Reasons why Principle-based standards require a conceptual framework

Describe about the conceptual framework.
 

The main goal of the principal-based standards is basing their standards on principles that are appropriate and consistent globally. This means they look for principles that are applicable all over the world. This can be done basing on a conceptual framework. The conceptual framework will eliminate the differences that lie between FASB and IASB standards. This implies the FASNB and IASB standards will be merged to one common thing by aligning their agendas closely to achieve convergence in their future standards (Deegan 2013). The principles have to be based on economic concepts rather than a collection or arbitrary conventions. For the best foundation on principal-based common standards, the boards tend  to undertake joint projects in developing a common and improved conceptual framework.

1. One set of Standards

A conceptual framework will seek to eliminate the main differences that exist between the FASB and IASB standards. This will be achieved by moving towards convergence of these two standards. The conceptual framework tends to initiate some of projects whose main aims are achieving convergence of the standards within the shortest time possible on specific aspects and issues. In this way, agendas can be aligned by both the boards of FASB and IASB that move more closely to structure oneness in their future standards. If this convergence is achieved, a set of one standard would have been achieved as a result of a conceptual framework.

1. Identification of troublesome Issues

The conceptual framework will mean that the approach is done jointly on the project. FASB and IASB agree to plan the project jointly, this will help to identify problems/troublesome issues that tend to appear repeatedly in a variety of standard setting projects. This will mean that the focus will be made on issues that appear to be comprehensive, those issues that cut across a variety of projects. The conceptual framework thus will provide a better way to consider the implications of such troublesome issues; thereby the IASB and FASB will get an upper-hand in developing standards-level guidance.

1. Financial Statement

A conceptual framework basically assists in the making of a statement of finance. A principal-based standard that applies conceptual framework will be a necessity in the preparation of financial statements. This means that common financial reporting standards will be used. These international standards will also help in dealing such topics that the IASB and FASB principles have not yet covered or developed.  This will thus be a better guideline to prepare financial statements that meet the required standards globally.

1. Unity and lack of confusion

Importance of Sharing Common Conceptual Framework between IASB and FASB

Unity is an aspect of oneness. Accounting standards that are based on a conceptual framework will mean that these policies are the same whether you are dealing with FASB or IASB. The confusions that would rather arise from basing your financial statements on one of either FASB or IASB would not be there. This is necessitated if the FASB and IASB align their standards to be one.

1. Efficiency of the operations

The operations of FASB and IASB will be more efficient if they are to operate on fair standards that fit both of them. This means none of their standards would be conflicting and thus, the operations and continuity of IASB and FASB is guaranteed. 

A common conceptual framework means that IASB and FASB will work towards making their standards be similar in a way. They will combine their standards and make standards that will be applicable globally for users from all over the world. The converged framework between FASB and IASB should be in a form of a single document including summaries and basis for conclusions on given aspects.

Combining these standards into one has some benefits to both IASB and FASB. The importance of sharing a common conceptual framework between FASB and IASB may include;

1. Proper Decision-Making

Relatively, these decisions will not be made at a personal level but at the levels of both FASB and IASB, this means both the parties will participate actively towards these. Decision-making therefore, is proper and well designed as each one of the parties is a participant. Therefore, on making decisions all aspects will have to be viewed before coming up with summaries and conclusions. 

1. Guidance for Unusual Transactions

There are some transactions that may sometimes appear tricky to treat when making a financial statement, such transactions may be actually difficult to handle. FASB and IASB can collectively discuss these transactions and come up with the standards on how to how to handle such transactions. Thus, both the parties FASB and IASB will be able to contribute towards the standards that would be set for such standards.

1. Consistency

When FASB and IASB share a common conceptual framework, there will be consistency in their standards. Their standards will thus, conform to the global standards. This means the standards of handling a transaction or aspect will remain similar for both FASB and IASB.

The main advantages of a conceptual framework include;

1. Allows the standard setters to develop accounting standards on a fair and consistent basis.
2. Assists auditors and financial accounting statement users to understand how the standard setting gives its approach to the financial statement.

However, the concept of a conceptual framework is more important to the parties that are engaged in setting standards. They will pass these standards most probably, based on what favor them. The beneficiaries of these policies are the citizens or residents of a nation. When these standards are detrimental, they will mostly affect the citizens and not the ones who implemented the standards. The conceptual framework is, therefore, very important to the standard setters as compared to the citizens who are the beneficiaries of these standards.

Benefits of a Conceptual Framework

The aspect of “cross-cutting” issue involves taking into account things that are uncertain to occur when measuring the value of assets or liabilities in a financial statement. For example, when measuring assets or liabilities, it is done with reference to the future cash flow. Here, the future cash flow is the uncertainty since there are ranges of possible outcomes in this future cash flow (Hogg 2000). When this measurement is being done, it is always advisable that the possible outcomes be reduced to single measures.  

Historical cost principle is an accounting policy used in the preparation of financial statements. According to this principle, the value of an asset to be recorded on the balance sheet should be based on the original cost that was used to acquire the asset (Eucken 2012). Thus, historical cost does not consider the changes in the value of money caused by changes in price levels. Therefore, the fundamental problem associated with historical cost accounting is that it presents asset value based on the cost used to acquire the assets without consideration of the changes in market value. Hence, this provides information that does not portray the actual economic state of a company. In respect to this; the financial statements prepared may not have any relevance to the financial community. 

Accounting basically includes the process of summarizing, analyzing, and issuing reports on the economic state of an organization. These reports are very important to investors and creditors of an organization. The financial reports are used for the following purposes;

• They are used to determine the company’s financial conditions; the financial conditions of a company are of great importance both to the company’s shareholders and the creditors as these are the major capital providers. Investors and creditors use the information provided on the financial reports to know how secure and lucrative their investments are. The reports also indicated a company’s outstanding debt and equity.
• Used to evaluate the annual results from the company’s operations; the financial reports are used to indicate the assets, liabilities and equity of a company at the end of the year. The results of various operations and the profits or losses made are also shown. From these operating results, investors can evaluate the performance of a company and make predictions about the future.
• The financial statements are also used to determine the organization’s cash flows; cash flows describe the cash exchanges that an organization had with the outside world over a given time span. This information is used by shareholders of a firm to determine whether a company is to pay for expenses or make purchases.
• Financial reports are used to determine the shareholder’s equity; the reports are used to evaluate the various changes in equity components which include retained earnings. The shareholder’s equity is used to calculate the net worth of a company. An increase in equity rather than shareholders base will imply an increase in the accumulated investment returns

 Thus, based on the above importance of financial reports to investors and creditors, it is necessary that the principles used in preparing the financial reports can provide information that will give a true and fair picture of a company’s economic state. This is because if the reports provide wrong information, it will lead to wrong decisions and this may affect the future financial conditions of a company as some investors may withdraw their capital. Wrong decisions will also affect the performance of an organization. 

The “economic reality” is used to define the financial conditions of an organization. Therefore, it is necessary for organizations to have well prepared financial reports that will portray the true and fair economic state of a company. Therefore, the financial reports prepared need to be reliable and relevant to both the investors and creditors. Reliability will imply that the information presented is free from errors or bias. Relevant information shows that what is being offered in the financial reports is meaningful to the users of the information such as the investors and creditors.

The Concept of “Cross-cutting”

The measure of the economic reality of an organization is based on the reliability and relevance of the information presented in the financial statements of the company. And as such financial statement should be altered in any way to favor an organization as this will not portray the actual financial position of a company.

This refers to the assurance of the information presented in the financial statements being free from errors or bias that is, the information is considered to true and fair. The concept of reliability in accounting is based on faithfulness and verification. An example case of reliability is where a firm is being sued by another firm for the damages caused. The costs involved in settling settle the damages caused would threaten the financial position of the firm (Power 2010). On the other hand, failure to disclose this information in the financial report would make the information unreliable to the investors and creditors. However, it should be noted that reliability does not imply that the information presented is certain or precise.

1. Neutrality

This principle requires that the information presented in financial statements should be free from any kind of bias that is, the information presented should reflect a balanced view of the general state of the company. Thus, the principle of neutrality requires that the information to be presented in financial records should not be deliberately or systematically be biased.

1. Faithful representation

The recorded data in the financial statements should represent in s faithful manner all the transactions and events that occurred during a given period of time. The transactions should be presented as they truly occurred and not just as a standard. This is referred to as Substance Over Form.

1. Prudence

This principle primarily is aimed at governing the professional judgment of accountants of a given company. The principle requires that accountants need to be cautious when deciding on the accounting policies to adopt while preparing the financial records. In this case, caution should be taken not to underestimate the liabilities and expenses of a company or overstate the assets and income entity. 

1. Completeness

The information presented in financial reports should provide complete information that is relevant to the investors and creditors.

1. Single Economic Entity

The financial statements of firms that operate as a group of firms must be prepared as a single unit.  

In accounting, fair value refers to a rational and unbiased estimation of the possible market price of an item, service, good or an asset. Asset retirement in a company simply means other than temporary removal from service, whether through sale, recycling, abandonment or disposal, which happens before or after the end of the asset’s productive life. The company must be in a position to recognize the assets’ retirement obligation, at the time when the bligating event occurs.

Fundamental problem of historical cost principle

The hierarchy of fair value estimation can be done in three steps. In order to estimate the fair value, the company may have to undergo the following levels;

1. Level One

Here, the preferred inputs to be estimated are given quoted prices within a given active market for the assets. This information is based on observing the transactions directly involving the specified asset. From all the market values marked, a resulting estimate of fair value would be categorized as either Level Two or Level Three.

1. Level Two

This valuation is based on the observations that are there within an actively operating market. It is acknowledged by FASB that the active markets for assets and liabilities that are identical are very uncommon when they happen to exist, they may be very slim to provide information that one can actually rely on. Within this level, the estimation of a fair value is done applying a valuation technique.

Assumptions that are considered significant (inputs) that can be observed in the market are used in the valuation technique e.g. quoted prices for similar assets, yield curves, credit spreads etc.  it should be noted that the values used for calculating fair value must be assumptions.

1. Level Three

The valuation is based on unobservable inputs. If Level 1and 2 did not yield any inputs, it is acknowledged that fair value estimation of the asset or liability is less precise. However, on this level too, estimation of fair value is based on the valuation technique. 

The concerns of recognition do not just arise spontaneously, some events which are either internal or external factors facilitates this. These internal and external factors tend to raise the suspicion that a liability exists.

Some of these aspects for deferment of a liability include;

1. Internal Realization/Discovery

An internal discovery of an existing problem which may include the current events with potential environmental damage may initiate the investigation on the existence and possible discovery of a liability.

1. Notification by a regulatory agency

The existence of a potential liability is always called into question by the regulating agencies. The authorities would, therefore, make a notice on such.

1. Commencement of operations

In some firms such as mining firms, commencement of activities may be sufficient enough to trigger recognition of liabilities.

Liability recognition

A liability is an obligation of an organization which results from a past event and its settlement involves the outflow of cash from the organization. Liability recognition involves the agreement by an organization to settle a given liability and the process will involve cash flowing out of the organization (Faure 2003). Accounting standards body have developed standards to be used before a liability can be recognized on the financial statements. For a liability to be recognized it has to fulfill the following conditions;

• There is a probability that the liability will result in the outflow of cash from an organization.
• It can be possible to estimate or measure the cost of the liability.

Core principle of measurement in Accounting

Thus, if a liability justifies the above conditions it will be represented in the financial statements. The inclusion of liabilities on financial statements will result into the have the following effects on the net profit and cash flow of an organization:

Net profit

The effect of liability recognition in relation to future restoration on the net profit for the current year is that the net profit will not be affected. However, the net profit will be affected as the company will have to include the liabilities on the financial statements.

Cash outflow

The cash outflows of the current will not be affected as the currently the liability recognition is not in effect. In the future years, the cash flows will be affected as the company may be required to honor some environment liability obligations.

It is important for companies to recognize their liability recognition such as environmental liabilities so as the organization can plan effectively on how to settle it. In addition, the recognition of the liability will enable the company to plan on its expenses. Liability recognition will imply that the company understands the limits to its operation so that no such operation will be carried out by the organization that affects its operations. Also, liability recognition will enable the firm to determine whether the liabilities are to be included in the preparation of financial statements.

Disclosure involves a company presenting the necessary information regarding its financial position. An organization is responsible for disclosing its liabilities in the preparation of financial statement. This will, in turn, enable the company to be able to determine the effect of the liabilities on the net profits and cash outflows. The extent of the disclosure should be at such a point that it provides the necessary information to the financial information users such as shareholders and creditors. If the disclosure is unreliable, wrong decisions can be made regarding the company’s financial position and this, in turn,  may affect the operations of a company as some shareholders may decide to pull out their capital. Thus, liability disclosure should be true and fair and unbiased.  

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