Financial Reporting - International Accounting Standards - Essay Example

? Financial Reporting – International Accounting Standards [School] Number] May 26, The essay discusses the challenges faced by International Accounting Standards Board in accomplishing its mission of introducing international financial reporting standards for general purpose financial statements. It further discusses about the key characteristics of International Accounting Standards Board’s framework. The essay finally discusses about development of International Financial Reporting Standard for small and medium sized entities and the modifications thereof. Financial Reporting – International Accounting Standards The essay analyses the challenges faced in establishing International Financial Reporting Standard, the characteristics of the Framework and International Financial Reporting Standard for small and medium entities. Challenges A financial reporting system should focus on the needs of all capital providers and not just for a class of people. International Accounting Standards Board was set up with the sole mission to develop, in the public interest, a single set of high quality, understandable and international financing reporting standards for general purpose financial statement. International Accounting Standards Board had it fair share of challenges to accomplish its mission. Let us analyse the challenges faced by International Accounting Standards Board below: National Financial Environment: Every country follows a certain set of accounting standards based on its local financial environment. Therefore developing an accounting standard which suits individual country specific needs is a very challenging task. International Convergence: The difference between the national accounting standards and International Financial Reporting Standard is minimal and it lies mostly because of the differential treatment of specific transactions. Hence the issue of international convergence comes in which tries to state whether the gap between the national standard and international accounting standard can be bridged and converged and adopted by countries. Government rules and regulations: Country specific rules and regulations have a bearing on the way the financial information is produced. Let us take for example, a country have the minimum tax rates and with lots of other perks to the companies. In this case a company incorporated in this country because of favorable tax regime will not try to malign its financial reports. Similarly, tax heavens (Tax Heaven) such as Mauritius, Bermuda, British Virgin Islands, etc. attract more investment from companies to save tax. Many countries have double taxation because of weak tax reforms but some countries have robust taxation policies which are transparent. International Financial Reporting Standard therefore needs to factor in such issues. Social and Cultural issues: Islamic countries follow Islamic financing, which are very much different from the other national standards. Therefore, International Financial Reporting Standard, whose role is to portray the correct picture of the financial stature of the company, may find hard to make a strong foot hold in such countries. Islam financing, does not allow companies to earn high profits due to which these companies try and manipulate the accounts accordingly (Mohammed Ibrahim). International Financial Reporting Standard being an initiative of the western countries may not be acceptable in this Islam driven countries. Update the International Standards on Regular Intervals: The national accounting standards are always updated to factor in and control various lags in the standards on a time to time basis. International Accounting Standards Board similarly also have to deliver on the same lines. The challenge here is that it is very complex and they have to do it on a global scale. Therefore this requires time, respective field experts and funds. Every time they update a standard based on practical issues, they need to convey it to the countries and they in turn also need to time to adopt and implement the updated standards. The time lag therefore is a big challenge. Fund issues of International Accounting Standards Board: The success of International Financial Reporting Standard by International Accounting Standards Board as a highly reliable global accounting standard depends on International Accounting Standards Board’s performing in a way which would have the confidence of the concerned stakeholders. International Accounting Standards Board performance may get affected if they do not have right resources at their disposal. Therefore it is very important to identify the funding sources for International Accounting Standards Board which are reliable and stable in nature. Cost: Adoption of International financial reporting standards definitely is an added cost to the company. Companies do not like to add cost unnecessarily, especially if it is a regulatory requirement. This cost does not add to the revenue of the companies and is unproductive in nature. This cost may be negligible to large firms but can be quite a pain to small and medium sized entities. International Accounting Standards Board has looked into this aspect and has come out with International Financial Reporting Standard for small and medium sized entities which have been discussed later in this essay. Professional Knowledge: The international standards are one which accommodates all the accounting needs which is acceptable throughout all countries. This brings in complexity and issues of understandability. Therefore, imparting knowledge and training at a global level so that the internationals standards can be understood and applied easily is a huge challenge for International Accounting Standards Board. Impact on the Financial Performance: Companies might resist to the adoption of International Financial Reporting Standard, if it impacts their decision making, profits and changes at large scale internally. Therefore educating the corporate honchos about the impact and advantages of International Financial Reporting Standard to the company is very important else it becomes a challenge for International Accounting Standards Board. International Accounting Standards Board’s Framework International Accounting Standards Board uses the framework for the preparation and presentation of financial statements to set consistent principles, internationally converged and lead to financial reporting that provides the necessary information to financial statement users (IASB). The qualitative characteristics of relevance, reliability and comparability identified in the International Accounting Standards Board’s Framework for the preparation and presentation of financial statements (Framework) are some of the attributes that make financial information useful to the various users of financial statements. Let us discuss these qualitative characteristics. Relevance: Relevant information is information that is capable of making a difference in the decisions made by the users (Deloitte, 2008). However, it can also effect the decisions of more than just the capital providers. Capital providers evaluate the potential effects of past, present and future events of a company and identify the deviations over the previous evaluations. However, if information is not made available at right time, i.e. timeliness, than it can affect the decision. For example: ABC Inc sold XYZ Inc merchandise worth $20 million. Investor A invested in ABC Inc. after this sale. The fact that the director of ABC Inc. is the promoter of XYZ Inc is another piece of information. This information was available only after the decision was made. In this case, if the information was available while the sale was made to XYZ Inc. investor A would have chosen otherwise and not invested in ABC Inc. Therefore relevant information has both confirmative and predictive value. Reliability: Reliable information has an underlying economic phenomenon that is complete, neutral and free from bias (Deloitte, 2008). Reliability ensures substance rather than just a physical form. In other words, financial information presented should represent the gist of the transaction rather than just fulfilling the legality aspect of it. It should be free from any kind of errors which could lead to incorrect decision making. Reliability also depends on the how prudently an information or transaction treated while reporting financial statements. For example: A company has foreign currency exposure and has hedged its position with the help of derivatives. If the company incurs losses on this hedge and the derivatives are not mark to market while reporting the financial statements, the information will be unreliable as it is not neutral and is biased with the sole intension of not booking losses. Comparability: Users of financial statements must be able to compare financial statements of an entity from period to period within the entity. Users should also be able to compare financial statements of different entities in order to evaluate the financial position, performance and changes in financial position (Deloitte, 2008). Comparability is in fact a supporting component of relevance and reliable information. Comparability characteristic has a basic assumption that the accounting policies are the same. In case accounting policies are changed, then necessary adjustments should be made so that draw correct conclusion of the financial reports. This ensures consistency and financial prudence in order to take correct and informed decisions. Determining International Financial Reporting Standard for Small and Medium Size Entities The principal aim when developing accounting standards for small to medium-sized enterprises is to provide a framework that generates relevant, reliable, and useful information which should provide a high quality and understandable set of accounting standards suitable for Small and Medium Size Entities. There is no universally agreed definition of a Small and Medium Size Entities and it is difficult for a single definition to capture all the dimensions of a small or medium-sized business. The main argument for separate Small and Medium Size Entities accounting standards is the undue cost burden of reporting, which is proportionately heavier for smaller firms. In most countries, great majority of the companies are small and medium size entities irrespective of how the term “small and medium size entity” is defined. The cost and expertise required to prepare and maintain financial reports for the stakeholders by small and medium size entities is the reason why International Accounting Standards Board has come out with full International Financial Reporting Standard specific to Small and Medium Size Entities. The different approaches which could have been taken by the International Accounting Standards Board (IASB) in developing the ‘International Financial Reporting Standard for Small and Medium-sized Entities’ are: GAAP: Generally accepted accounting principles could have been developed on a national basis for such small and medium sized entities and International Financial Reporting Standard focusing on public listed companies. However, this approach would not be in line with the very purpose the International Accounting Standards Board was created. Limiting the scope to only public listed companies is likely to result in standards or practices for other firms which are inconsistent with International Accounting Standards Board’s Framework or Standards, may not address the needs of external users of financial statements and also not help achieve the qualitative characteristics i.e. comparability. It will also lead to an issues when the small and medium size entities gets listed on the bourses because they the transition phase to International Financial Reporting Standard may not be as smooth as it should be. However, as per one of the views, (Deloitte, Comments - Preliminary Views on Accounting for Standards for SME, 2004) very low number of small and medium size entities seek to grow into larger entities that achieve public listings. Exemptions: Areas where the small and medium size entities phase can be easily identified. Once these areas are identified, International Accounting Standards Board can give way some leeway in terms of exemptions in the mainstream accounting standards, i.e. International Financial Reporting Standard. For example a separate section can be created in International Financial Reporting Standard stating about the exemption that are applicable to the small and medium size entities. Full International Financial Reporting Standard: Full International Financial Reporting Standard are suitable for all those entities that are preparing financial statements to provide information to wider audience of stakeholders but if the scope of these stakeholders is small than full International Financial Reporting Standard might not be required. In case of small and medium size entities, shareholders are the one who do not change frequently and just play the role of stewardship. Therefore, full International Financial Reporting Standard is not required for small and medium size entities. Separate Set of Financial Reporting: International Accounting Standards Board should develop separate set of financial reporting standards on the lines of International Financial Reporting Standard but keeping in mind the small and medium size enterprises. Many national jurisdictions round the globe have their own set of reporting standards. Standards that can be deduced easily and worked upon to achieve the accounting treatment or disclosures are required. Small and medium size entities do not have the required expertise to deal with the complexities of full International Financial Reporting Standard hence, standards which can be easily replicated in their businesses should be developed. Approach taken by International Accounting Standards Board: International Accounting Standards Board drafted International Financial Reporting Standard for small and medium size enterprises. International Financial Reporting Standard for small and medium size enterprise is a standard set of accounting principles, based on full International Financial Reporting Standard, but easily understandable so that they are suitable for small and medium size entities. International Financial Reporting Standard for small and medium size entities is quarter in size and has distinct frameworks when compared to that of full International Financial Reporting Standard. Though, the approach does not lead to an independent development of set of standards, it is based on recognized concepts and pervasive principles. If the small and medium size entity later becomes a public listed entity, it can be transitioned smoothly from the International Financial Reporting Standard for small and medium size entities to full International Financial Reporting Standard. The draft for International Financial Reporting Standard for small and medium size entities was developed by considering the modifications that are appropriate in the light of user’s needs and cost benefit considerations (IASB, IFRS for SME, 2007). Differences and Modifications to International Financial Reporting Standard for Small Medium Sized Entities There is no robust definition of small and medium size entities. Most definitions are based on variables such as size, number of employees, turnover, asset size, etc. However, none of this variable is consistent across borders. The issue therefore was to define as to which entities International Accounting Standards Board standards for small and medium size entities would be intended. The various alternatives which International Accounting Standards Board had at its disposal were (IASB, Preliminary Views on Accounting Standards, 2004): Regulatory Authority: Differentiating between large companies and small and medium size companies can vary from country to country. For example a company in USA with a capital base of $300 million could be treated as small and medium size company whereas the same company in Sri Lanka could be treated as a large size company merely because the number of large companies in USA is more with high average base capital when compared to that of Sri Lanka. Therefore in this case International Accounting Standards Board could just stick to developing of the standards and let the regulatory authorities of respective countries classify companies into small and medium size entities. Public Accountability: A company that is classified as small and medium size entity and is listed or publicly traded should follow full International Financial Reporting Standard rather than the standards for small and medium size entities merely because the investors primarily depend on external financial reporting. Therefore companies which do not have public accountability can only follow International Financial Reporting Standard for small and medium size entities. Therefore International Financial Reporting Standard for small and medium size entities has attempted to define small and medium size entities as entities that (IASB, IFRS for SME, 2007): a) Do not have public accountability; and b) Publish general purpose financial statements for external users. Examples of external users include owners who are not involved in managing the business, existing and potential creditors, and credit rating agencies. An entity does not have public accountability if their equity or debt is not publicly traded. The differences and modifications to International Financial Reporting Standard for small and medium size entities which the International Accounting Standards Board has made to reduce the burden of reporting for small and medium size entities is discussed below (PWC). Financial Statements: A complete statement of changes in equity is not required if only changes to the equity are a result of profit or loss, payment of dividends or a change in accounting policy. Concepts and pervasive principles The qualitative characteristics include understandability, relevance, materiality, reliability, substance over form, prudence, completeness, comparability, timeliness and achieving a balance between benefit and cost. General: There is no prescribed format of balance sheet but items required are mentioned. A combined statement of income and retained earnings can be presented instead of separate filings of statement of changes in equity and statement of comprehensive income. Cash Flow: Both direct method and indirect method can be used to present cash flows from operating activities. In case of cash flows from financing activities and investing activities, figures reported should be gross. Estimations: In case of full International Financial Reporting Standard, sensitivity analysis is required for all the estimation and judgments with respect to accounting policies but the same is exempted in International Financial Reporting Standard for small and medium size entities. Goodwill: Goodwill is treated as intangible asset and is amortized over its useful life which is considered to be 10 years. Gain on bargain purchase is termed as negative goodwill which is recognized in profit or loss account. Financial Instrument: Lists of financial instruments which normally qualify as basic are specified in International Financial Reporting Standard for small and medium size entities but in full International Financial Reporting Standard it is not applicable. Research and Development Expenses: All research and development expenses are recognized as an expense but full International Financial Reporting Standard treats research costs and development costs separately. Sections omitted: International Financial Reporting Standard for small and medium size entities does not speak about certain sections which are mentioned in the full International Financial Reporting Standard. 1. Segment Reporting 2. Interim Financial Reporting 3. Earnings per share 4. Insurance 5. Assets held for sale. References Deloitte. (2004, September 10). Comments - Preliminary Views on Accounting for Standards for SME. Retrieved March 26, 2011, from IAS plus: http://www.iasplus.com/dttletr/0409sme.pdf Deloitte. (2008, Septemeber 29). Exposure draft of an improved conceptual framework for financial reporting. Retrieved March 26, 2011, from Deloitte: http://www.iasplus.com/dttletr/0711sme.pdf IASB. (2004, September 24). Preliminary Views on Accounting Standards for SME. Retrieved March 26, 2011, from IAS Plus: http://www.iasb.org/NR/rdonlyres/40DFAE7D-3B5F-4764-AF05-0E2F0252F7E7/0/DPonSMEs.pdf IASB. (2007, October 1). IFRS for SME. Retrieved March 26, 2011, from IASB: http://www.iasb.org/NR/rdonlyres/DFF3CB5E-7C89-4D0B-AB85-BC099E84470F/0/SMEProposed26095.pdf IASB. (n.d.). Conceptual Framework. Retrieved March 26, 2011, from IAS Plus: http://www.iasplus.com/standard/framewk.htm Mohammed Ibrahim, S. H. (n.d.). MPRA. Retrieved March 26, 2011, from Munich Personal RePEc Archive: http://mpra.ub.uni-muenchen.de/12539/1/MPRA_paper_12539.pdf PWC. (n.d.). Modifications- IFRS SME. Retrieved March 26, 2011, from PWC: http://www.pwc.com/gx/en/ifrs-reporting/Comparison-IFRS-for-SMEs.jhtml Tax Heaven. (n.d.). Retrieved March 26, 2011, from Taxhavenco: http://taxhavenco.com/tax_havens.html Read More