Chapter 1 - Test your knowledge Flashcards
What is the role of a regulatory framework in the preparation of financial statements?
The role of regulatory frameworks for the preparation of financial statements is:
1) to ensure financial reporting is regulated through financial reporting standards such as UK and US GAAP and IFRS;
2) to ensure financial information is reported objectively to provide relevant, reliable and faithfully represented information that enable users to make financial decisions;
3) to provide an adequate minimum level of information for users of financial statements;
4) to ensure financial information is comparable and consistent in the relevant economic arena (this is especially important with the growth in multinational companies and global investment);
5) to ensure and improve transparency and credibility of financial reports, promoting users’ confidence in the financial reporting process;
6) to regulate the behaviour of companies and directors through the corporate governance framework; and
7) to achieve desired social goals through environmental and CSR reporting.
List the key objectives of accounting standards
The key objectives of financial accounting standards are to:
1) improve the transparency of financial reporting and make financial information reliable, relevant and easier to understand;
2) reduce the risk of creative accounting;
3) make the financial statements of different period or of different entities
comparable
4) increase the credibility of financial statements by improving the uniformity of accounting treatment between companies; and
5) provide quality financial reports and accounting information which can be relied upon for consistency, commonality and overall transparency
What are the key arguments for adopting harmonisation of accounting standards across the world?
1) Financial statements presented under IFRS make global comparisons easier.
2) Cross-border listing is facilitated, making it easier to raise funds and make investments abroad.
3) Multinational companies with subsidiaries in foreign countries have a
common, company-wide accounting language.
4) Foreign companies can be more easily appraised for mergers and
acquisitions.
5) Multinational companies benefit for the following reasons:
A. preparation of group financial statements may be easier;
B. a reduction in audit costs might be achieved;
C. management control would be improved; and
D. transfer of accounting knowledge and expertise across national
borders would be easier.
Why is there an ever-growing need for businesses to account for and report on environmental issues?
Environmental reporting allows organisations to account for and report on the environmental effects of an organisation’s economic actions.
It has economic
implications, some of which are listed below.
- Risk management:
financial, legal and reputation implications. - Marketing advantages: public image and brand enhancement by
demonstrating its environmental responsibilities. Businesses that are
considered environmentally irresponsible are likely to lose market share. - Legal needs: a business may be legally required to provide environmental reports. It is a legal requirement for quoted companies and those that carry on insurance market activity.
- Competitive advantage: it can improve relationships with key
stakeholders such as investors, suppliers and the wider community.
Improved environmental performance should lead to cost savings.
- Ethics: showing a commitment to accountability and transparency.
Principles-based versus rules-based systems
A principles-based system (such as IFRS) uses a ‘conceptual framework’ to provide an underlying set of principles within which standards are developed.
In the absence of such a framework, rules have to be designed to cover every eventuality. Some local or national GAAPs (such as the current US GAAP approach) are considered a more rules-based system of accounting.
One presumed advantage of rules-based systems is that the exercise of judgement is minimised and is preferred by auditors who fear litigation.
However, they may lead to a large volume of regulatory measures, which do not always detect or prevent financial irregularities. It could be argued that a rules-based approach is more appropriate for controversial areas in accounting.
Arguments against accounting
regulation?
- A rigid accounting regulation could have a detrimental effect in the long term and the influence of political, economic and cultural climates of different countries is often ignored. One reporting regulation may not fit all countries when considering disclosure regulation (Bushman and Landsman, 2010).
- Frameworks apply to entities from various industries and the tendency to enforce standardisation may not be suitable for those on the margins.
The choices provided by accounting standard setters, such as on the valuation of inventories, can be somewhat arbitrary. There would be considerable disagreement as to the method to be used, which could distort the comparability of companies’ financial statements.
- There is a concern amongst some professionals that standards tend to remove the need for accountants to exercise their judgement. However, others argue there is still plenty of scope for this.
- A key criticism of standardisation is that it gives an illusion of precision and comparability. This is debatable and arguably not fully justified in view of the wide range of subjective decisions that have to be made.
- A final criticism of accounting regulation is that there are simply too many standards of increasing complexity
What are the various legal and regulatory structures that make up the regulatory environment of accounting?
It includes:
- agency theory and the role of corporate governance
- national or company law
- financial reporting and accounting standards
- regulatory frameworks on corporate governance
- environmental reporting
- corporate social responsibility (CSR)
What do each of these entail:
It includes:
- agency theory and the role of corporate governance
- national or company law
- financial reporting and accounting standards
- regulatory frameworks on corporate governance
- environmental reporting
- corporate social responsibility (CSR)
They include:
- Agency theory and the role of corporate governance
Developed by Jensen and Meckling (1976) and defines the characteristics of a public limited company (a company which may be listed on a capital market). The theory suggests that the modern corporation is based on the principal–agent relationship, where the owner (shareholder) is the principal and the manager is the agent. The two enter into a contract whereby the manager acts as
the custodian over the assets of the firm and aims to maximise the owner’s wealth.
- National or company law
The legislation that regulates businesses in the UK is the Companies Act 2006 (CA2006)
- Financial reporting and accounting standards:
Without a single body with overall responsibility for producing financial reporting standards, GAAP would be unable to evolve in a structured way in response to changes in economic conditions. The accounting standards are generally produced by independent private sector bodies who are given authority by legislation to set standards.
- Regulatory frameworks on corporate governance
The seeks to enhance financial reporting by providing confidence to the users of accounting information. They aim to align the interests of directors, management and shareholders in pursuing the success of the company.
- Environmental reporting & Corporate social responsibility (CSR)
This seeks to enhance financial reporting by providing confidence to the users of accounting information. They aim to align the interests of directors, management and shareholders in pursuing the success of the company
Agency theory problem?
Agency theory problem?
The manager or agent may pursue their own interests at the expense of the principal.
Solution to the agency theory problem…
The principal will incur agency costs to monitor the agent’s activities and take corrective action where necessary.
Agency costs are direct and indirect costs arising from the disagreement or the inefficiency of a relationship between
shareholders and business managers.
Examples of direct agency costs include use of company’s resources for the agent’s own benefit (such as excessive executive pay) and the monitoring costs such as fees payable to external auditors to assess the accuracy of the company’s financial statements.
What is the key objective of an external audit?
The key objective of an external audit is to protect the interests of shareholders by independently reporting the state of a company’s finances.
The auditors ensure that the board receives accurate and reliable information and makes an assessment on the appropriateness of the accounting principles.
An audit results in an audit opinion about whether the financial statements give a ‘true and fair’ view of the company’s state of affairs and operations for the period.
What is Indirect agency costs?
Indirect agency costs refer to lost opportunities that arise out of the shareholder/management conflict but does not have a directly quantifiable value.
To reduce the risk from conflicting interests and to minimise the agency cost, the contracting parties will seek to optimise their relationship.
The conceptual framework?
The conceptual framework itself is not a standard. Its purpose is to help the IASB to develop new or revised accounting
standards, to assist in the application of the accounting standards and to deal with any issues that the standards do not
cover.
What does the IASB conceptual framework cover?
The IASB conceptual framework covers:
- the objectives of financial reporting;
- the underlying assumptions;
- the qualitative characteristics;
- the elements of financial statements;
- the recognition (and derecognition) of the elements;
- the measurement of the elements; and
- the concepts of capital and capital maintenance
