Introduction to FInancial Reporting
Financial Reporting is a method through which monetary information is made known to the concerned users like government, tax authorities, shareholders, etc. IASB and FASB are developing common international reporting standards to bring the consistency in reporting standards. In this report we will study various International Accounting Standard (IAS) like IAS 39, IAS 38, IAS 21.
Earnings Management which is also referred as Creative Accounting is a technique used by companies to manipulate there earnings so that it matches the target. Various aspects related to it, legal and illegal earning management are also discussed.
Discuss the criteria that need to be met before expenditure on intangible items can be recognized in the statement of financial position as intangible assets
An intangible asset is a non-monetary asset that is without any physical substance but is identifiable (IAS 38: Intangible assets, 2013).
An intangible asset can be recognized only if:-
- The associated future economic benefits of the asset will pour in the corporation.
- The asset can be measured consistently.
An intangible asset should be considered originally at its cost:-The cost of a intangible asset which is separately acquired comprises of its purchase price and any cost which is directly attributable for preparing the asset. In case an intangible asset is acquired in a business combination, the cost of that asset is its fair value on the date at which it is acquired. No intangible asset being internally generated by research shall be recognized (Hunter, Webster and Wyatt, 2008).
An intangible asset arising from development will be recognized only if an entity demonstrates the following:-
- The intangible asset will be completed technically so that it will be available for use.
- It can use or sell the intangible asset.
- The intangible asset can be used and sold through technical, financial and other sources.
Explain why ideal conditions are unlikely to hold
Newton plc operates under the ideal conditions of uncertainty. Its cash flows or revenue depends upon the demand of its products. The probability of demand being favorable is given as 0.4. If in the economy there is inflation then it can create an unfavorable demand for its products. Also if there is increase in the price of the product or decrease in the price of its substitute may lead to unfavorable demand.
Explain why, under non-ideal conditions, it is necessary to trade off relevance and reliability. Define these two terms as part of your answer
Trade off between relevance and reliability are required when there are non-ideal conditions. They both are considered as the qualitative characteristics of accounting information. (Entwistle and Phillips, 2003).
- Relevance: Relevant information is that information which helps investors to measure the present value of the receipts of the asset that will be obtained in future. Under non-ideal conditions, this requires a set of states to be specified. Also an interest rate must also be specified. As in non-ideal conditions these procedures are subject to errors and thus this relevant information is not reliable.
- Reliability: An information is considered as reliable when it represent the information which is unbiased and is verified by a third party. Considering an example, the reliable information like the historical cost of a capital asset will be of low relevance as it involves no estimation of future receipts and payments (Johnson, 2005).
Therefore, there should be proper trade-off between these two as increase in one decreases the other.
There are number of issues involved in implementing common accounting standards. Changing accounting standards to IFRS will require transformation by companies. There will be a need to focus and clearly define plans for their future use of IFRS. Additionally it has been said that adapting IFRS will first increase the quality of domestic governance institutions and then will decrease it (Fifield, and et.al., 2011). Also it has been evidenced that more powerful countries will be least interested in adopting IFRS as they will not surrender there authority of standard setting to IASB. Another major issue concerning IFRS is the costs associated with it. It can be costly to the countries adopting IFRS if legal and cultural factors are not accompanied by the capital market changes (Daske, 2006).
Discuss drivers of international financial reporting convergence
The IASB is promoting convergence rather than standardization, which means it is making global accounting standards as similar as possible. As comparable standards would reduce costs to both the users and people, who prepare financial statements and it will smoothen the operations of world capital markets. The goal or aim of the convergence is to develop high-quality international accounting standards that will be used for both domestic and cross border financial reporting (FASB, 2013).
Many factors influence the international financial reporting convergence like political factors, economic factors and various macro economic factors of a country. Also the IFRS adoption decision of a country is influenced by the information costs a country incurs and also the opportunity and switching costs of domestic governance standards (Daske and et.al., 2008). Also it has been considered that the global accounting standards shall not be adopted by powerful countries as they will not be willing to surrender their standard setting authority to IASB. Geographical factors like a country in a geographical region adapts IFRS it will influence other countries in that geographic region too (Chen and et.al., 2010).
Discuss the benefits of having a common conceptual framework and what are the issues involved in completing this project
There are various benefits of common conceptual framework of international financial standards. As capital flows and trade is becoming more globalized, it will help in reducing information costs as reporting will be done in same way and it will be cheaper to the participants of capital market to become familiar with global international accounting standards. International harmonization of accounting will lead to improvement in capital market efficiency and it will reduce information costs and costs of auditing to market participants (Nobes, 2008). The most important benefit of adopting IFRS is consistency. Also it will help in streamlining there operations, training and development standards. IFRS will allow companies to adapt new standards efficiently and quickly (Munteanu, 2011).
Explain the concept of functional currency under IAS 21
Concept of functional currency
Functional currency is the currency of that entity which operates in the principal economic environment. An entity where it is primarily based and carry out its operations and generates cash is known as its primary economic environment (IAS 21 — The Effects of Changes in Foreign Exchange Rates, 2013). The following factors are considered in indentifying functional currency:- The currency:
- That influences the sales price of its goods and services.
- Of that country, whose regulatory and competitive forces decide the sales price of its goods and services.
- The currency that influences the labor overheads, materials and other such costs of providing goods and services.
Other than the functional currency of the company or the entity, there is a foreign currency. It is the currency of that foreign country, where the company has expanded its operations. Whenever a transaction in foreign currency is to be recorded, the spot exchange rate between the foreign currency and the functional currency will be applied at the date on which the transaction was carried out, on initial recognition of the functional currency. The financial statements of an entity can be presented in any currency, functional currency or foreign currency (Heidrich, 2007).
Discuss the main accounting treatments for foreign currency allowed under IAS21 with respect to primary and secondary translations
An entity can have foreign operations in two ways. It can have transactions in foreign currency or it may carry foreign operations. The primary economic environment is the environment in which an entity operates and its currency is known as functional currency. The foreign currency is the currency other than the functional currency.
A foreign currency transaction shall be recorded, by applying the spot exchange rate between the functional currency and foreign currency at the date of the transaction on the initial recognition of the functional currency, a foreign currency transaction shall be recorded At the end of each reporting period:
- Using the closing rate foreign currency monetary terms shall be translated.
- Using the exchange rate at the date of the transaction, non-monetary items that are measured in historical cost in a foreign currency shall be translated.
Compare and contrast the difference between legal and illegal earnings management
Earnings are referred to as the net income of the company. They indicate what are the probable profits of a company in a year. They have an important place in the income statement of a company. A company’s value is indicated by its earnings as if there are increased earnings, it has increased company’s value and vice-versa (What is Earnings Management?, 2001). Earnings management will be considered as Legal earnings management when company is following reporting its financial statements as per the standards prescribed. A company’s main aim is to earn high profits but by following fair practices and it is achieved by Legal Earning Management (Lang, Raedy and Wilson, 2006).
Illegal Earning Management on the other hand refers to the illegal activities carried on by companies to manipulate there financial statements and which does not reflects the true position of the company (Yu, 2008). Companies sometimes fraud to show their earnings higher as compared to actual in order to build their image. These activities are considered illegal as they do not show the true picture of the company’s financials. Insider trading is an example of Illegal Earnings Management (Al-Khabash and Al-Thuneibet, 2009).
Various alternative approaches employed by firms in managing earnings are:
Under this technique the firm when acquires another firm may show high reported earnings if the acquisition was properly planned. It permits a firm to buy guaranteed current and future earnings by acquiring another firm (Dechow and et.al., 2012).
As the name suggests in this approach a company throws out a subsidiary which is in losses or which id underperforming. A firm can employ no. of ways like it can spin off the subsidiary, sell the subsidiary. etc.
Use of Derivatives
Derivatives are financial instruments whose value is derived from other financial or commodity assets. They are used for eliminating various risks like interest rate risk, foreign currency risk, etc. firms can enter into derivatives contracts in order to manage their earnings.
Early payment of Debt
Firms can also pay their debts early in any fiscal year to manage their earnings. They can select the fiscal year in which they will retire the debts early for managing their earnings.
By studying this report we can conclude that International Accounting Standards are required to be followed by every firm while reporting there financial statements. Accounting for foreign currencies, accounting for intangible assets and recognition and measurement of financial instruments should be done in accordance with IAS 21, IAS 38 and IAS 39. It can be inferred from the report that Illegal Earnings Management is considered as a malpractice and no company should get involved in such activities.
Journals and Books
- Al-Khabash, A.A. and Al-Thuneibet, A.A., 2009. Earnings management practices from the perspective of external and internal auditors: Evidence from Jordan. Managerial Auditing Journal. 24 (1). pp.58 – 80.
- Al-Yaseen, B.S. and Al-Khadash, H.A., 2011. Risk relevance of fair value income measures under IAS 39 and IAS 40. Journal of Accounting in Emerging Economies. 1(1). pp.9 – 32.
- Callao, S. and et.al., 2009. The impact of IFRS on the European Union: Is it related to the accounting tradition of the countries?. Journal of Applied Accounting Research. 10 (1). pp.33 – 55.
- Chen, H. and et.al., 2010. The Role of International Financial Reporting Standards in Accounting Quality: Evidence from the European Union. Journal of International Financial Management & Accounting. 21 (3). pp.220–278.