In faithfully represented information in an entity’s financial statements

In today’s world, rapid globalisation and the need for logical and consistent accounting information has necessitated a conceptual framework. One that governs what information is considered to be useful to potential users such as investors and provides accountants with clear principles on how to construct useful financial statements. Furthermore, to provide accountants with a foundation on how to report relevant and faithfully represented information about an entity.

 

A conceptual framework is a set of accounting objectives and fundamentals to ensure uniformity in interpretation across various accounting methodologies. Furthermore, it details the basic reasoning underlying the financial statements and financial reporting in general Course (2017).

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For financial reports to be valuable and beneficial, it must faithfully represent the information it contains. Faithful representation is the concept that financial statements be produced that accurately reflect the condition of a business Bragg (2018). Accounting information should meet the objective of being useful for its users to support this it must adhere to some basic elements. “If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable” Conceptual Framework (2010).

In this essay, I will be critically evaluating how the conceptual framework facilitates the reporting of relevant and faithfully represented information in an entity’s financial statements and how this information is useful in assessing the prospects for future net cash inflows to the entity.

 

One element of the conceptual framework that we can evaluate is the use of fair value accounting in terms of the relevance and degree of faithful representation it provides to users of financial statements. This is a type asset/liability valuation measurement system employed by the conceptual framework. According to IFRS 13 fair value accounting is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. Gjorgieva-Trajkovska (2016) states that it is a practice of accounting that values certain assets and liabilities at their current market value, and it seeks to capture and report the present value of future cash flows associated with an asset or a liability.

 

 

 

 

Fair value accounting provides relevant financial statements to users as it gives an accurate valuation on an ongoing basis. Valuations simply follow the market price if it increases or decreases. In other words, this method of accounting makes financial reports more relevant because prevailing prices are a reliable measure of value. Furthermore, fair value accounting provides more information compared to another measurement basis such as historical cost. Fair value accounting requires accountants to disclose extensive information about the methodology used, the assumptions made, risk exposure, related sensitivities and other issues that result in a thorough financial statement (Betakova, J, 2014). This enhances the informative power of financial information and thus the degree of relevance.

 

Leading on, this measurement basis provides users with a measurement of true income. Fair value accounting aids in faithfully representing the financial health of a business. This method gives accountants less opportunity to exploit and manipulate accounting data. Gains or losses from a price change in an asset or liability are reported in the period in which they occur. Thus, the changes to income occur when asset values change, and these are reflected in the net income numbers. Fair value is especially significant for users like investors and creditors because it delivers estimates of future cash flows.

 

However, on a side note, volatile assets can report changes in net income that may not be accurate in a company’s financial reports resulting in misleading gains or losses in the short-term Gjorgieva-Trajkovska (2016). If the value of an asset follows the development of a market environment, this means that the value of asset changes with the market. If the market price goes up, the price of a given asset goes up; if it decreases, the price goes down too.  This can affect the accuracy of the pricing of assets and liabilities and furthermore the degree of faithful representation of the financial statement.

 

Another flaw that may arise with fair value accounting is an issue of accurately reflecting market prices of asset and liabilities. It may arise that the price observed of an asset in a market could be misleading and not be indicative of its fundamental value. Markets can be inefficient and not reflect and incorporate all available public information resulting in the market price deviating from its fundamental value. Further factors such as investor irrationality, behaviours bias can also be a factor. Again, as the previous point can affect the degree of faithful representation. Additionally, Ball (2006) suggests that market liquidity is an important issue to take into account because spreads can be large enough to be a cause for concern about fair value and therefore introduce large overall value deviations into financial statements.

 

A second element of the conceptual framework that can be investigated with respect to its usefulness and aid in supporting users in examining future net cash inflows is the accrual-based accounting method. Accrual accounting is an accounting methodology under which transactions are recognised as the underlying economic event occurs, regardless of the timing of the cash related receipts or payments Khan et al (2009). Therefore, revenue is recognised when income is earned not just when cash is received. Accrual accounting also gives users extensive information on projected cash inflows and the current state of cash flows because future payables and receivables are taken into account. One benefit of this methodology for users is that it gives a truer depiction of financial performance and supports in faithfully representing the assets (trade receivables) and liabilities (trade payables) of the business. This serve as an advantage because it is useful for external and internal users to assess the prospects of future net cash flows for investment purposes and provides more relevant information compared to cash basis accounting which only recognises income when cash is received.

 

On the other hand, one area where accrual based account is flawed is that it can indicate the presence of profits even when cash inflows have not been received. A company that may report high profitability could go bankrupt because it is lacking in cash. This hinders the level of faithful representation incurred in the financial statements as it is not accurately reflecting the condition of the business.

The conceptual framework is constructed with the primary objective of meeting external users’ information needs. This objective is primarily concerned with supporting users with economic decision making, for example, assisting trade creditors to determine whether they will receive amounts owed in time. Concepts supporting this objective have been composed in a way that reflects real-world economic phenomena i.e. assets the business own, claims to these assets (liabilities) and changes in assets and claims. A thorough report on the condition of the business enhances the relevance of financial reports as it reflects the economic substance of transactions and other business events. Additionally, the conceptual framework includes many financial reports one being the cash flow statement this information is important in helping users to predict future cash flows.

 

Furthermore, the conceptual framework has also greatly helped the comparability of reported financial information across many businesses by having economically similar transactions and other events reported in similar ways. This makes the comparison of financial reports between businesses to determine the prospects of future net cash flows more straightforward and whether an investment would be profitable. This is especially useful for potential investors who are pursuing diversification. A study conducted by Barth et al. 2010 found the adoption of IFRS improved the comparability of a firm’s results with those of US firms reporting under US GAAP, although differences have remained.

 

The conceptual framework is also made more comparable and useful to users by the number of countries who had adopted it. According to Ifrs.com (2018), approximately 120 nations and reporting jurisdictions permit or require IFRS for domestic listed companies. This supports economic efficiency as it allows potential investors to pinpoint investment opportunities and avoid risky ones, in turn, bettering capital allocation across nations and the world. On another note, the standardisation of financial reports has eliminated the need for users to interpret it further increasing comparability.

 

In evaluating the usefulness of financial statements, we can also discuss the value relevance it provides to its users. Value relevance according to Kar?in (2013) can be defined as the ability of information that is presented by financial statements to capture and summarise firm value (market value of a business). The adoption of IFRS has been studied in many perspectives with regards to the quantity and quality of value relevance it brings.

 

One study conducted by Iatridis (2010) examined the outcome of switching UK GAAP to IFRS in the UK. The results found that the implementation of IFRS in financial reports reinforced accounting quality and lead more value relevant accounting measures.

 

This is especially useful and relevant to users like investors who rely on quality information about the financial health of a business on whether a business is profitable. That is, value-relevant information enables investors to make an informed decision.  

 

However, an opposing study by Khanagha (2011) examined the value relevance of accounting information in pre- and post-periods of IFRS implementation in the United Arab Emirates (UAE). It concluded that accounting information is value relevant in UAE stock market in general, but the value relevance of accounting data decreased with IFRS application. It is also stated that cash flows’ incremental information content increased in the post-IFRS period.

 

The objectives of the conceptual framework mainly consider how useful and relevant information is to users in making economic decisions. This is subject to debate as there is still much debate on what they should be. The downsides of the conceptual framework objectives are that the conceptual framework does not allow the primary users to assess the stewardship of management. The conceptual framework may only benefit some users and may not be useful or acceptable to all parties. Many of today’s users of financial statements regard information on stewardship as highly relevant and valuable information on how a business’s operations affect the environment and society. This is also significant when making investment decisions. This is especially important for ethical investors who have a vested interest in how a business is behaving in and having an impacting on society. Financial statements predominantly focus on reporting information on how a business is operating in the economic landscape usually regarding monetary transactions.

 

In conclusion, the contribution of IFRS’s conceptual framework has proved important in supporting users in providing relevant and faithfully represented information and examining the prospects of future net cash inflows to the entity. Both fair value accounting and accruals play significant roles in achieving these objectives. Despite the limitations of the conceptual framework such as its flaws in accurately reflecting markets prices of assets due to volatility and inefficient markets among other downsides, the benefits of the conceptual framework and its contribution to accounting practice far outweigh the limitations.