Analysis of Conceptual Frameworks in Accounting

Introduction

International Accounting Standards Board (IASB) has launched a collaborative project with the US Financial Accounting Standards Board (FASB) to revamp the frameworks that exist and merge the frameworks into a common one. The first step is to provide some background. In the United States, the US Securities and Exchange Commission (SEC) has suggested that businesses that are required to file financial statements that comply with the SEC start changing U.S General Accepted Accounting Principles (US GAAP) with International Financial Reporting Standards (IFRS) starting in 2014. In all practical terms, this would mean the acceptance of IFRS (principles-based) for all companies operating in the United States (U.S. accounting standards are regarded as a rules-based models). The goal is to align US accounting standards with an international standard in conjunction to the increasing globalization of capital markets.’Norwalk an arrangement between FASB with the IASB was signed, paving the way to the development of accounting standards based on principles to facilitate global financial reporting (Wikipedia 2010, 2010).

What is a Conceptual Framework?

International Conceptual Framework of Financial Reporting is a set of interconnected objectives and basic principles that establishes an established set of guidelines for the preparation of Financial reports.A conceptual framework comparable to a constitution which defines the purpose, nature and limitations for financial reporting and accounting.

What is the reason a conceptual framework is required? In the first place, for it to be beneficial the standard setting process should be built upon and be based on established ideas and goals. A well-developed conceptual framework can allow either the IASB as well as the FASB to develop more efficient and consistent standards in the course of time. A consistent set of rules and standards will be the result, as they are built on the same base. The framework will improve the understanding of financial statement users of financial statements and their confidence and also improve the comparability between companies’ financial statements. The second reason is that new and emerging issues in the real world should be easily solved through reference to the framework that exists in the fundamental theories. For instance, PandaCorporation sold two issues of bonds which it could redeem with either the equivalent of $1,000 cash or 50 ounces of silver depending on the amount at the time of maturity. The bonds had an interest rate that was stated as 9 percent. What amount would the bonds have been reported by Panda or buyers who purchased the bonds? What is the price or discount on bonds, and how should it be amortized, in the event that the bonds redemption payments will be with the form of silver (the actual value was undetermined at the time of issuance)?It isn’t easy, but not impossible in the hands of an organization like the FASB as well as the IASB to recommend the appropriate accounting treatment for situations such as this. Accountants who are practicing have to resolve such issues daily. By exercising the right judgment, and with the help of a widely-accepted conceptual framework, accountants can eliminate certain alternatives quickly and concentrate on a suitable solution.

An harmonisation of the accounting standard is extremely crucial. For example, multinational corporations operating across more than one nation will discover that it is difficult to meet multiple sets of accounting guidelines established by different authorities in various nations.

Standardization in accounting can benefit the world economy in way that follows: helping to facilitate international transactions while minimizing the cost of exchange through providing more “perfect” information; by making it easier for world-wide economic policy makers; by improving the information on financial markets; and also by enhancing accountability of government. Financial-based investment and international investment management decisions can be taken with lower risk.

In addition, the harmonization of accounting practices would ensure the benefit of a “level playing field” globally. Auditors and regulators will receive the same information and will be able to make the same evaluations.

In the current accounting world there are two kinds of accounting systems, specifically the rules-based system and the principles-based system.Almost every business is obliged to prepare their financial statements in accordance with either of the two types of standard. Recently, there was some debate over whether principles-based accounting is more effective as opposed to the more popular rules-based accounting due to accounting scandals like Enron. Due to the Enron scandal, the current way of accounting has put under a lot of examination.

Rules-based Accounting

Rules-based accounting , like US GAAP is basically a detailed set of guidelines to be adhered to when making financial statements. Many accountants are in favor of using standards based on rules, since in the absence of rules they could be taken before a judge if their assessments regarding the statements are incorrect. If there are strict rules to be followed and that are followed, the risk of lawsuits is reduced (Investopedia 2009). The existence of a set of guidelines will increase the accuracy of your reporting and lessen the uncertainty that could trigger reckless reporting decisions made by management. The rules matrix, however, may cause excessive complexity in the creation of financial statements.

Principles-based Accounting

Principles-based accounting like asIFRS is used as a basis of conceptualization for accountants. A set of basic objectives is set to ensure accurate reports, e.g. qualitative properties, accurate representation. Examples are given as guidelines. They also define the goals. While certain rules cannot be avoided but the guidelines aren’t intended to be applied to any situation (Investopedia 2009). Specific requirements may force managers to modify the accounting statements to meet the requirements that are required. The issue with accounting based on principles is that the absence of guidelines could result in unreliable and inconsistent data that makes it difficult to assess the performance of an organization to one another.

In deciding which accounting method is the most effective, it should be verified that the data provided within the statements are pertinent, reliable and comparable across different reporting times and organizations. A growing debate has driven accountants to adopt a principle-based approach to accounting, however, it is acknowledged that the system requires modification to make it more efficient and efficient.

For illustration of the two, let’s say that the cost of depreciation of all fixed assets needs to be fixed at 10 percent annually of the initial cost of the asset up to the point that it is completely depreciated.Such an arrangement does not allow for any judgment or disagreement over how much depreciation expense that should be acknowledged. Consistency and comparability across businesses and over time is almost certain under such a policy. It is a rules-based system.In contrast, in the principle-based system the depreciation expense for the period of reporting must reflect the decrease in valuation of assets during the period. This standard calls for the use of judgment and assessment by both auditors and managers. The objective is to record the true value of an asset on an “as is” basis.

The differences in IFRS in comparison to U.S. GAAP

Statement of Income- Under IFRS the extraordinary items are not segregated on the income statement. In contrast in US GAAP, they are included below net income.

Consolidation – IFRS favors a control-based model, while U.S. GAAP prefers a risk-and-rewards approach. Certain entities that have been that are consolidated according to FIN 46(R) might have to be categorized separately under IFRS.

Inventory : According to IFRS, LIFO (Last In First Out) is not a valid method, however in U.S. GAAP,companies have the choice of LIFO or FIFO (First In First Out). The use of the LIFO method will result in a lower gross profits that allows companies to pay less tax.

Earnings-per-Share – In IFRS the calculation of earning-per-share is not averaging of the individual calculations of the interim period however, according to U.S. GAAP the computation is averaging of the individual interim incremental shares of the time.

Development Costs – These costs are able to be capitalized in IFRS provided certain conditions are met. However, they are considered “expenses” under U.S. GAAP(Remi Forgeas, 2008).

Advantages

Rules-based System

  • Accuracy increased, less uncertainty, and a reduced risk of lawsuits.
  • The rule-based standard is generally regarded as more audit-friendly for compliance reasons and could result in more comparable and consistent financial reports across organizations.
  • Auditors are more confident in their taking decisions due to the fact that they have an illuminating guideline.

Principles-based System

  • The primary benefit of accounting based on principles is that the broad guidelines are applicable to a wide range of situations
  • Potentially extremely flexible in relation to changing and new environment and products. Therefore, they will need less care.
  • Another benefit of a principles-based approach is that it will result in standards that are simpler. A system based on principles would result in standards that are shorter than 12 pages instead of more than 100 pages.
  • Accountants are able to use their expertise and judgement more freely conformity with the professional codes in the preparation of financial statements. The application of their knowledge and knowledge will improve their professional competence.

Disadvantages

Rules-based System

  • Insufficient transparency in disclosure. In the wake of recent accounting scandals, such as Enron and Worldcom, investors are becominghypersensitive to the reliability of published accounts and suspicious of the possibility of inflated earnings.
  • The biggest drawback to rules-based systems is the complexity involved in the process of preparing financial statements.
  • It could be a result of a lack of flexibility to adapt to new conditions or products, resulting in constant maintenance.
  • Sometimes, organizations look for loopholes that satisfy the strict definition of the standard, however they do not meet the purpose in the standards.

Principles-based System

Some critics of a principles-based approach claim they are harder to audit and would likely be less comparable and consistent across different industries. Additionally, issues related to how to measure and recognize income will remain in the spotlight. For instance, what amount of revenue would General Electric actually recognize on the basis of a multi-year defense contract using the method of percentage of completion of accounting? Is this comparable to the earnings that its competitors report?

If they rely on their own judgement to interpret and apply the rules There is a risk that they could be used to alter the financial results. What happens if, for instance, the auditors are acting poorly? They abuse their authority and don’t adhere to the standards of “good faith consistent with the intent and spirit of the standards.”

Auditors have less confidence in their judgments.

In the case of the principles-based and the rules-based models, it’s believed that the latter is more practical and preferable by all people around the world, due to its universal appeal, based on morality, sound judgment integrity, transparency, and even common sense elements. Furthermore, in the internationalized business world, this model is easier to accept and comprehend.

and is acceptable in contrast to strict rules that could be read differently and accepted in other countries.

Example Cases

Enron Case

U.S. accounting standards are considered to be a rule-based model. As an example, we take a take a look at the Enron scandal that broke in the month of October 2001, and ultimately resulted in the demise of Enron Corporation. By using accounting loopholes, special-purpose entities (SPE), and inadequate accounting, Enron was able to hide billions of dollars of loans resulting from unsuccessful transactions or projects. In the U.S accounting law, it is possible for companies to exclude an SPE from their financial statements when an independent person is in control of the SPE and the independent party holds a minimum of 3 percent in the SPE.

Enron required an avenue to hide its amount of debt because high levels will lower the investment grade of the company and cause banks to cancel loans. By using the company’s stock as collateral the SPE was run by CFO Fastow and was a large borrower of amounts of money. The money was used to pay off the overvalued contracts of Enron. This is why the SPE allowed Enron to convert assets and loans burdened by debt obligations into earnings. Additionally, the transfer of assets by the SPE led to Enron’s transferring of more stock to the SPE. However, the debt, as well as assets acquired by the SPE that was heavily burdened by debts, were not listed in Enron’s financial records.

Enron was also found guilty of using a shady mark-to-market accounting method in the sales of its gas forward contracts. In this system, the income was calculated as the value at present of future cashflows net to determine “true economic value”. In the event that these projects failed, however, the income was still reported as a result of the initial value, which was of course not correct. Therefore, more projects needed have to be “created” to sustain a constant flow of income to please shareholders.

Shareholders suffered losses of nearly $11 billion in the event that Enron’s share price, which was at an all-time high of $90 per share in mid-2000 plummeted to below $1 by November 2001.

Transmile case

An audit of special significance, conducted through Moores Rowland Risk Management Sdn. Bhd revealed that Transmile had a pretax loss that totaled RM126 million, and RM77 million in the years 2006 and 2005 respectively, as opposed to pre-tax earnings that were RM207 million or RM120 million, as reported originally in a total of RM530 million overstated. They had their auditors Deloitte & Touche decline to approve the account when Transmile did not provide evidence to support the trade accounts. The loss, however, was not discovered from the perspective of Deloitte & Touche.

Worldcom case

Does this case unveil how one of the world’s largest Mississippi telecommunication providers managed to make $3.8 billion disappear? The solution is in the CFO of the company Scott Sullivan’s approach to capital expenses and the accrual method one of the most fundamental concepts of accounting. Sullivan did a sloppy job of taking billions of dollars in operating expenses and distributed them across “property” accounts, which is a form of capital expense account. This enabled Worldcom to pay the expenses at a slower pace as well as in lesser amounts rather than reporting the expenses directly to investors. The U.S’s rules-based accounting system is lack transparency. Transparency is becoming a matter of survival rather than choice. One way to address most of the shortcomings that have been mentioned is to push for greater openness in the financial report. This basically means that firms should begin providing all the data that they believe to be pertinent rather than just fulfilling their required regulations.

Southern Bank Bhd (SBB) case

In the review of the Southern Bank Bhd’s financial statements that were audited for the fiscal year ending Dec 31, 2005, there were accounting errors that amount up to RM 160 million. The details are as follows:

Not properly the value of certain financial instruments that are derivatives and not writing down completely their collateral values.

Incorrectly writing back certain conditions pertaining to specific foreclosure properties.

Capitalizing instead of deducting certain expenses is similar to the Worldcom Financial scandal.

It is evident that the standard of accounting and auditing in Malaysia is quite low. To protect the interests of the smaller shareholders and investors the accounting and auditing standards must be improved.

Conclusion

Personally, I don’t like relying on either principle. Without solid principles and rules, they are useless. Without regulations, accountants aren’t protected.

We had rules based on principle prior to the time that the IASB/FASB was formed. Specific rules or guidance were issued after lawsuits were filed against accountants and auditors who questioned their professional judgment. The accounting profession believed that the decision to create specific rules would lessen the possibility of lawsuits involving the accountant’s professional judgment. It is interesting that we are making a complete turn and trying ways to make accounting more simple considered. We’ll make this change and in a few years, what happens if a new accounting scandal occurs, who is asking for additional rules?

But, we might be better off recognizing that neither a strict rules-based nor a pure principles-based system is the most effective solution for itself. Perhaps a more principle-based system that is governed by a single rules’ code could be the perfect solution. The rules of any system will be subject to interpretation. Rules will only be just as good as the people who apply them.

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