Accounting: The Language of Business - Vol. 2 (Intermediate: Part 6)

There are only two things as complicated as insurance accounting and I have no idea what they are.

Andrew Tobias

The Financial Reporting Environment

(Part F)

by

Charles Lamson

The Global Standard-Setting Structure: International Financial Reporting Standards (IFRS)

As illustrated in Exhibit 1.9, the International Accounting Standards Board is part of a larger organizational structure that also includes:

• The IFRS Foundation

• The Monitoring Board

• The IFRS Advisory Council

• The IFRS Interpretations Committee

The IFRS Foundation oversees the IASB and is responsible for financing the IASB operations. Unlike funding for the FASB, the IASB relies on contributions from companies and other parties that have an interest in promoting International Accounting Standards. The monitoring board was formed in 2009 to enhance the public accountability of the IFRS Foundation while still allowing for independence in the standard-setting process.

The Monitoring Board oversees the IFRS foundation, participates in nominating individuals to serve as foundation trustees, and approves appointments. The IFRS Advisory Council advises the IASB and the IFRS foundation on many issues, including the IASB's agenda and the implementation of standards. The IFRS interpretations committee is the interpretive body of the IASB, similar to the EITF in the United States.

The IASB is composed of 14 members who are appointed by the IFRS Foundation's board of trustees. At least 11 members serve full-time, and no more than three can be part-time members. To ensure broad and diverse international representation, the IASB is composed of:

• Four members from the Asia/Oceania region

• Four members from Europe

• Four members from the Americas

• One member from Africa

• One member appointed from any area, subject to maintaining overall geographical balance

The IFRS Interpretations Committee (IFRSIC) develops interpretations of standards that must be approved by the IASB. Whenever the need arises, the IFRS Interpretations Committee forms working groups, which are task forces for individual agenda projects. the IASB will also normally form working groups or other types of specialized advisory groups to advise on major projects; an example is the Emerging Economics Group.

Standard-Setting Process: IFRS

The IASB follows a similar process to the FASB standard-setting process, so we discuss it only briefly here.

When a topic is identified, the Board considers the nature of the issues, seeks input from the constituents, and prepares an exposure draft. After receiving comments on the exposure draft, the IASB may modify the proposed standard before approving a final standard.

Unlike the FASB, the IASB is required to carry out a post-implementation review of each new standard or significant change to an existing standard. The review focuses on controversial issues identified during the development stage, unexpected costs, and implementation problems. This review is normally carried out up to two years after the new standard has been in effect.

Standard Setting as a Political Process

The issuance of new standards and changes in existing standards can have significant effects on an entity's reported net income. In turn, these income effects impact the flow of capital throughout the economy.

At the company level, managers have incentive to oppose changes in standards or new standards that reduce their company's reported net earnings. On the financial statement user level, a new standard or a change in existing standards should provide better and more transparent financial information that will assist users in making more effective investment and credit decisions.

Standard setters address the concerns of both the managers and financial statement users by employing the standard-setting process as described in the previous section. These processes rely on the information gathered and opinions of users, managers, and auditors along with comments obtained from responses to exposure drafts and public roundtables. The standard-setting bodies analyze this information to gauge the economic consequences of the proposed standard and to assess the improvements in the quality of the financial information disseminated to the market. Standard setters address this trade-off between the income effect and the value of financial information, reaching a balance before issuing the final standard.

Trends in Standard Setting

This post concludes our discussion of the financial reporting environment by introducing three current trends in standard setting, that we will explore further in later posts:

• A move toward a less rules-based (or a more principles-based) system as found in International Financial Reporting Standards

• A move toward standards that are focused on the asset/liability approach

• A move toward measuring balance sheet items at fair value rather than historical cost

Rules- versus Principles-Based Standards

Both the U.S. GAAP and IFRS systems of accounting standards are based on principles and rules. A principal-based standard relies on theories, concepts, and principles of accounting that are linked to a well-developed theoretical framework. A rules-based standard contains specific prescriptive procedures rather than relying on a consistent theoretical framework.

Principles-Based Standards. Pure principles-based standards exhibit the following characteristics:

• Provide a clear discussion of the accounting objective related to the standard.

• Involve few, if any, exceptions.

• Involve no tests [referred to as bright-line tests (A bright-line rule, also known as a bright-line test, is a law or standard that is intended to be unambiguous and prevent subjective interpretation. Bright-line rules are commonly used to make quick, predictable and consistent decisions.) ( techtarget.com)]  that require meeting a pre-established numerical threshold (For example, a rule specifying that a material item is 10% or more of net income is a bright-line test.).

• Provide insufficient guidance to implement the standard. 

• Involves a significant amount of interpretation and application.

With pure principles-based standards, comparability across entities is often lost due to the extensive amount of preparer judgment required. In addition, preparers and auditors worry that regulators will not support the judgment used when reporting under a principles-based system, even judgments made honestly without intent to bias. Finally, the lack of application guidance can make it difficult to enforce principles-based reporting requirements in practice.

Rules-Based Standards. Unlike principles-based standards, rules-based standards may not relate to a consistent theoretical framework. In addition, pure rules-based standards:

• Contain numerous exceptions to the types of firms and industries that are covered by the standard.

• Contain numerous bright line tests.

•  Result in inconsistencies between standards.

• Contain detailed application guidance.

• Do not rely on extensive use of professional judgment.

As is the case with pure principles-based standards, pure rules-based standards also result in implementation problems. At times, reporting entities may circumvent rules and are therefore able to override the intent of the standard. A system of rules-based standards is difficult to interpret from a user perspective. Rules-based standards tend to result in an environment where financial reporting is viewed as an act of compliance rather than a process of disseminating transparent financial information to investors and creditors.

Objectives-Oriented Standards. An SEC report studying rules-based and principles-based standard setting indicated that an objectives-oriented standard is optimal. Similar to principles-based standards, objectives-oriented standards are derived from and are consistent with a high-quality theoretical framework and clearly stated accounting objectives. However, objectives-oriented standards include a sufficient level of rules to provide detail and structure, resulting in the consistent application of accounting standards across entities and across time. An objectives-oriented standard would minimize exceptions to a particular standard and reduce the number of bright-line tests used in its implementation. Many of the existing standards in both U.S. GAAP and IFRS qualify as objectives-oriented standards. 

U.S. GAAP and IFRS: Rules versus Principles. Neither U.S. GAAP nor IFRS fits perfectly into a rules- or principles-based approach. The greatest difference between the two standards is that U.S. GAAP contains many more rules than does IFRS (It is likely that the considerable number of rules in U.S. GAAP were written in an attempt to protect preparers and auditors from potential, excessive litigation in the U.S. reporting environment.). Although U.S. GAAP includes more rules than IFRS, it is not purely rules-based. Similarly, IFRS is not purely principles-based. Both U.S. GAAP and IFRS base standards on their respective conceptual frameworks, which we discuss in more detail in an upcoming post. Exhibit 1.10 shows the placement of U.S. GAAP and IFRS standards on the rules-based and principal-based continuum.

Assets/Liability Approach

The next trend relates to the interrelationship between the balance sheet and income statement. When a firm reports an event on the income statement, the transaction typically also changes a balance sheet account. For example, if a firm reports revenue, it also increases the balance in accounts receivable or cash.

Although the two financial statements are interrelated, which set of accounts is dominant---the revenues and expenses on the income statement or assets and liabilities on the balance sheet? For example, in a typical sales transaction, an account will increase accounts receivable and revenue. But how does the accountant decide whether to record the transaction?

1. Recording based on revenue recognition criteria involves an income statement approach.

2.  Basing the decision on whether an economic resource is received and it meets the definition of an asset, such as accounts receivable, is an asset/liability (balance sheet) approach.

In FASB's early years, it tended to focus on an income statement approach. However, in recent years, it has shifted to the asset liability approach [FASB, Statement of Future and Accounting Standards No. 109, "Accounting for Income Taxes" (Norwalk, CT: FASB, 1992), which is now codified as FASBASC 740. Income Taxes, provides an example of the trend toward the use of the asset/liability approach. Prior to this standard, the profession employed an income statement approach when accounting for income taxes but now uses a balance sheet approach.].

Fair Value Measurements

Another trend in standard-setting is the movement toward the use of fair value measurements as a viable alternative to historical cost. Fair value is the amount of which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties. Twenty years ago, firms reported very few items on the balance sheet at fair value. Today, firms use fair values to measure some balance sheet accounts. For example, firms must report some investments in equity securities that have a readily determinable fair value and some investments in debt at fair value, as opposed to historical cost. We will discuss fair value measurements more extensively in a later post. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 14-17*

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