Aveneu Park, Starling, Australia

The the objectives of financial reporting, ‘valuation

The
conceptual framework and accounting standards for financial reporting provide
an agreed set of fundamental principles and concepts that lead to consistent
standards to ensure that these principles are met accordingly and the
information required by users are faithfully represented and relevant (IASB,
2010). These standards are required in order to ”assess managements
stewardship and make informed economic investment decisions” (Elliot &
Elliot, 2017). The purpose of this essay is to critically evaluate how the
conceptual framework and accounting standards are facilitating the reporting of
”relevant and faithfully represented” information in the entities financial
statements that are useful in assessing the prospects for future net cash
inflows to the entity. Specifically, this essay will evaluate the objectives of
financial reporting, ‘valuation usefulness’ and ‘stewardship usefulness’. Also,
the importance of reporting relevant and faithfully represented information
within the conceptual framework will be discussed.

 

The
conceptual framework and accounting standards state the qualitative
characteristics of financial information that is required to reflect truthfully
a company’s financial performance (IFRS, 2010). Relevant information is capable
of making a difference to a user’s decision. Relevant information has
predictive value because it helps users to evaluate the potential effects of
past, present, or future transactions or other events on future net cash inflows
(Nobes and Stadler, 2015). In addition to predictive value, confirmatory value
contributes to the relevance of financial reporting information. If the
information in the financial report provides feedback to the users regarding
previous transactions or events, this will help them to confirm or change their
expectations (Jonas & Blanchet, 2000) (Christensen, 2010). Faithful
representation is the second fundamental qualitative. To faithfully represent
economic phenomena that information purports to represent, financial information
must be neutral, complete, and free from error (IFRS, 2010).

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However,
the quality of ‘transparency’ is not directly mentioned in the exposure draft
even though it is often referred to in the context of good financial reporting.
A study from Nobes and Stadler (2015) regarding the usefulness of qualitative
characteristics, showed that preparers frequently refer to transparency in the
context of policy changes under IAS 8.

 

IAS
1 states that the primary objective of financial reporting is to provide information
that is useful to those making investment decisions, such as buying, selling or
holding equity investments (IFRS, 2010) (Gore & Zimmerman 2007).  Given that valuation usefulness is seen as
the dominant role of contemporary financial reporting (Zeff, 2013), it is not surprising
that financial statements are found to be very useful to investors and other
creditors when valuing a firm. The conceptual framework provides accurate and
timely financial information, relevant to the accounting standards for investors
and stakeholders (Ball,2006). This should lead to more-informed valuation in
the equity markets.

 

 

A
major feature of the conceptual framework and accounting standards that
facilitates the reporting of relevant and faithfully represented information is
the concept of fair value (IFRS 13). Hermann (2006) states that fair value is
the most relevant measure of financial reporting. IAS 16 provides a fair value
option for property, plant, and equipment and IAS 36 requires asset impairments
and reversals adjusted to fair value (IFRS, 2010).
Under the fair value measurement
approach, assets and liabilities are re-measured periodically to reflect
changes in their value, resulting in a change in either net income or other
comprehensive income for the period.

 

In
addition, fair value meets the conceptual framework criteria in terms of
qualitative characteristics of accounting information better than other
measurement bases. Fair value makes financial information relevant because
current prices are reliable measures of value as it reflects present economic
conditions that are related to economic resources and obligations (Barth,
2008). Also, according to Hermann (2006), fair value is more relevant to
decision makers. Fair value makes an entity’s financial information faithfully
represented because it accurately reflects the condition of the business.
Management and entities may sometimes rearrange asset sales and use the gains
or losses from the sales to over or understate net income at a current time.
Fair Value prevents entities from manipulating their reported net income as
gains or losses from price changes are reported in the period in which they
occur. As pointed out by Ball (2006), this results in a balance sheet that
better reflects the current value of assets and liabilities. However, the use
of fair values results in an unavoidable trade-off between relevance and
reliability of accounting standards and could increase manipulation
opportunities in highly liquid markets (Marra, 2016) (Barth, 2008).

 

Moreover,
IAS 1 requires entities to prepare its financial statements, except for cash
flow information, using the accrual basis of accounting (IFRS, 2010).  Accrual accounting is a method which measures
the performance of a company by recognizing economic events regardless if any
cash transaction occurs (IFRS, 2010). The accruals concept gives entities a
better assessment and understanding of future net cash inflows, therefore
enabling managers to make more informed financial decisions. The accrual basis
informs users about obligations to pay cash in the future and of economic
resources that represent cash to be received in the future. Just like fair
value, Accrual accounting also meets the framework criteria of qualitative
characteristics. Accrual accounting enables predictability as it helps users
evaluate the potential effects of past, present or future transactions or
future cash flows, and confirmatory value to confirm or correct their previous
evaluations. Accrual accounting produces more faithfully represented financial
statements as it constitutes better representations of actual circumstances and
the entities performance in any time period. There is evidence that as a result
of the accruals process, reported earnings tend to be smoother and that
earnings provide better information about economic performance to investors
than cash flows (Dechow 1994).

 

Overall,
both the accruals and fair value concept makes financial statements relevant
and faithfully represented, Therefore, making valuation more useful as
investors are able to accurately assess the prospects for future net cash
flows. In fact, it would be tough to identify better alternative methods in
order to meet the requirements of the qualitative characteristics of accounting
standards and the conceptual framework.

 

However,
the conceptual framework and accounting standards have been criticized due to
being inconsistent and its lack of guidance when defining and recognizing
assets and liabilities. Most notably, IAS 38 Intangible Assets. Intangible
assets are only recognized if it is probable that the expected future economic
benefits that are attributable to the asset will flow to the entity (IFRS. 2010). The
general requirement in IAS 38 is similar to the requirement for Property,
Plant, and Equipment of IAS 16. Conversely, in the remainder of the standard,
and interrelated requirements in IFRS 3 Business Combinations, different
requirements are included which could result in the recognition of intangible
assets that do not meet the recognition and definition criteria of the Conceptual
Framework and standards as well as the exclusion of intangible assets that do
meet the definition of an asset (Brouwer, 2015). The lack of recognizing many
intangible assets on financial statements due to this problem has been
criticised by Lev (2003), who holds that this information is required to solve
the issue of partial, inconsistent and incomparable information regarding
non-current assets. Eckstein (2004) concludes that the objective of providing
relevant information must include the recognition of intangible assets.
Disclosing the true value of intangible assets in the financial statement is
fundamental in order to meet the objectives of financial reporting (Laux, J.
(2011).

 

According
to the recent exposure draft of the conceptual framework, the objectives of
financial reporting has two aspects. One is stewardship, which deals with
management responsibility towards the company, and another is
decision-usefulness, which mainly deals with the decision-making users of
financial statements. The current Exposure Draft gives more prominence to the role
of stewardship, which is an improvement on the existing 2010 framework (IFRS
2015). This issue concerns the very nature of financial reporting and may hinge
on whether one believes that financial reports are utilized to such an extent
or more for control and evaluation of management as they are for resource
allocation decisions (Gore & Zimmerman 2007).

 

Andrew
Lennard (2007) argues that stewardship and decision usefulness should be
recognized as separate objectives. The assessment of how management has satisfied
its stewardship responsibilities may require more information that is not
necessarily provided to achieve the objective of financial reporting.
Stewardship helps to increase the decision usefulness to the relevant decision
maker by imposing responsibility for management to take care of the entity’s
resources, thus increasing the relevance and faithful representation of the
financial report. Stewardship helps to accurately record, assess management
performance, and provide information to optimise firm value, therefore
improving overall investment decisions. Management stewardship is meaningful to
financial reports users who are interested in making resource allocation
decisions because managements performance in discharging its stewardship
responsibilities significantly affects an entities ability to generate net cash
inflows (Kuhner and Pelger 2015).

 

However,
assessing the performance of management stewardship through financial
statements may prove difficult because of the agency problem. Agrawel and
Koeber (1996) state that the concern about stewardship being a separate
objective seems to arise from the potential conflict between the interests of owners
and management. Bebchuck and Fried (2003) argue that managers have a lot of
influence and power over shareholders in different aspects, such as influencing
the link their performance and their salary. Managers have almost complete
freedom which enables them to benefit from their own private interests. For
example, a manager may pay out less of the entities earnings in dividends and
retain more in order to invest for the growth of the entity. Also, managers may
not want to distribute excess cash making financial statements irrelevant and showing
an inaccurate reflection of allocating managerial resources. Boshkoska (2014)
states that increasing managerial compensation will reduce the agency costs to
shareholders which would make financial statements more likely to represent
accurate information about a firm’s stewardship.  Also, this will reduce conflict of interest
between the manager and shareholder, so that when shareholders benefit,
managers can also benefit.

 

 

Furthermore,
Kuhner and Pelger (2015) show that the concept of fair value has different
impacts on the valuation and stewardship usefulness of financial statements. To
clarify, fair value can display a negative impact on the ability of financial
statement users to assess stewardship of the managers of the company. Lennard
(2007) argues that to be able to assess how the management discharged their
responsibilities towards the shareholders, information is required that is
difficult to agree with. To simplify, the historical cost method to value
assets and liabilities is seen as a more relevant and superior measure for the
purpose of relevant and faithful representative financial statements.

 

Different
opinions continue to exist about whether providing information about management
stewardship should be stated as an objective of financial reporting. A separate
objective for stewardship is not required because it is comprised of the
decision usefulness objective. The decision-usefulness objective is to provide
decision-useful information to current and future providers of finance.
Additionally, the same information about economic resources and claims, and
changes in them is the same information needed for assessing management
stewardship. Therefore, discussing the information that is helpful in assessing
stewardship would be impractical to the objective of financial reporting
(Whittington, 2008).

 

To
conclude, it is evident that there are limitations by using the conceptual
framework and accounting standards. The limitations may make an investors’
assessment of an entities net future cash flow inaccurate. However, the
contributions far outweigh the shortcomings. Without these regulations, it
would be impossible to produce accurate, and unbiased financial statements.
Even if financial statements were slightly inaccurate, it would be impossible
to predict future net cash inflows without them. Faithful representative and
relevant financial information would not be possible without these accounting
standards. Continued development and enhancement are recommended. With regards
to stewardship, it would not be sufficient to only use financial statements to
measure management responsibilities of the entity. Therefore, I believe that
valuation should be considered as the main objective of financial reporting.

 

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