ACC307 : Accounting Theory - Revisiting The Conceptual Framework -Assessment Answer

Accounting Theory Assignment

Case Scenario1

The FASB and IASB began a joint agenda project to revisit their conceptual frameworks for financial accounting and reporting in 2002. Each board bases its accounting standards decisions in large part on the foundation of objectives, characteristics, definitions, and criteria set forth in their existing conceptual frameworks. The goals of the new project are to build on the two boards' existing frameworks by refining, updating, completing, and converging them into a common framework that both Boards can use in developing new and revised accounting standards. A common goal of the FASB and IASB, shared by their constituents, is for their standards to be 'principles-based'. To be principles

• based, standards cannot be a collection of conventions but rather must be rooted in fundamental concepts. For standards on various issues to result in coherent financial accounting and reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent.Without the guidance provided by an agreed-upon framework, standard setting ends up being based on the individual concepts developed by each member of the standard

• setting body. Standard setting that is based on the personal conceptual frameworks of individual standard setters can produce agreement on specific standard- setting issues onf y when enough of those personal frameworks happen to intersect on that issue. However, even those agreements may prove transitory because, as the membership of the standard-setting body changes over time, the mix of personal conceptual frameworks changes as well. As a result, that standard-setting body may reach significantly different conclusions about similar (or even identical) issues than it did previously, with standards not being consistent with one another and past decisions not being indicative of future ones. That concern is not merely hypothetical: substantial difficulties in reaching agreement in its first standards projects was a major reason that the original FASB members decided to devote substantial effort to develop a conceptual framework.

The IASB Framework is intended to assist not only standard setters but also preparers of financial statements (in applying international financial reporting standards and in dealing with topics on which standards have not yet been developed), auditors (in forming opinions about financial statements), and users (in interpreting information contained in financial statements). Those purposes also are better served by concepts that are sound, comprehensive, and internally consistent. (In contrast, the FASB Concepts Statements state that they do not justify changing generally accepted accounting and reporting practices or interpreting existing standards based on personal interpretations of the concepts, one of a number of differences between the two frameworks.)

Another common goal of the FASB and IASB is to converge their standards. The Boards have been pursuing a number of projects that are aimed at achieving short-term convergence on specific issues, as well as several major projects that are being conducted jointly or in tandem. Moreover, the Boards have aligned their agendas more closely to achieve convergence in future standards. The Boards will encounter difficulties converging their standards if they base their decisions on different frameworks.

The FASB's current Concepts Statements and the IASB's Framework, developed mainly during the 1970s and 1980s, articulate concepts that go a long way toward being an adequate foundation for principles-based standards. Some constituents accept those concepts, but others do not. Although the current concepts have been helpful, the IASB and FASS will not be able to realise fully their goal of issuing a common set of principles-based standards if those standards are based on the current FASS Concepts Statements and IASB Framework. That is because those documents are in need of refinement, updating, completion, and convergence.

The planned approach in the joint project will identify troublesome issues that seem to reappear time and time again in a variety of standard-setting projects and often in a variety of guises. That is, the focus will be on issues that cut across a number of different projects. Because it is not possible to address those cross-cutting issues comprehensively in the context of any one standards-level project, the conceptual framework project provides a better way to consider their broader implications, thereby assisting the boards in developing standards-level guidance.

As noted in the chapter, the boards have issued and received comments on an exposure draft relating to Phase A Objectives and Qualitative Characteristics. A discussion paper relating to Phase D Reporting Entity had been issued and work is continuing on Phase B Elements and Recognition and Phase C Measurement.

Case Scenario2

The trend toward fair value accounting

by J Russell Madray, CPA

The Debate

Critics contend that GAAP is seriously flawed. Some in the accounting profession go so far as to pronounce financial statements almost completely irrelevant to the financial analyst community. The fact that the market value of publicly traded firms on the New York Stock Exchange is an average of five times their asset values serves to highlight this deficiency. Many reformers, including FASB chairman Robert Herz, believe that fair value accounting must be part of the answer to making financial statements more relevant and useful.* Advocates of fair value accounting say it would give users of financial statements a far clearer picture of the economic state of a company.

But switching from historical cost to fair value requires enormous effort. Valuing assets in the absence of active markets can be very subjective, making financial statements less reliable. In fact, disputes can arise over the very definition of certain assets and liabilities.

The crux of the fair value debate is this: Each side agrees that relevance and reliability are important, but fair value advocates emphasize relevance, while historical cost advocates place greater weight on reliability.

Relevance versus Reliability

The pertinent conceptual guidance for making trade-offs between relevance and reliability is provided by FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. It provides guidance for making standard-setting decisions aimed at producing information useful to investors and creditors. Concepts Statement No. 2 states:

The qualities that distinguish "better" (more useful) information from "inferior" (less useful) information are primarily the qualities of relevance and reliability ... The objective of accounting policy decisions is to produce accounting information that is relevant to the purposes to be served and is reliable.

Critics of fair value generally believe that reliability should be the dominant characteristic of financial statement measures. But the FASB has required greater use of fair value measurements in financial statements because it perceives that information as more relevant to investors and creditors than historical cost information. In that regard, the FASB has not accepted the view that reliability should outweigh relevance for financial statement

measures.

Some critics also interpret reliability as having a meaning that differs in at least certain respects from how that term is defined in the FASB's Conceptual Framework. Some critics equate reliability with precision, and others view it principally in terms of verifiability. However, Concepts Statement No. 2 defines reliability as "the quality of information that assures that information is reasonably free from error or bias and faithfully represents what it purports to represent." With respect to measures, it states that "[t]he reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has that representational quality." Thus, the principal components of reliability are representational faithfulness and verifiability.

Although there are reliability concerns associated with fair value measures, particularly when such measures may not be able to be observed in active markets and greater reliance must be placed on estimates of those measures, present-day financial statements are replete with estimates that are viewed as being sufficiently reliable. Indeed, present day measures of many assets and liabilities (and changes in them) are based on estimates, for example, the collectability of receivables, salability of inventories, useful lives of equipment, amounts and timing of future cash flows from investments, or likelihood of loss in tort or environmental litigation.

Even though the precision of calculated measures such as those in depreciation accounting is not open to question since they can be calculated down to the penny, the reliability of those measures is open to question. Precision, therefore, is not a component of reliability under Concepts Statement No. 2. In fact, Concepts Statement No. 2 expressly states that reliability does not imply certainty or precision, and adds that any pretension to those qualities if they do not exist is a negation of reliability.

Case Scenario3

Disclosure of environmental liability

by Lindene Patton C.l.H., Senior vice-president and counsel, Zurich

Around the world, companies are being required to meet higher levels of disclosure of environmental liability ... In the United States, for example, the US Financial Accounting Standard Board (FASB) issued provisions in 2002 for accounting for environmental liabilities on assets being retired from service. The provision for accounting for asset retirement obligations required companies to reserve environmental liabilities related to the eventual retirement of an asset if its fair market value could be reasonably estimated.

The intent of the ruling was disclosure, but the conditional nature of estimating a fair market value caused corporations to take the position that they could defer their liability indefinitely by 'mothballing' a contaminated property. Companies effectively postponed the recognition of their environmental liabilities in the absence of pending or anticipated litigation.

Earlier this year, FASB clarified its intention by providing an interpretation that said companies have a legal obligation to reserve for environmental and other liabilities associated with the eventual retirement of manufacturing facilities or parts of facilities, even when the timing or method of settlement is uncertain. Among examples given by FASB:

• An asbestos-contaminated factory cannot simply be 'mothballed' without adequate reserves to cover the eventual cost of removing the asbestos
• Reserves must be established today for the eventual disposal of still-in-use, creosote• soaked utility poles

As a result of what may seem like a minor technical re-interpretation, companies may have to recognise immediately millions of dollars in liabilities in their income statements to comply with this change.

In Europe, regulators have also initiated efforts to promote disclosure. In 2001, the European Commission promulgated tougher, non-binding guidance for disclosing environmental costs and liabilities, and various countries in Europe have issued additional requirements related to environmental disclosure. In 2002, the Canadian Institute of Chartered Accountants published voluntary guidance that stressed the importance of disclosing all material risks, including environmental liabilities, in companies' annual reports.

Some financial institutions have also pledged to adhere to tenets of international initiatives such as the Equator Principles, which factor environmental and social considerations into assessing the risk of a project. Also, a group of pension funds, foundations, European investors and US state treasurers have endorsed UN efforts to promote a minimum level of disclosure on environmental, social and governance issues.

Recognition of environmental liabilities may also soon emerge as an issue for companies in Asia. While environmental issues may have taken a back seat to rapid economic development over the past 20 years, that situation may change as legislation and regulation catch up with development.

The responsibility for disclosing future environmental liability is clearly a growing issue for companies around the world. However, accurately estimating cleanup costs is not an easy task due to unknown contaminants, legacy liabilities related to formerly operated property, regulatory changes or unexpected claims related to natural resource damage.

Assignment Task1

You are now required to use knowledge learned from MGT306 to analyse this real world case in accordance with following instructions:

1. Explain why principles-based standards require a conceptual framework.
2. Why is it important that the IASB and FASB share a common conceptual framework?
3. It is suggested that several parties can benefit from a conceptual framework. Do you consider that aconceptual framework is more important for some parties than others? Explain your reasoning.
4. What is meant by a 'cross-cutting' issue? Suggest some possible examples of cross•cutting issues

Assignment Task2

1. What you think is the fundamental problem with financial statements based upon the historic cost
2. measurement principle used under US GAAP ?
3. What do you think of the principle' ... accounts must reflect economic reality' as a core principle ofmeasurement in accounting?
4. How would you measure economic reality?
5. What is reliability in accounting?

Assignment Task3

1. The article states that the US standard setter FASB requires companies to record a provision inrelation to environmental costs of retiring an asset ('to reserve environmental liabilities') if its fair value could be reasonably estimated. How do you think companies would go about estimating such a provision?
2. What aspects of the requirements were used by US companies to defer recognition of a liability?
3. In what ways does the recognition of the liability in relation to future restoration activity affect (a) netprofit in the current year and future years; and (b) cash flow in the current and future years?
4. The article refers to changes in disclosure requirements relating to environmental liabilities in manycountries around the world. How important is it that companies recognise the liability? To what extent is disclosure about the liability sufficient?

Introduction

Solution1:

Case study 1 revisiting the Conceptual framework

1 Principles-based standards require a conceptual framework due to the reason that a conceptual framework helps in defining the nature and purpose of accounting, giving due consideration to the theory and concepts of financial reporting and aiding the establishment of a coherent and consistent foundation for the accounting standards. The framework is like a frame of reference for evaluating the existing practices and developing the new ones. It helps in the determination of the measurement basis i.e. Historical value or fair value and report format.

Principles based accounting standards may be prone to serious defects in the absence of the framework in as

• They may be inconsistent with each other especially in terms of the prudence and accruals.
• They would also be internally inconsistent in terms of their effect on the statement of financial position and income statement.
• In the absence of the framework the standards would be reactive, rather than being proactive in nature and accounting bodies would develop them only on the occurrence of an accounting scandal.
• Lone standard setting bodies may be biased in terms of fair representation of all user groups which may deteriorate the quality of standards.
• There may be overlapping issues with the standards covering the repeated concepts as regards the definition of assets and liabilities and other issues.
• The framework may be inflexible, but will render financial statements comparability and consistency and global convergence
• The ‘principles-based’ standards would be more so conceptual with specific objectives which would assist in the development of future standards and the review of existing ones.
• The framework would assist the preparers of financial statements in dealing with accounting transactions without a specific accounting standard.
• The Framework helps the auditors, and other users to understand the objective of financial statements, the characteristics of the reporting entity and the users and the qualitative characteristics of financial statements.

2 It is important that the IASB and FASB share a common conceptual framework on the following grounds

• A common framework would aid in achieving the convergence and improvement of aspects of the separate frameworks like objectives, qualitative characteristics, elements, recognition, and measurement.
• The common framework would help to consider and address issues like cross-cutting issues which give rise to a number of convergence and consistency issues.
• The common framework will aid in making the standards clearly consistent with appropriate accounting principles by refining and updating, converging and completing them.
• The accounting principles ought to be rooted in the fundamental concepts rather than being based on previously followed conventions. The common framework would be a foundation for the development of this principle based standards which would be an overall improved version of the framework.
• The common framework rather than concentrating on changing the aspects of the existing frameworks would aid in converging the essence of the aspects. The common framework would reconsider very comprehensively issues for the completion, updating and refinement of principle based standards already existing.
• The common framework may be criticized on the basis of being rule based, inflexible and prescriptive in nature but one cannot undermine the comparability and consistency which the common grounded framework would ensure

3 .The conceptual framework may not necessarily be more important for some parties than others. The reasoning for this opinion is grounded on the purpose of the conceptual framework which is to ensure and promote consistency and understanding of the various parties reading the financial statements. These parties may be prepares, investors, suppliers, employees and other stakeholders. The purpose of the framework is to make the information depicted by the financial statements understandable and reliable by basing them on a consistent set of rules and regulations in terms of the nature, function and limits of the financial statements so that resolution of accounting disputes becomes easy and repetition of fundamental principles is done away with. The framework does not render the information presented more important for some parties rather than others. Each and every party or user of the framework based statements ought to be convinced of the common reliable and comparable grounds on which these are based.

4 Cross cutting issues have emerged on the IASB and FASB project initiative intending to share a common conceptual framework These issues are those identified troublesome issues which are not only difficult to resolve but reappear time and again in one form or another . This issue also cut across and are identified in more than one project for seeking the common ground for the two accounting body’s standards. The impossibility involved in the resolution of these issues comprehensively has been dealt with by the common project suitably on a priority basis. The examples of these issues include

• Objectives of preparation of financial statements: for existing shareholders, or a wide range of users?
• Trade off of characteristics where information verification is difficult.
• Meaning of ‘reliability’ and the separation of representational faithfulness with verifiability.
• Conflict of the prudence concept with neutrality.
• Priority assignment to comparability, relevance and reliability.
• Definition of Asset in terms of control, recognition criteria, recognition of events that result in the entity obtaining control of the asset.
• Definition of Liability in terms of conditions to be met for specific cases like preferred dividends, employee bonuses, and projected benefit obligations.
• Distinguishing Liabilities and Equity with respect of specific instances like shares at fair value, obligations settled in shares, and minority interests in subsidiaries necessitating the introduction of the elements of debt, equity and “quasi-equity “and their explicit definitions.
• The Effect of Uncertainty and determination of the flow of economic benefits to or from the entity, recognition of an asset or a liability thereof , effect of the influence of the entity on the event , clarity on the meaning of ‘probable’ and ‘expected’ and the reporting criteria in this respect.
• Clarity on the conditions of recognition and derecognition of the events, importance of legal ownership and control in this regard and dependency on the measurement attribute.

Solution2:

Case study 2 the trend towards fair value accounting

1 The fundamental problem with financial statements based upon the historic cost measurement principle used under US GAAP are that the costs represented may not be the current costs of the assets , liabilities or equity represented by the financial statement of the entity. The principle completely ignores the change in price levels over a period of time. This is in contrast with the concept of relevance of accounting information as the costs and values represented may not necessarily be the realizable values of the elements being represented. The historical cost principle requires that asset, liability, or equity be recorded at its original acquisition cost.These costs are not only easily traceable but are also objective and can be verified readily.

The problems that follow with the cost principle are that the historical cost simply represents the worth of the element on the acquisition date which may have changed significantly. To illustrate the point, the sale price of asset may be totally out of sync with the historical cost. This makes the costs irrelevant and makes the information inaccurate as regards the financial position of the entity Also, the principle is not applicable to financial investments, where the recorded amounts are adjusted to fair values at the end of each accounting period.

The principle may at the most be justified for costing the short-term assets and liabilities as there may not be marked changes in their valuation on the reporting date. However, long-term assets and liabilities are at risk. Depreciation, amortization, and impairment charges may seek to align them with their fair values over time, however upward revaluation is restricted due to the conservatism concept. So the balance sheet may not accurately reflect the actual values of the assets recorded on it.

2 The principle’ ... accounts must reflect economic reality’ is really a core principle of measurement in accounting.The fundamental purpose of financial reporting is the provision of a transparent and comparable set of financial statements that reflect economic reality so as to inculcate increased investor confidence. Any deviation from the principle would result in low levels of confidence and uncertainty in regard to the financial information The IASB, FASB and all other global accounting bodies generally are committed to delivering standards that generate useful information so that rational decisions on the allocation of resources can be taken. The concepts of relevance, reliability and comparability are all based on the reflection of economic reality (Financial Times, 2016)

Where economic reality is compromised, the results can be devastating, as vouched by recent corporate reporting scandals. Investors, creditors and employees may end up paying a huge opportunity cost due to unrealistic, inflated values and distorted financial position. In terms of valuation of intangible assets, financial engineering wherein companies take advantage of accounting treatment so as to mislead economic reality and other relevant issues, no measurement of economic reality may result in inaccurate decisions (Sec.gov, 2016)

3.The Measurement of economic reality is really grounded in the principles of Representational faithfulness so that the measure portrays what it is supposed to present, and is free from measurement bias. Substance over form and economic reality ought to override the legal form of transactions. Objectives of financial statements ought to be socially constructed, and profit is no different as it can only exist in the context of economic and social context so as to promote and maintain the interests of particular groups (Macrothink.org, 2016)

The classic example of the FASB Statement illustrating the concept of relevance by reference to drugs wherein a drug that is relied upon to cure the condition has reliability as it has proved to be effective, and in terms of what it is expected to do, it has predictive ability.

In terms of defining the cost principle for the measurement of economic reality in as the decision on the historical cost basis or the fair value basis; the valuation may be prone to subjectivity in the absence of active markets in certain cases, compromising the reliability of financial statements and the decision on the recognition and valuation of assets and liabilities. The measurement of economic reality ought to consider both the relevance and reliability factors.

4 Reliability in accounting implies information represented faithfully. This means agreement between the measure and the phenomenon it represents. Thereliability principlein simple words also implies recording transactions in theaccountingsystem that is verifiable with objective evidence like sale invoices, purchase receipts or cancelled checks.Thus, reliability in accounting implies representational faithfulness and verifiability.

Reliability of payables in a balance sheet, net of allowances is a claim that the stated amount is payable. However, if the allowance is inadequate; the depiction is not reliable as it has failed to represent faithfully the actual payable amount. The reflection of economic resources and obligations and the transactions has to be clearly represented. So Accounts payable in the statement of financial position ought to reflect economic obligations or liabilities faithfully. The same rule applies to assets.

Reliability in terms of Verifiability as per Concepts Statement 2implies a reasonable degree of assurance that accounting measures represent what they ought to represent Verifiability implies Consensus among observers and assurance of correspondence to economic events free of any bias and direct verification like physical verification of cash and inventory versus indirect verification like verification of the measurement basis of the cost of inventory through checking inputs and verification of outputs.

Reliability in accounting is different from Predictive effectiveness which implies financial predictions related to future economic phenomena, cash flow forecast from dividends and redemption and maturity of securities. In the accounting parlance, reliability does not include prediction in which case audited financial statements do not claim reliability as regards predictive effectiveness. The reliability of audited financial statements is in terms of representational faithfulness while the reliability of profit forecasts appearing in prospectus is in terms of the effectiveness of the predicative model used.

Solution3:

Case study 3 Disclosure of environmental liability

1 US standard setter FASB requires companies to record a provision in relation to environmental costs of retiring an asset if its fair value could be reasonably estimated. Companies would estimate such a provision based on the guidance available in this respect issued by AICPA on Statement of Position 96-1 relating toEnvironmental Remediation Liabilities("SOP 96-1").

The guidance specifically provides that the framework of the accounting treatment mandated by SOP 96-1is FASB 5, wherein a contingency loss is defined as an existing condition, which involves uncertainty regarding a possible loss or expense that is dependent on the happening or not happening of a future event. FASB 5requires the estimated loss or expense to be recognized where estimation is possible. Otherwise, footnote disclosure of the contingency ought to be made where estimation is difficult.

SOP 96-1provides that where litigation or a claim is probable and it is certain that the outcome would be unfavourable. (Probability of unfavourable outcome is simply proved where the company was associated with the subject site. Association includes present and prior ownership or operation of the site or transportation of waste to the site). Liability is also triggered by governmental enforcement of rules and regulations.

The SOP further provides factors for making estimates even in those case where companies asserted that reasonable estimation was not possible, . In these cases, liability ought to be accrued at an an amount that is at least equal to the lower end of the range of estimates. The estimate ought to include the incremental direct remediation costs, compensation and benefits payable to employees and the legal costs incurred in connection with the environmental remediation efforts undertaken.

Legal cost estimation has been detailed in three categories. The first category involves determination of the extent of remedial actions and the type of remedial actions required. The second and third categories include allocation among potentially responsible parties and seeking recoveries from others. The SOP recognizes that few companies may be induced to accrue large liabilities in advance and that discounting of liabilities to reflect the time period involved would be difficult.

Recognition of liabilities was deferred by US companies on the grounds that disclosure was not possible, taking advantage of the conditional nature of the fair market value estimation. Companies thus deferred their liability by resorting to ‘mothballing’ of the contaminated property. They postponed the recognition of their environmental liabilities where the litigation was not forthcoming on the date when the accounts were prepared. These properties were either warehoused or mothballed. Past history of lax enforcement was also used to circumvent the law made in the US in this behalf. These companies took advantage of the fact that in majority of these cases; where litigation was probable but still not made or where reasonable estimation was not possible due to the nature of the claim, it was easy to defer the liabilities till suitable regulations were enforced in this behalf.

The recognition of the liability in relation to future restoration activity affect net profit in the current year by including costs that are directly attributable to remediation activities so as to bring the site up to the current minimum standard for use. Other restoration costs ought to be capitalized to future periods

Directly attributable costs would normally include the cost of development and implementation of the remediation strategy, payroll and reporting costs, facilities and equipment with no alternative use, materials, and maintenance costs during restoration, legal and other similar costs Damage costs of natural resources, surveying costs of archaeological sites and research and development costs of field sites are to be excluded Once the restoration has been done, the costs would be treated as normal operating costs

The cash flow effect for the current year would normally involve a reduction in the operating as well as investing cash flows of the company as warranted by the nature of the expenditure .The cash flow effect of the liability estimate where based on future cash requirement may be discounted using an appropriate discount rate. The liability estimate ought to be reviewed each year-end to reflect changes due to inflation. The liability ought to be reduced by expected net recoveries where measurement and estimation and probability can be established.

It is important that the companiesrecognise the liability. At the bare minimum the following disclosure of the liability is warranted. Disclosure on an aggregate basisabout

• The nature of the restoration liability;
• Basis for the estimation of the restoration liability;
• Reasons for non-disclosure of the restoration liability; and
• Estimated recoveries on account of environmental restoration if any.

This would not only ensure a consistent recognition of the environmental liabilities but will also help to forecast the expected future cash outflows associated with the obligations and associated investments in assets required in respect of capitalized costs of environmental restoration. Moreover, the financial statements of the entity would disclose a true and fair view of the transactions related to environmental liability.

Where companies have adhered to FASB 143related to Accounting for Asset retirement obligations, no significant impact may be perceived. However, where Companies have deferred the liability on the pretext of circumventing the law significant, negative impacts on the balance sheet may be seen.

The disclosure about the liability as a footnote to the financial statements may be regarded as sufficient where the probability and reasonable estimation cannot be established so that the users of the statements are aware of the existence of the contingency or probable obligation that may arise subsequent to the balance sheet date. The changes in the legislation around the globe have ensured that the situation where reasonable estimation of the environmental liability is difficult is reduced to the bare minimum so that the statements reflect a true and fair view of the performance and position of the reporting corporate.