In all the users’ (Atrill and McLaney. 2016)

In this essay, I
will be critically evaluating how the Conceptual Framework for Financial
Reporting and Accounting Standards are facilitating the reporting of relevant
and faithfully represented information in the entity’s financial statements
that is useful in assessing the prospects for future net cash flow to the
entity.

 

“Accounting is
concerned with collecting, analysing and communicating financial information. The
ultimate aim is to help those using this information to make more informed decisions”
(Atrill and McLaney, 2016). There are two categories of accounting: managerial
accounting and financial accounting. ‘Management accounting seeks to meet the
accounting needs of managers; and financial accounting seeks to meet those of
all the users’ (Atrill and McLaney. 2016) who wish to use this information for
their own use.  

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The link between
management accounting and financial accounting is very different as ‘managers and controlling owners have incentives to manage
reported earnings in order to mask true firm performance and to conceal their
private control benefits from outsiders’ (Leuz, Nanda and Wysocki, 2001). This can
come as a disadvantage to potential investors as ‘insiders can use their
financial reporting discretion to overstate earnings and conceal unfavourable
earnings realizations (e.g., losses) that would prompt outsider interference’
(Leuz, Nanda and Wysocki, 2001). However, there are legal systems in place which
‘effectively protect outside investors reduce insiders’ need to conceal their activities.
We therefore propose that earnings management is more pervasive in countries
where the legal protection of outside investors is weak, because in these
countries insiders enjoy greater private control benefits and hence have
stronger incentives to obfuscate firm performance’ (Leuz, Nanda and Wysocki,
2001). Annual reports can never be free from bias as managers want what is best
for economic performance whereas investors wish to know the financial
performance.

 

This further links to agency theory whereby the management and investor have
different goals set for financial information and performance. Agency theory is
defined as the relationship between principles and agents in business. Its main
objective is concerned with resolving problems that exist in agency relationships
due to different goals between users or different levels to risk. ‘The primary feature of agency theory that has
made it attractive to accounting researchers is that it allows us to explicitly
incorporate conflicts of interest, incentive problems, and mechanisms for controlling
incentive problems into our models’ (Chapman, Hopwood and Shields, 2007). Management
is the agent in the case of agency theory and is directed to manage the entity’s
assets and is responsible for the growth and profitability of the organisation.
The main stakeholders – which in larger firms are investors – have direct influence
over how management achieve their goals. Investors act in self-interest to
ensure they have maximum return on their investment. Management act in
self-interest to ensure the organisation is ethical and ensuring employment and
share of profitability. This comes as a disadvantage as both parties in this
relationship act in self-interest.

 

“Financial
reporting should provide information to present and potential investors and
creditors and others to assess the amounts, timing,
and uncertainty of the entity’s future cash inflows and outflows (the entity’s
future cash flows). That information is essential in assessing an entity’s
ability to generate net cash inflows and thus to provide returns to investors
and creditors” (Benston. 2007). This citation represents the usefulness
of financial statements and what value there is in an investor point of view.
Financial statements are a key tool for investors and creditors to learn the
activities of an organisation through findings published by the organisation
publishing financial statements of past and present financial activates such as
revenue earned, overall costing, and past and present net cash flow.

 

Included
in an entity’s financial report is the stock price which ‘is assumed to
represent the market value of the firm, while accounting figures represent firm
value based on accounting procedures’ (Beest, et al. 2009). This is important
information for investors who can use to predict future returns on their investments
or whether they will invest in this company to weigh out the risks. However, (Beest,
F et al. 2009) argues an entity producing stock prices ‘does not explicitly
show whether or not tradeoffs have been made when constructing accounting
figures. In addition, the stock market may not be completely efficient. Therefore,
stock prices may not represent the market value of the firm completely accurate’
(Beest, F et al. 2009).

 

Conceptual
framework was introduced to set standards for accounting principles and
practises, and to help users of information understand financial report. ‘The purpose of the present IASB conceptual framework is to
assist the Board in developing future accounting standards, to assist the Board
in promoting harmonisation of regulations and accounting standards, to assist
national standard-setters, to assist auditors in formulating opinions, and to
assist users’ (Christensen. 2010). The framework’s main objectives are
to assist: ‘standard setters in the development of future standards so that
there is a rational basis for reducing the number of alternatives in existing
standards; preparers in applying standards and in having a principles basis for
the treatment of matters not covered by a standard; auditors in satisfying
themselves that financial statements being audited are in conformity with the
Framework principles; and stakeholders when interpreting the financial
statements’ (Elliott and Elliott. 2012).

 

There are two
main fundamental characteristics of conceptual framework: faithful
representation and relevance. For accounting information to be faithful
representation, it ‘should represent what it is supposed to represent. to do
this, the information should be complete. In other words, it should contain all
of the information needed to understand what is being portrayed. It should also
be neutral, which means that the information should be presented and selected
without bias. Finally, it should be free from error. There should be no errors
in the way in which these estimates have been prepared and described’ (Atrill
and McLaney. 2016). For accounting information to be relevant, it ‘should be
capable of influencing user decisions. To do this, it must help to predict
future events, or help to confirm past events by confirming past events users
can check on the accuracy of their earlier predictions. This can, in turn, help
them to improve the ways in which they make predictions in the future’ (Atrill
and McLaney. 2016). There are further qualitative characteristics which are comparability
verifiability, timeliness and understandability.

 

For financial information
to be useful for the reader, it also needs to be comparable which ‘is a
qualitative characteristic that interacts with both relevance and reliability’
(Elliott and Elliott. 2012), and understandable which information is ‘capable
of being understood by a user with reasonable knowledge of business activities
and accounting’ (Elliott and Elliott. 2012). “Although
understandability, comparability, and timeliness are perceived to be less
important than relevance and faithful representation, for a comprehensive
assessment it remains important to include them in the analysis. In addition, the
complete annual report has to be taken into account since financial reporting
refers to both financial and non-financial information” (Beest, et al. 2009).

 

However, there
are some limitations to conceptual framework. A main limitation to this
framework is the very complex set up. Another limitation is it is very
time-consuming to set up and can be very expensive. This is in the case of many
undeveloped countries who use conceptual framework in their accounting systems.

 

Moreover, in
some cases managers do not align by the fundamental qualities. There have been
some unethical corporations who provide false financial statements which in
turn affects investors decision making. “The
qualitative characteristics of financial reporting are very much important to
the external users in making their economic decisions. The wave of accounting
scandals happened in recent times in the international financial community has
raised many criticisms about the financial reporting quality” (Hasan, Abdulan
and Hossain, 2014). An example would be the accounting scandal regarding
Enron. This scandal was and still is the largest in the U.S. with FBI ‘agents conducted more
than 1,800 interviews and collected more than 3,000 boxes of evidence and more
than four terabytes of digitized data. More than $164 million was seized; to
date about $90 million has been forfeited to help compensate victims.
Twenty-two people have been convicted for their actions related to the fraud,
including Enron’s chief executive officer, the president/chief operating
officer, the chief financial officer, the chief accounting officer’ (Federal Bureau
of Investigation, 2018). The main purpose of the bankruptcy of Enron was caused
by the company cheating ‘investors and enriched themselves through complex
accounting gimmicks like overvaluing assets to boost cash flow and earnings
statements, which made the company even more appealing to investors. When the
company declared bankruptcy in December 2001, investors lost millions,
prompting the FBI and other federal agencies to investigate’ (Federal Bureau of
Investigation, 2018).

 

Also, conceptual
framework cannot be used to assess management as financial performance is used
for assessing management; which is majorly affected by the political and
economical climates. “An increasingly important consideration in the annual
report related to faithful representation is the corporate governance
statement. Corporate governance can be defined as the mechanisms by which a
business enterprise, organised in a limited liability corporate form, is
directed and controlled. Several researchers examine the association between
financial reporting quality and corporate governance, internal control,
earnings manipulations and fraud, and find that poor governance and internal
controls reduce the quality of financial reporting” (Beest, et al. 2009). Furthermore,
corporate governance look to help the government overall by addressing issues
on wages, salaries and ethical issues. Governments can do this by pressing ‘managers to stabilize employment, to forego some
profit-maximizing risks with the firm, and to use up capital in place rather
than to downsize when markets no longer are aligned with the firm’s production
capabilities; these political tendencies correspond closely to managers’
historical tendencies’ (Roe. 2003). This could be an issue in the view of
stakeholders as their main objective is profit-maximisation.

 

Accounting
standards was implemented to conduct rules and guidelines which is issued by accounting
institutions like GAAP. The focus of conducting these rules is to have a
uniformed preparation and consistent financial statements which its focus is on
the different stakeholder’s groups – mainly investors and creditors who use
this information to compare financial statements. The purpose of accounting
standards is to implement terms and conditions of accounting policies by way of
code, guidelines and adjustments which makes the user of the information easy
to read, view and understand.

 

This further
links to statement of principles which is the development of accounting
standards. The statement of principles focus is on users ‘who want to know where
the board is coming from, and it is aiming where to go’ (Elliott and Elliott.
2012). This is based for users who wish to know the current and future
decisions of the organisation. Moreover, the ‘objectives
of the Statement is to help preparers and auditors faced with new or emerging
issues to carry out an initial analysis of the issues involved in the absence
of applicable accounting standards’ (Benston, Bromwich and Wagenhofer, 2006);
as there have been many organisations who fail to meet accounting standards
requirements with the statements and reports they produce. “Statement of
Principles follows the IASC Framework in the identification of user groups. The
statement identifies the investor group as the primary group for whom the
financial statements are being prepared” (Elliott and Elliott. 2012).

In conclusion, conceptual framework and accounting
standards implement ‘faithful representation and relevance’ through financial
reports which are strongly used by investors and creditors. These primary users
can make judgements and assessments with the past and present financial information
provided. Investors can use this information to make future decisions on
investment opportunities. Accounting statements must be produced and by law
must abide by all conceptual framework laws. Conceptual framework is more
restricted in higher economical economies like the U.S. and U.K. However, as
quoted above they may not be faithfully represented in a way to meet investors
needs by producing true and accurate information. This would dramatically affect
the usability of information as it is produced as false and inaccurate which
investors may be investing in organisations producing false financial
information. Evaluating the findings above, organisations producing financial
reports is a key tool for investors to use this information to make investment
decisions; moreover, auditing plays a major role in finalising these financial
statements to make sure they have covered all legal requirements and
qualitative characteristics.