Financial Reporting Convergence - Building the Platform
A major objective for financial reporting is to achieve a position within the next five years where a consistent set of financial reporting standards is used by all companies listed on global capital markets. To achieve this, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB), the two main standard-setters, have entered into a memorandum of understanding, writes Brendan Sheridan.
On foot of this memorandum, a programme for the completion of new and revised standards in areas identified as critical for improvement and development has been drawn up with a target for completion by 2011. This programme focuses on what are considered the key areas and recognises that there are many other areas which will require attention thereafter. It is also recognised that standard-setters must be alert to changing market conditions and where these call for review of and potential improvements to standards, that they are in a position to act effectively and efficiently. An example of this is the current liquidity crisis which dominates financial markets. As a consequence, both the IASB and the FASB have prioritised for attention the projects they already had under way on fair values, together with projects on both consolidation and derecognition.
Of major assistance to achieving this are the initiatives taken by the U.S., with firstly the acceptance for SEC filing purposes of the financial statements of foreign issuers prepared in accordance with IFRS without reconciliation to U.S. GAAP, and secondly the detailed consideration being given to allowing U.S. domestic issuers to file their financial statements prepared in accordance with IFRS. With over 80% of companies listed on global capital markets filing financial statements prepared in accordance with either IFRS or U.S. GAAP, movement towards IFRS by U.S. issuers would be a major move forward in global convergence of reporting.
The approach taken by the IASB and the FASB to formulating standards has differed significantly in the past with the IASB adopting a principles-based approach and the FASB adopting a rules-based approach, an approach which is referred to by many as the “cookery book” approach. The need for a sound, mutually accepted foundation for developing future accounting standards has been identified as a matter requiring priority attention.
Accordingly, the IASB and the FASB have on their agenda a joint project to develop an improved common conceptual framework, which will eventually replace the current IASB framework and the various concept statements currently in issue in the U.S. Such a framework is essential to fulfilling the goal of developing standards that are principle-based and internally consistent, and lead to financial reporting that provides the information capital providers need to make decisions in their capacity as capital providers.
The project is being undertaken in eight phases, of which four are currently active (phases A to D). The eight phases are as follows:
A.Objectives and qualitative characteristics
B.Definition of elements, recognition and derecognition
D.Reporting entity concept
E.Boundaries of financial reporting, presentation and disclosure
F.Purpose and status of the framework
G.Application of the framework to ‘not for profit’ entities
H.Remaining issues, if any
Earlier in 2008, an exposure draft (ED) was issued on Phase A which followed a discussion paper issued in July 2006, and a discussion paper (DP) was issued on Phase D. Both documents are open for comment until 29 September 2008. The IASB and the FASB are currently working on initial consultative documents for Phases B and C which are currently planned for publication in 2009.
Phase A - Objectives and Qualitative Characteristics
The ED on Phase A concludes that the fundamental objective of general purpose financial reporting is ‘to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers’. Other creditors include employees, suppliers and customers.
The approach taken in the DP to defining the qualitative characteristics of financial reporting has been refined in the ED with ‘relevance’ and ‘faithful representation’ being identified as fundamental. A number of additional characteristics are highlighted to enhance the decision-usefulness of financial information and that are complementary to the fundamental qualitative characteristics. These are comparability (including consistency), verifiability, timeliness and understandability.
Financial reporting information is considered to be of ‘relevance’ when it makes a difference in decision making by virtue of its predictive or confirmatory value. This takes into account the interests of both present and potential investors.
The ED also presents an improved description of ‘faithful representation’ as follows – ‘to be useful in financial reporting, information must be a faithful representation of the economic phenomena that it purports to represent’. Faithful representation is attained when the depiction of an economic phenomenon is complete, neutral and free from material error. Financial information that faithfully represents an economic phenomenon depicts the economic substance of the underlying transaction, event or circumstances, which is not always the same as its legal form.
The ED gives consideration to a number of other potential characteristics. One of those considered is ‘True and Fair View’ with the conclusion expressed in the ED that this is equivalent to ‘faithful representation’. The continued relevance of the ‘true and fair’ concept was confirmed by Legal Counsel opinion obtained by the Financial Reporting Council in the U.K. The opinion confirmed the centrality of the true and fair requirement to the preparation of financial statements by U.K. companies, whether they are prepared in accordance with international or UK accounting standards. This equally applies to financial reports prepared by Irish companies.
Importance of Stewardship
A major criticism of the proposals put forward in the DP issued in July 2006 was the absence of recognition of stewardship as a fundamental objective of financial reporting. Reporting on performance for the year and the financial position at year end is seen in this part of the world as key to understanding the financial well-being of the entity and the manner in which those charged with stewardship have deployed and managed its resources. Major concern was expressed that development of future reporting standards without due regard to stewardship as a key reporting objective, would not serve the needs of investors and other direct interest groups.
The recently issued ED does not identify stewardship as a separate objective but the reference to ‘present and potential’ investors is intended to acknowledge that general purpose financial reports are used for both future investment decisions and for assessing the stewardship of resources already committed to the entity. The Boards have acknowledged that evaluating past performance of an entity is as important as predicting future cash flows.
The potential differing interests of existing versus future investors is often characterised as the battle between fair value accounting and the historic cost approach. The recognition of past performance and stewardship as a key part of financial reporting will have a fundamental impact on when and how ‘fair value’ should be used in financial reporting.
Phase D - What is a Reporting Entity?
The DP on Phase D of the project considers what is a reporting entity. The DP adopts the approach of broadly describing rather than precisely defining what are the defining characteristics of a reporting entity. The description put forward is ‘a circumscribed area of business activities of interest to present and potential equity investors, lenders and other capital providers’. It also suggests that a reporting entity should not be limited to business activities that are structured as legal entities.
The DP proposes that the composition of a group reporting entity should primarily be determined using the ‘controlling entity’ model. Consolidated financial statements should be presented from the perspective of the group reporting entity (the ‘entity’ approach), not from the perspective of the parent entity’s shareholders, (the ‘proprietary’ approach). The basis adopted by the revised IFRS 3 ‘Business Combinations’, issued earlier this year, is consistent with this approach. Adopting the ‘entity’ approach in IFRS 3 presents some challenging issues particularly where there are changes in ownership interests.
The need for a robust conceptual framework is fundamental to the future development of consistent standards accepted on a global basis and which by virtue of being based on clear reporting principles will have the flexibility of meeting the challenges of ever-evolving global economic and financial conditions. The recognition of stewardship as a key element of the conceptual framework being developed is welcome and should help to ensure that the information needs of both present and potential investors are served well by future developments in reporting standards.
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