1. Explain why principles-based standards require a conceptual framework?
2. Why is it important that the IASB and FASB share a common conceptual framework?
3. It is suggested that several parties can benefit from a conceptual framework. Do you consider that a conceptual framework is more important for some parties than others? Explain your reasoning?
4. What is meant by a ‘cross-cutting’ issue? Suggest some possible examples of cross•cutting issues?
5. What you think is the fundamental problem with financial statements based upon the historic cost measurement principle used under US GAAP?
6. What do you think of the principle’ accounts must reflect economic reality’ as a core principle of measurement in accounting?
7. How would you measure economic reality?
8. What is reliability in accounting?
9. The article states that the US standard setter FASB requires companies to record a provision in relation to environmental costs of retiring an asset if its fair value could be reasonably estimated. How do you think companies would go about estimating such a provision?
10. What aspects of the requirements were used by US companies to defer recognition of a liability?
11. In what ways does the recognition of the liability in relation to future restoration activity affect net profit in the current year and future years; and cash flow in the current and future years?
12. The article refers to changes in disclosure requirements relating to environmental liabilities in many countries around the world. How important is it that companies recognise the liability? To what extent is disclosure about the liability sufficient?
Framework refers to the platform on which any kind of work can be done and Conceptual framework refers to the infrastructure framed for performing particular work or an activity keeping in consideration the values and concepts within the ambit of which the work or an activity is required to be performed. For defining and developing any accounting and reporting principles and practices, framework is required. If the framework is not present then the principles and practices will be prepared in random and disordered manner and will automatically result in the standards which may be inconsistent with the others and with the law prevailing for that standard. Thus, conceptual framework for financial reporting helps in defining the nature and aim of the accounting by considering the theoretical issues relating to the financial reporting (IASB, 2010 and Deegan,2006). There are two types of standards rules based and principle standard. The absence of conceptual framework leads to increase in the number of rule based standards whereas its availability leads to formation of principle based standards. Rule based standards details the rules which needs to be followed in the preparation of financial statements and these rules can easily be manipulated by the influence of some group or management whereas principle based standards are formed only on the basis of pre defined principles or concepts and the framework containing it (FASB,2002). If there is no conceptual framework, the principle based standards cannot be formed. Thus, in this manner, for setting up of the principle based standards presence of conceptual framework is of utmost importance.
IASB and FASB have entered into joint project namely New Conceptual Framework Project wherein the main object is to revisit the frameworks within which standards have been set up for financial accounting and reporting purposes. The main aim of revisiting the conceptual framework is to come up with the common framework by redefining, updating and completing the existing framework. This new common framework will be shared by both the standard setting bodies. As per the new project, the main aim of both the bodies – IASB and FASB is that the accounting and reporting standards shall be based on defined principles and policies which can be applied universally and uniformly instead of having the standards consisting of the principles and provisions which have been created out of the individual perceptions and arbitrary provisions and that too changes in case governing body of the standard setting board changes. Without having the common framework, there will always be the matter of argument or discussion over one issue or the other (Nash,2006). Along with this reason there are factors which require the sharing of common framework:
As discussed, conceptual framework plays significant role in the financial accounting and reporting, it also provides various benefits to its users. One of the main parties who will get benefit of having the conceptual framework is the standard setter. Standard can only be defined when there is accounting and reporting framework and is defined and laid down by the standard setters. Along with him, there are other users. Another main party is the preparer of the financial statement. Preparer of the financial statement prepares the financial statements by keeping in view the standards set by the bodies which are known as International Financial Reporting Standards. Conceptual framework helps preparers in the way where no standard has yet been developed still the preparer forms the financial statements according to the developed conceptual framework. Another major party is the auditors of the organizations. Auditors are required to audit the financial statements of companies and give their opinion on the financial statements like whether it represents true and fair view or not. Auditors with the help of defined standards and where there is no standards with the help of conceptual framework checks the authenticity of financial information and gives their opinion. Third major parties are the users of the financial statements. Users of the financial statements are the stakeholder or shareholder of the companies and include banks, financial institutions, investors etc. By having the common conceptual framework, the users of the financial statements can interprets the information and can compare the same with the financial statements of the rivals of same companies. Thus, conceptual framework is more important to the other parties than the standard setters.
Cross cutting issues are defined in common parlance as the issues which are relevant to all aspects of the development like the environment, diseases, equality of gender, etc. Cross cutting issues in the context of accounting and financial reporting are defined as the issues which should be kept in consideration and are encountered when the development of any activity takes place in the field of accounting and financial reporting. These issues come across all the time and reappears whenever any sort of development takes place in the field of accounting and financial reporting. There is huge list of Cross cutting issues and following are some examples:
As per the historical cost principle, the asset or liabilities are recorded equivalent to the price of purchase or acquisition or with the amount of its incurring. The assets or liabilities so created are never revalued for appreciation or depletion in accordance with the current market prices. The basic and fundamental problem in the use of the historical cost principle is that the cost of an asset or the amount of liability does not change with the change in the market value. For instance, if the current market price of an asset increases then the figures stated in the financial statement are not reinstated to give effect to the change in the market price. This drawback give rises to another drawback which is defined as irrelevant (Whttington, 2007). By providing the historical cost based financial statements, the users of the financial information find the financial statements as irrelevant. The term irrelevancy is attached to the historical cost principle by most of the critics. (Nicole and Peppe, 2012). Users of the financial statements like bankers or investors requires the financial information which gives them the true picture of the financial results of the company and provides the insight to the users as to the amount realizable in case the company is wound up or provides the amount of cash flows which the company can generate in near future. Due to lack of this information, US GAAP and other bodies follows different measurement model which consists of mixture of the historical cost principle, fair value method and cash flows using discounted rates.
Economic reality is defined as the position of the economy of the world in real and fair terms which are relevant for making an analysis rather than providing the false position. For example, providing the actual death and birth rates by keeping the recent decade year as base year instead of having the start year of analysis as base year and providing the figures for people below poverty line and above that, minimum wage rate and the cost of living of normal people and so on. Economic reality in terms of accounting is referred to as the presentation of the financial statements to its users in the real and fair terms. Real term is referred to as the market or fair value with which the financial statements shall be stated. Thus, in this way, the concept of economic reality requires the financial statements to be stated with the market prices or fair value at the point of time and adjusted every time for change and thus emphasizes the importance of the concept of relevancy.
There are various concepts that are described as the measurement principles of accounting like relevancy, comparability, understandability and reliability. The financial statements presented shall be reliable and relevant for the users of the financial statements and along with that it shall be understandable and comparable. As economic reality lays the focus only on the importance of relevancy and have left the portion of having reliable financial statements, I disagree with the statement that the economic reality is core principle for measurement in accounting.
Economic reality is nothing but the economic position and performance of the company in real and fair terms as per the current market price and situations prevailing. To measure the economic reality, first all the items of the financial statements including the Balance Sheet, Statement of Income and Comprehensive Income shall be adjusted with the change in the market price as on that date and for the year respectively (CFA,2010). For example an asset purchased 30 years ago for $5,000 /- and stated in balance sheet at $1,250 after providing depreciation and impairment shall be adjusted for change in market price and shall be reported at the fair value as on the date of balance sheet. Similarly with the liabilities. The amount of liabilities shall be stated at the market price. After reinstating the same, the statements shall be made available for the users.
The users then analyze the financial statements and information and if they find it relevant and comparable then the economic reality is positive. For instance, as per the current market price, it is assumed that the current net worth of the company shall be $200 billion and earnings per share shall be $20000 /- and the actual figures comes out with the approximate figures of the same then it will be assumed as the company has positive economic effect and the figures are real and sufficient to effect the decision of the users of the financial statements. Otherwise, the measurement of economic reality will serve no purpose and is less useful.
As per the principle of reliability in accounting, only those transactions can be recorded in financial statements which can be easily verified and checked. For example, purchase of asset of $1000 with the invoice and payment has been made through cheque. In this way, the transaction of purchase of asset can be verified through invoice and cheque and thus can be recorded. Concept of reliability plays very significant role in the preparation of financial statements. Every user of the financial statements has reliance on the financial statements of the company. Only because of this reliance, financial institutions gives loans to the companies, investors invest their money in the company and so on.
The financial information is said to be reliable only when the information is verifiable and genuine. These can be checked through invoices and payment mode, etc. After checking the reliability of financial information the auditors of the companies issues clean audit report otherwise they issues qualify audit report or sometimes issues disclaimer of opinion depending upon the circumstances and facts of the case. The reliability in accounting presupposes the presence of historical cost based accounting method. It underlines that an asset or liability shall be recorded with the purchase or acquisition price and thereafter adjusted for depreciation and impairment. Thus, the concept of reliability in accounting provides the reliable figures on which every users can easily rely and it does not focus the principle of fair value measurement as the figures in this method are questionable at each and every stage and are not authentic.
As per the principle of prudence, losses shall always be anticipated and recorded in the books of accounts. Following the rule of prudence, it is very difficult and challenging task of estimating the provision of environmental costs because of the presence of the higher degree of uncertainty and contingency in the occurrence of environmental expenses like clean up costs, damages related to third party or damages of natural resources. Companies have different methods in estimating the cost varying from single outcome method to the probability methods. Therefore, it is clear that the one price can never be fitted to estimate the environmental costs (Ernst and Young, 2010). It is because in each case there are different uncertainties. Following are the methods to estimate the provision:
As per the provisions issued by United States Financial Accounting Standard Board (US FASB) in the year 2002, every corporation is required to make the provision for environmental cost in the financial statements on the retirement of an asset which will occur in the near future provided the fair market value of the environmental costs can be estimated.
The pre requisite of having the fair market valuation of the environmental costs on making the provision of environmental costs has given way to many corporations to defer the creation of provision of environmental costs for future years and that too till the litigation or pending case be settled. The similar way has been adopted by the companies of United States.
Second requirement that has been taken as plea for deferment of the liability for environmental costs is the uncertain time and method for settlement of the retirement of an asset. No certain method has been identified for valuing the environmental costs and also the correct time for settlement when the liability in actual arise cannot be determined. Companies of US has taken this plea also for deferment but it has not been come longer as the FASB in due time has clarified that the provision needs to be maintained even when the time or method for settlement is not certain and thus thereafter all the companies have created the piled up environmental costs of different properties in one year itself. Thus, US companies has been able to defer the creation of obligation towards environment for some years.
By recognizing the liability of environmental costs, following affects has taken place:
In the future years, there is no need to create the provision for environmental liabilities again and again unless there is requirement to reinstate the provision according to the market value in the future years. Therefore, in the future years there will be no effect in the Net profit or loss of the company.
In the case study it is mentioned that once it has been clarified that the provision has to be maintained irrespective of the fact that the timing or the method is not certain. After that all the companies have created the provisions and the Net Profit of the companies has been gradually decreased in the current year as compared to the future years.
In the future years, as the time for settlement comes, the environmental costs is required to be paid and thus in the future years the there will be cash outflow.
References
Mac Donald L, (2002), “Principle based approach to standard setting”, FASB newsletter, available on https://www.fasb.org/project/principles-based_approach.shtml accessed on 24/01/2017.
BullenH,(2005),“Revisitingheconcepts”,availableonhttps://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175818825710&blobheader=application%2Fpdf accessed on 24/01/2017.
Nicole T and Peppe M, (2012), “Fair value accounting versus historical cost accounting – the impact on financial statement presentation” Ovidus, Romania.
CFA,(2010),“FairValueastheMeasurementbasisforfinancialinstruments”,availableon https://www.cfainstitute.org/ethics/Documents/fair_value_as_measurement_basis.pdf accessed on 24/01/2017.
Sullivan E, (2005), “Estimating Environmental Liabilities”, available on https://www.whitmanco.com/files/publications/Estimating_Environmental_Liabilities.pdf accessed on 25/01/2017
ErnstandYoung,(2010),“FinancialReportingDevelopment:EnvironmentalObligations”,availableon
ttp://www.ey.com/publication/vwluassets/financialreportingdevelopments_bb0638_environmentalobligations_april2010/$file/financialreportingdevelopments_bb0638_environmentalobligations_april2010.pdf accessed on 25/01/2017International Accounting Standards Board (IASB), (2010), “Conceptual Framework for Financial Reporting 2010” , pp 16-21
Deegan C, (2006), “Financial Accounting theory”, available on https://www.sekoyen.com/DeeganFAT_3e_Chapter_01.pdf accessed on 26/01/2017.
Whttington G., (2007), “Fair Value and the IASB / FASB Conceptual” available on www.eiasm.be/userfiles/fair_value_and_the_iasb_septclean.doc on 25/01/2017.
Nash H.,(2006),“ConceptualFrameworkforFinancialReporting”,available on https://www.ifrs.org/Current-Projects/IASB-Projects/Conceptual-Framework/DPJul06/Comment-Letters/Documents/CL9.pdf accessed on 25/01/2017.
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