about stewardship being a separate objective seemsto stem from the potential tension between the interests of management andthose of owners (Agrawel andKoeber, 1996). Bebchuck and Fried (2003) state that managers have a lot ofinfluence and power over shareholders in different aspects, such as their own salaryas they have the ability to reduce the link between their performance and theirsalary.
Managers have almost complete freedom allowing them plenty ofopportunities to benefit for their own private interests. For example, it is possiblefor a manager to not distribute excess cash when the firm does not have profitableinvestment opportunities, therefore, making financial statements express aninaccurate reflection of managerial allocation of resources. Boshkoska(2014) shows thatincreasing managerial compensation will reduce the agency costs to shareholderswhich would make financial statements more likely to represent accurateinformation about a firm’s stewardship.
Also,this will help support managerial and shareholder interests together, so thatmanagers benefit when shareholders benefit.Furthermore, Kuhner and Pelger (2015) showthat the concept of fair value has different impacts on the valuation andstewardship usefulness of financial statements. To clarify, they have anegative impact on the ability of financial statement users to assessstewardship of the managers of the company. Lennard (2007) argues that, to beable to assess how the management discharged their responsibilities towards theshareholders, a piece of information that is difficult to disagree with isdemanded.
In other words, historical cost method to value assets andliabilities is seen as a more relevant measure for the purposes of financialstatements. Different opinions continue to exist aboutwhether providing information about management stewardship should be stated asan objective of financial reporting. I believe that a separate objective for stewardshipis not required because it is comprised within the decision usefulnessobjective. The decision usefulness objective is to provide decision usefulinformation to current and prospective providers of finance.
Additionally, thesame information about economic resources and claims, and changes in them, isthe same information needed for assessing management stewardship. Therefore,adding a discussion about the information that is helpful in assessingstewardship would add nothing substantive to the objective (Whittington, 2008).Toconclude, it is evident that there are many opportunities and limitations byusing the conceptual framework and accounting standards. Despite limitationssuch as its inadequacy in certain situations, the contributions of theconceptual framework and accounting standards far outweigh the shortcomings. Continueddevelopment and enhancement is therefore recommended. With a well formulatedconceptual framework there is an expectation that information will be generatedthat is one or more relevant to report users, as well as being more faithfullyrepresented. The conceptual framework has shown the importance of comparabilitywithin financial statements whilst also showing how stewardship can developover time which helps to compliment users reviewing financial statements.