International Accounting Standards Board - Literature review Example

THE CONCEPTUAL FRAME WORK PROJECT: CHAPTER ONE AND THREE Affiliation Table of Contents Introduction 3 Chapter One of the Conceptual Framework 3 Issues Surrounding the Stewardship Concept 4 IASBs View on the Introduction of Stewardship 4 Chapter Three Of The Conceptual Framework 6 The Concept Of Prudence 6 Controversy Surrounding The Prudence Concept 7 IASB’s Reasons For The Exclusion Of The Prudence Concept 8 The Reliability Concept 9 The IASB Reasons For Removal Of The Reliability Concept 9 Why retain the reliability concept? 10 Motives Behind IASB Actions 10 Conclusion 13 References 14 THE CONCEPTUAL FRAME WORK PROJECT: CHAPTER ONE AND THREE Introduction The International Accounting Standards Board (IASB) is an independent and a non-profit organisation. The organisation was established in 2001 and mandated with designing high quality and understandable financial reporting guidelines that are based on well-articulated principles (Johnson, 2004). Financial Accounting Standards Board (FASB) is a private organisation established in 1973 to establish standards of financial accounting that guide preparation of financial statements by the nongovernmental organisations. The organisation is based in Unites States of America (Johnson, 2004). The conceptual framework refers to statements that have been prepared by the accounting standards setting bodies (Storey and Storey, 1998). They are the concepts used to prepare and present financial statements. In addition, they are the standards for developing new financial reporting rules and norms against which practical problems are tested objectively. In the year 2004, both IASB and FASB set a joint project to review the conceptual framework (Johnson, 2004). However, due to many competing priorities, the project was dropped. In 2013, the IASB Board revisited the issue of the conceptual framework to work on chapter two. However, stakeholders of the financial reporting standards were not satisfies with the changes made in the theoretical framework earlier on. The IASB board was for the idea of not revisiting chapter one and three of the theoretical framework. However, the pressure from the public has made the board rethink about the reinstating prudence, introducing stewardship as an objective of financial reporting reinstating their liability concept that has already been replaced by the notion of faithfulness. Chapter One of the Conceptual Framework Chapter one of the conceptual framework outlines the general purpose of the financial reporting. According to Ernst & Young (2010) the amended conceptual framework states that the purpose of financial reporting is to provide financial information of an entity, that relevant for the decision-making. The framework identifies the primary users of the financial information as the existing or the potential investors, the lender or other creditors of the firm. The joint revision of the chapter by the IASB and FASB touched on many factors. For example, the employees, the customers, the government, and the public are no longer among the primary users of the financial information. However, the change that raised issues among many stakeholders if the exclusion of the steward shop concept as an objective of the financial reporting as discussed below. Issues Surrounding the Stewardship Concept The amended framework did not recognise the stewardship concept as an objective of the financial reporting. In their analysis, Oldroyd and Millers (2011) states that the concept has been maintained within the framework as a subset of identifying an entities future performance. Many respondents including Europe felt that the objective of the financial statements should not be cast wholly into providing the information necessary for decision making to investors and other stakeholders (EFRAG, 2013a). They felt that stakeholders also need information on how the management and the directors have used the resources entrusted to them (Lennard 2008). Most people effect that the concept of stewardship should be introduced, not to replace the notion of faithfulness but to reinforce it. The two notions ought to run concurrently. Chapter 1 of the conceptual framework avoids the term ‘stewardship’ while describing the purpose of financial reporting. The IASB often argues that the concept was not included since it does not translate wholly into a lot of languages. IASBs View on the Introduction of Stewardship One, IASB argues that stewardship is concerned with the accountability of the directors or the management board of a business entity to its shareholders (Deloitte, 2012). They explain that the issue is at the heart of many financial reporting processes in many jurisdictions. For example, a report by IFRS (2012) states that firms are required to disclose the related party relationships and transactions in the business. IASB argues that stewardship deals more with present events that would affect the firms rather than in the future events that would influence the future cash flows. Hence, stewardship and decision-making run parallel. They all are viable objectives. The objectives do not crush but rather have different emphasis (IFRS, 2014a). Two, IASB also states that the conceptual framework should only have one objective of financial reporting. According to Ernst & Young (2010), the purpose suggested is that of assisting the users of financial statements information in making viable investments, lending, and other resources allocation decisions. The IASB argued that the objective encompassed the provision of information that is useful in assessing management stewardship. Nevertheless, the board argues that the information that is necessary to assess stewardship is also necessary for the resources decision-making. In fact, the board points out that inputs to stewardship is necessary for the resource providers who for their voting for or against the current management (KPMG, 2014). Hence, provision of information for resources allocation decisions superseded the stewardship concept. However, in responding to the discussion paper, 78% of the viewers indicated that stewardship and accountability were two different objectives that needed to be addressed separately (IFRS, 2014b). Three, the board argues that it chose to describe the term ‘stewardship’ rather than use it because it is hard to translate the term into other languages without distorting the meaning Oldroyd and Miller (2011). The board felt that the word stewardship had very general and different meanings depending on various parties. As a result, it would be had to include it as an objective of financial reporting. Lennard (2008) however states that the board might be willing to adopt the concept if it could be accorded one definition. The IFRS (2014a) March staff paper shows that the stakeholders were dissatisfied with that explanation. In response, they suggested the use of ‘accountability’ in the place of ‘stewardship’. Four, the Board stated that there was no obvious implication in the inclusion of stewardship either alone or as part of accountability to the financial statements (Lennard, 2008). In their analysis states, that board feels that some impact on the financial statements is needed to demonstrate the usefulness of separating the objectives. IFRS (2013b) indicates that the argument is a weak one. For example, sometimes the management may decide to issue share schemes to the staff as a bonus payment. The problem results in no cash inflows and no cash outflows. Under the accountability principle, there may be no need to disclose the matter in the financial statements since the net effect on the financial statements was zero (IFRS, 2013c). However, the shareholders may be more concerned with such information since it can affect their future cash flow through dilution. As a result, the information may be vital under the stewardship concept and less important under the accountability concept. The term accountability show, that the obligation, to take care of the shareholders resources. Furthermore, it shows that beyond taking care of the resources, the managers have a duty to give an account of the resources that they have been taking care of as and when they are requested to do so. Chapter Three Of The Conceptual Framework The chapter captures the characteristics that are necessary for useful financial information. Useful financial information is one that may be relied upon by the users, in making viable decisions (Ernst & Young, 2010). The characteristics are divided into two. One is the fundamental qualitative characteristic, which constitutes of relevance and faithful representation concepts. The second category is the enhancing qualitative characteristics that include comparability, verifiability, and timeliness and understand ability. An analysis made by Deloitte (2010) states that the issues surrounding this topic are the replacement of the concept of reliability with the concept of faithful representation. The second major issue was the removal of the concept of prudence from the chapter. These issues have been discussed in details below. The Concept Of Prudence Future events are often uncertain. Though some forecasting can be done, a one hundred per cent certainty is hard to achieve. As a result, professionals and managers often have to use their judgment in using accounting policies and estimates. The concept of prudence calls upon the managers, to exercise due caution in the adoption of policies and significant estimate (ACCA, 2000). Due diligence ought to be taken to ensure that assets and equity are not overstated while reducing the value of liabilities of a firm. The rationale of the principle is that assets should not be presented at a value higher than the recoverable amount. Likewise, liabilities should not be recognized at a value lower than what is expected to be paid out. There is a high risk of overstating assets and income. Firms gain from higher profitability and huge asset base. Lower leverage benefits the firms in terms of low cost of financing and increased share prices. Management has a tendency to adopt the accounting principles that would favour their conditions. The prudence principle serves to eliminate such a bias (Storey and Storey, 1998). Controversy Surrounding The Prudence Concept The first controversy surrounding prudence concept was its non-inclusion as a quality of the financial statement. IASB has decided to work on the conceptual framework of accounting and specifically chapter two. There are mixed reactions that they should revisit the concept of prudence (EFRAG, 2013b). The primary issue is whether the IASB should reintroduce the notion of prudence that was scrapped off in the year 2010. The discussion paper DP/2013/1 by IFRS (2013c) reports that the issue has attracted a lot of debates, especially from the euro zone. According to a report by ACCA (2014) contributing to the debate, cites the importance of the inclusion of prudence. The report argues, that failure, to include prudence may lead to undesirable actions my management. In fact, the report states that already lack or over the exercise of prudence by banks is being attributed the World Economic Crisis of 2007. Although the majority of the people seem to support the idea of exclusion of prudence from the framework, there is still support reinstatement of the concepts. The second controversy is what amount of prudence the management should exercise. According to the staff paper, by IFRS (2014b), the stakeholders not only want the former concept reintroduced in the financial statements but also want the concept to be redefined. The former concept did not state the exact amount of prudence that managers should exercise. Consequently, managers have always. Most important, the ACCA (2014) reports that the stakeholders’, worry is not the understatement of the financial statements but the overstatement of the profits and assets. Thirdly, there is a feeling that if IASB is to reintroduce the prudence concept, then he exact meaning of the concept needs to be specified. According to the fed back obtained by IFRS of the issue, many people interpret the concept differently (IFRS, 2014b). Due to its misuse by the management, the report states that IASB need to clarify what prudence means and what it does not mean. The broad definition has been maximised by scrupulous managers in smoothing profits, overstate losses and liabilities while understating assets and liabilities. The correct definition would limit such incidences. IASB’s Reasons For The Exclusion Of The Prudence Concept First, including prudence as a principle embedded in faithful representation would be inconsistent with neutrality. Even if the conceptual framework amended in the year 2010 prohibits deliberate misstatements, a requirement to be prudent would lead to some level of biases in the preparation and reporting of financial information. In his speech, the chairperson of IASB stated that the concept of being cautious while in doubt was still engraved in the International Financial Reporting Standards. Besides, the notion of neutrality was more emphasized when the definition of prudence was left out (IFRS, 2014a). Secondly, there was a general perception that the inclusion of prudence would give management a chance to understate assets deliberately and overstate liabilities (Johnson 2004). Such an intentional error would lead to overstating of the financial statements in the later periods. Hence, Managers may use this technique to lie to the shareholders that they are implementing the right policies and investing in the viable decisions while in the real sense that is not true. Hence, the exercise of prudence in one period could lead to an overstatement of performance in the subsequent years. The concept was also removed because the Accepted Accounting Principles did not have the right definition of the word prudence. Due to lack of a standard definition, different parties interpret the meaning differently. Different interpretations may lead to differences in the application of the concept of prudence. It would be contrary to the conceptual framework that aims at setting the standard against which financial preparation and reporting is based (IFRS, 2013). The Reliability Concept Reliability is the quality of the financial statements to be relied on by stakeholders in making investment decisions (Johnson, 2004). Under the new IFRS rules set in the year 2010, the concept was replaced with faithfulness. Faithfulness requires that the information be a full representation of the whole economic factors that intends to represent (IFRS, 2014a). It captures the economic resources, obligations, and other events, which may change from time to time. Information about such events must be neutral, verifiable, and complete. As opposed to reliability, faithful representation requires the judgment of the economic substances and the real world economic phenomena rather than merely the accuracy of the figures. As a result, its fair value were deemed better represent ‘economic substance’, the historical cost might be considered to be an inappropriate measure, despite the latter possibly being a. However, the historical measurement might be considered a wrong measure for adoption when faithfulness is substituted for reliability. The IASB Reasons For Removal Of The Reliability Concept The IFRS (2014c) staff paper notes that IASB felt that there was the Generally Accepted Accounting Standards had no right definition of the term ‘reliability’. The term was often mistaken to mean verifiability. Hence, it was right to scrap off the concept from the qualitative characteristics of the financial information. The IASB notes that term is used to represent more information other than just measurability and material errors. The board also felt that the term faithful representation was also more representative. A section of people think that it was wise to replace the term reliability with faithful representation. They argue that the term has often been mistaken to show financial statements that are sustainable in the end. Why retain the reliability concept? The introduction of faithful representation has led to the loss of the trade-off characteristic that was there between reliability and relevance (IFRS, 2014c). The previous conceptual framework recognized that the most reliable information might not be the most relevant. Consequently, the most relevant information may as well not be capable of being portrayed in a reliable manner. The trade-off has been lost with the introduction of the new framework. The second concern is that faithful representation assumes that anything is capable of being represented as long as there is sufficient disclosure. However, this creates some ambiguity, as the concept is not a good filter to identify the information that should be included in the financial statements and that which should not. The third argument is that the term reliability is easily understood as opposed to the concept of faithful representation. In addition, the idea that financial statements need to be credible is an important concept that should not be lost. Finally, some people feel that omitting reliability from the conceptual framework would mean allowing recognition of items that could be measured reliably (Penman, 2007). Motives Behind IASB Actions Firstly, the characteristic of prudence was avoided not because of its lack of meaning but due to the need to converge with FASB. In his article, Whittington (2008) confirms that the joint project by the IASB and the FASB was aimed harmonising the two frameworks. However, that piece of news has not been received greatly. IASB being an independent body should not twist the rules to favour any jurisdiction standard setting body. Although the amendments were made jointly by IASB and FASB, it is worth noting that future decisions will be made by IASB alone. Hence, future decisions should not be constrained by the 2010 chapters. They should be clarified or amended if they do not provide solutions to issues at the workplace (IFRS, 2014a). Secondly, IASB may be avoiding reviews of chapter one and three may be a time constraint. Under the previous project, IASB had set out that it would evidence the entire framework once all the phases had each been individually revised. According to the new plans, all the remaining parts will be will now be subject to a single evaluation. As a result, there will be limited time to dwell on each area as opposed to the prior plan. The organisation has set for itself a strict time frame for accomplishing the project by the end of 2015 (IFRS, 2013). It leaves little or no chance to revisit the issues that were closed in 2010. However, it is imperative to note the speed may lead to inconsistencies if the revised parts are not be amended. Thirdly, the IASB may be reluctant to revisit chapter one and three of the conceptual framework to avoid bowing down to the EUs pressure (Leuz et al., 2004). Most of the European countries lead by Italy, Germany, and Australia are against the idea of scrapping off the concepts from the conceptual framework. For example, in the joint report by the European Financial Advisory Reporting Group expresses their dissatisfaction with the amendment made in 2010 (EFRAG, 2013b). Furthermore, the report expresses pressure on the IASB to revise their decision and revisit the issue. There is a possibility of failure by European Union to accept the standard if prudence concept is not introduced. However, IASB is meant to be an independent body. To protect their sovereignty, the organisation may fail to reintroduce the concept (IFRS, 2014b). The fourth motive is the desire by IASB to emphasise on an issue that it deems important. For example, IASB wants a shift in focus from the concept of reliability to the concept of faithful representation, which it thinks is wider and more representative (IFRS, 2014c). Likewise, the board want a shift in focus from the practice of the estimation of policies and figure by managers to the use of the objectivity. The only way that the Board can challenge the status quo is a removal of concepts that contradict with the new school of thought. The European Financial Advisory Reporting Group states that, as a result, reliability and prudence have been removed from the conceptual framework (EFRAG, 2013b). The IASB chairperson, during his speech at the Federation of European Accountants Conference on corporate reporting highlighted that the use of judgement as opposed to having the concept of prudence has improved the accounting standards (Deloitte 2012). Differently stated, Hans Hoogervorst was drawing attention the concept of neutrality and its superiority over the prudence notion. The fifth motive is the desire by IASB to show its superiority and autonomy. IASB is the body charged with setting accounting standards. Over the time, all the reporting standards that the body has always set have been fully adopted the word. However, the recent changes made because of the collaboration with the FASB have faced challenge and resistance. To show its autonomy and power, the IASB may not revisit the issue. If it does revisit them, then it might be a future date when the process will be under no influence. By doing so, the board would prove its autonomy and power and hence keep off parties that may want to influence its strategic direction (Leuz et al., 2004). Lastly is the notion that the conceptual framework is a guide for standard setting and financial reporting (Whittington 2008). Hence, however, important concepts are, they all cannot fit in the conceptual framework. As a result, IASB has included the concepts that they feel are more representative. The IFRS September staff paper represents that IASB argument that though stewardship is important, it is engraved in the concept of accountability in reporting (IFRS, 2014b). Likewise, IFRS (2013) states, that IASB argued against their introduction of the reliability concept due to its representation in the faithful representation. Given that the framework is just a guide, it is logical enough not to make it too bulky with every concept, especially is such concepts have been represented in other sections of the same framework. How I would deal with these issues if I were to revise chapter 1 and 3 of the conceptual frame work The main reason cited for the absence of the stewardship concept is that it does not easily translate into other languages. However, this is an inadequate explanation in my view. In fact, global financial regulators are increasingly looking for ways and means to incorporate the concept into their frameworks. Thus, stewardship is a vital concept. I believe that the absence of the concept in the conceptual framework poses a real risk in that it will lead to the development of biased IFRSs (albeit unintended) which will tend to focus more on needs of short term investors instead of the needs of long term investors. More focus should be aimed at long term investors since they provide capital in bad or good times unlike short term investors who can sell their stakes when the firm performance is poor. In light of this, I would incorporate the stewardship concept into the conceptual framework. Its incorporation will benefit both the primary and secondary users of financial statements. Although I agree with the board’s decision to replace the term reliability with faithful representation, I believe that the concept of reliability is a vital part of faithful representation. As such, I would include reliability’s role in faithful representation. Reliability often is the extent to which a measurement leads to a similar result when done by different professionals who are qualified. Conclusion In conclusion, it can be supported the idea of the IASB removal of the prudence and reliability concepts. The decision is not to make the stewardship concept a financial reporting objective. The terms have been captured in other sections of the conceptual framework. As such, it would be unwise to repeat them and other sections given that there are many guidelines that have to be laid down in the same frameworks. Hence, the resistance from the stakeholders is not emanating from the complexity of the new concepts or the non-inclusion of the old concepts. However, people are resistant to change. Changing the accounting frameworks come with costs plus time is needed to adjust to the new rules. In addition, there may be need to adjust the previous financial data for consistency. In addition, stakeholders fear such costs. Otherwise, the changes are fine, and they should be embraced for a better financial reporting. References Association of Chartered Certified Accountants, ACCA, (2000). The Accounting Framework. London: BPP Publishing. Association of Chartered Certified Accountants, ACCA, (2014). Prudence and IFRS, [Online]. Available at: [http://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-prudence.pdf][Accessed: 25.03.2015] Delloitte (2012). Speech By Hans Hoogervorst On The Concept Of Prudence, [Online]. 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