The Conceptual Framework Criteria of Relevance and Faithful Representation - Term Paper Example

Conceptual Framework: Mixed-Model Approach College: Name: Students ID: Date: Course Name: Unit Code: Time: Instructor: Introduction In May 2008, the International Accounting Standards Board (IASB) in unison with the Financial Accounting Standards Board (FASB) made public an exposure draft (ED), “Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information.” The genesis of this was the Norwalk Agreement ascribed to by the IASB and FASB on September 18, 2002 where the two bodies worked jointly to come up with a universal ‘conceptual framework’ through a projected eight-step process (FASB & IASB, 2002). The intended goal is the establishment of future common global accounting standards. Given the recent global developments, such as social reporting and economic crises, the conceptual framework is intended to provide converged information to all users of financial statements in a global scale (FASB, 2010). Out of all the proposed items, one subject matter that apparently has touched most people and been the most controversial is that of measurement. There are various measurement bases, but, the discussion has been engulfed between the predominant measurement bases; the common historical cost method and the emergent fair value method. Other applicable methods include; value of the venture, realisable value, current cost, and present value (IASB, 2005). Each method has its inherent use such that one cannot be easily abandoned in favour of the other. Amid these developments, this paper evaluates in detail the assertion that, “The conceptual framework criteria of relevance and faithful representation are best met by a mixed-model approach rather than a single-model approach to measurement in general purpose financial reporting.” First I define the conceptual framework within the qualitative characteristics of relevance and faithful representation. I then argue that a mixed-model approach is the best suited approach to the above criteria in opposition to a single-model approach to measurement in general purpose financial reporting. The Conceptual Framework The conceptual framework is a current concept. In the past developers of accounting standards have controlled financial reporting with no existent conceptual framework. The conceptual framework proposes a uniform application of financial reporting standards across the globe such that businesses use the same standards to report in a bid to avoid confusion and ease the understanding of global business operations. It reduces the danger of having inconsistent standards and provides a universal objective for the preparation of financial statements. FASB (2010) states that the objective of the General Purpose Financial Reporting (GPFR) is to; “…provide financial information about the reporting entity that is useful to the existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.” This objective seeks to ensure informational needs of the primary users of financial statements (present or potential investors, lenders and capital providers) are fully met. These users do have a valid claim on a business entity’s wherewithal. Other users referred to in the framework include the employees, suppliers and other trade creditors, the government and government agencies, customers along with the public. All these users need this information to arrive at informed decisions (Ball, 2006). The above objective is the foundation upon which the conceptual framework is built. FASB (2010) states that it is out of this objective that; “…other aspects of the conceptual framework - a reporting entity concept; the qualitative characteristics of, and the constraints on, useful financial information; elements of financial statements; recognition; measurement; presentation and disclosure – flow logically from…” The information provided to the users of financial statements is what forms the qualitative characteristics. For the financial information to fully satisfy the users’ informational needs, the conceptual framework proposes that it must appeal to two key qualitative characteristics: (1) Relevance, and (2) Faithful representation. FASB (2010) defines an example of such information as information regarding economic resources or ‘economic phenomena’, reporting entity’s strategy, management’s expectations plus any additional forward-thinking information. It also proposes supporting qualitative characteristics that are; comparability, verifiability, timeliness, and understandability (Drever et al 2007). Relevance This is the information that may well significantly impact financial statement information user’s decisions. Such information ought to have a ‘predictive value, confirmative value, or both’ (FASB 2010). The information is said to have predictive value if users can employ it in predicting upcoming events, and confirmatory value if it facilitates confirmation or revision of earlier evaluations. Materiality is an independent element introduced under relevance that means if the information is omitted or misstated; it possibly will have an effect on decisions users make based on that information as related to a particular business entity. Faithful Representation This is where the financial statement information relied upon by the users is supposed to truly embody the economic phenomena that it asserts to represent. This may not be wholly achieved but should be optimised by ensuring that the information describing an entity’s economic phenomenon is ‘complete, neutral, and free from material error’ FASB (2010). Complete means the whole information required by a user to comprehend the economic phenomena being described. Neutral means that the information should be unprejudiced in selection or presentation. Whereas free from material error means that there are no mistakes or omissions in describing economic phenomena and the procedure employed in arriving at the information ought to be error-free. Measurement in General Purpose Financial Reporting (GPFR) In his article, Barth (2007), asserts that, “Measurement is a key aspect of financial reporting”. To be frank, in some way, a measure of an entity’s financial reporting on performance as well as financial standing affects nearly everybody. At present, various business entity’s use various methods to measure their performance or financial position. However, in the recent in the face of current developments such as economic crises, this issue has come under severe debate. The argument now is on which suitable method (single-model approach) or methods (mixed-model approach) that must be used to measure performance or financial performance (Barth, 2007). Taking into consideration today’s economic and financial situation plus the aim of the conceptual framework, a mixed-model approach would be the most fitting. Going for a single measurement basis in financial reporting that will get the most out of the level to which information meets the objectives of GPFR is not feasible. A single-model approach would appear perfect, given that the link connecting different amounts recorded in the financial statements would be clear: especially, the amounts of diverse assets and liabilities may well be added to present meaningful totals (Reilly, 2011). Nonetheless, there is no single method that fits each and every one situation. For illustration, consider the most common historical cost measurement basis. Using this method, it is possible to record excess or outdated assets to net selling price. On the other hand, by means of a market value measurement basis, this is not possible because assets and liabilities for which market values are not known will have to be substituted (Laux, 2009). The use of a mixed-model approach enables preparers of financial statements to choose different measurement bases in different situations to pull off a proper sense of balance, or exchange, between the various qualitative characteristics. This will ensure the two key objectives of the GPFR conceptual framework, relevance and faithful representation, are met at all times. Besides, the drawbacks of using different measurement bases can be scaled down. Through a mixed-model approach, dissimilar measurement bases can be chosen where this is warranted by economic circumstances so that an entity is able to report its economic phenomena appropriately. Furthermore, given that the bulk of the most vital information relayed by financial statements relates to distinct parts and not summative amounts, good production and disclosure can guarantee that the measurement bases employed along with the amounts reported on each one basis are understandable (Ryan, 2008; Mosso, 2010). The table below summarises the differences in the measurement bases as regards whether they are historical or current, from entry or exit perspective, market or entity specific and their capital concept hence the need to adopt a mixed-model approach; Table 1: Conceptual Differences in Measurement Bases Measurement basis Historical or current Entry or exit Market specific or entity specific Capital concept Historical cost Historical Entry Entity specific Financial capital Market value Current Either Market specific Ability to earn market return Replacement cost Current Entry Entity specific Operational capacity Source: IPSASB (2010) Conclusion The joint conceptual framework released by the ISAB and the FASB intends to maximise on two key qualitative characteristics; relevance and faithful representation. Recently debate has ensued as to whether to use one method or different methods in measurement of performance and financial position of an entity. A single-model approach would be preferable but it does not capture all circumstances. For this reason, a mixed-model approach is the most fitting seeing as it can be used in different circumstances and guarantee that the qualitative characteristics of relevance and faithful representation are met (Ohlson et al 2010). References Ball, R. (2006). International Financial Reporting Standards (IFRS): pros and cons for investors. Accounting and Business Research, Special Issue: International Accounting Policy Forum. Barth, M.E. (2007). Standard-setting measurement issues and the relevance of research. Accounting and Business Research, Special Issue: International Accounting Policy Forum. Drever, M. Stanton, P. and McGowan, S. (2007). Contemporary Issues in Accounting. 5th edn. Milton: Wiley. Financial Accounting Standards Board and International Accounting Standards Board (FASB & IASB) (2002). Memorandum of Understanding. The Norwalk Agreement. 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