Question

Lev, Beaver, Revsine and Watts each discuss the nature of the capital market and stakeholders relevant to the firm in conjunction with different approaches to financial reporting disclosures.   Based on their discussion, the knowledge that earnings management occurs (Dechow and Skinner, 2000 and Nelson et al, 2003) and other readings you have done, what are the benefits and drawbacks to have more or less rigid financial reporting rules? In which direction should standard setters move (more or less rigid) over the next several years?

Answer 1

Solution =

Q1. what are the benefits and drawbacks to have more or less rigid financial reporting rules?

ANS - It should be no surprise that accounting standards have become more complex over the years. Transactions have become increasingly challenging as new products and services emerge and financial instruments become more complicated in a global economy. Meanwhile, financial statement users’ demands for more information in a more timely fashion have caused standard setters to create more disclosure requirements to provide additional transparency. As the amount of information in financial statements has grown, “simplification” and “reducing complexity” have become themes in recent years for regulators and accounting standard setters.

Despite all these challenges, attempts to reduce complexity continue because many in the financial reporting arena believe the benefits of simplicity can be numerous. Here are seven impacts that experts foresee—or already are experiencing—in the financial reporting realm.

1. Preparers may benefit from simplicity

Some financial statement preparers say they see disclosure simplification efforts as a positive change.

“Nobody likes change for change’s sake,” said Chris Rogers, CPA, CGMA, the CFO of New Jersey software developer Infragistics Inc. “But if it adds to the ability to make informed financial decisions and makes my life easier, then I support it.”

2. Cost savings for private companies

Reducing complexity and increasing disclosure effectiveness should result in financial reporting that is simpler and less costly. This is especially true for private companies. Rogers, who served on FASB’s former Private Company Financial Reporting Committee, believes FASB has already made meaningful accomplishments by adopting GAAP changes that simplified accounting and disclosures for private companies through the work of the PCC. “The reporting requirements and cost/benefit analysis are radically different for private versus public companies,” he said.

Users’ needs are different for each reporting company, and user demands have required preparers to disclose more information in different formats than they need to run their business—and more information than even GAAP requires. Rogers said the PCC’s accounting and disclosure simplifications for private companies make sense because private companies are more transparent to their financial statement users

3. More effective public company disclosures

The impact of the new initiatives for public companies is related to improving disclosure effectiveness. Susan Callahan, CPA, director, Americas Accounting and Global Accounting Policy at Ford Motor Co., said that what investors find useful may not always be the same as what is required.

“Our objective, in addition to compliance, is to disclose what is relevant for investors to make decisions,” she said. “Our investors will often ask questions about the business, and over the years and when appropriate, we have responded by modifying our disclosures to present the information they are requesting. This may not always cleanly align with what the standards require. We often find ourselves challenged in balancing our disclosures between what is required and what is relevant for the users, particularly when either the disclosure is for something that is immaterial, or when the volume or content of the required disclosure could obfuscate the important information.”

4. Redeployment of finance resources

Reducing the level of complexity and reporting requirements may result in cost savings through efficiencies and reduction in required numbers of personnel. But the more likely outcome, experts say, is a redeployment of resources to improve the quality of reporting or to address other business needs.

“Every dollar spent in finance is a regulatory cost,” Rogers said. “But finance staff can partner within their organizations or with customers to make better business decisions, or pair up with information technology to fix systems or get real financial information to decision-makers. Junior accountants can be made into analysts to provide insight into other areas, like marketing, to improve ROI.”

Callahan does not believe that audit fees will be reduced in any significant way as a result of simplification, given new accounting standards, required audit documentation, and additional pressures from regulators, including the PCAOB.

Auditors say that applying private company accounting changes more broadly to simplify accounting for all companies is a positive development. Many companies had trouble with complex GAAP in areas such as impairment of goodwill and intangible assets, fair value, derivatives and hedging, and consolidation of variable-interest entities. These challenges resulted in difficult audit issues as well, and the time spent by all did not always result in financial information that was meaningful or useful to the users of those financial statements. Simplification in these areas of accounting should result in overall time and cost savings.

Accountants in public practice have an interest in simplification efforts because of the effect on their clients, firms, and staffs. This impact will depend on the types of clients in their practice and whether they include private companies eligible to use different frameworks. In general, small business clients stand to gain the most, but the audit workload isn’t expected to decrease significantly.

“PCC changes within GAAP are going to catch on and will be beneficial to small businesses that are unnecessarily impacted by complex standards,” said Harold L. Monk Jr., CPA, a partner with Carr, Riggs & Ingram. “For accounting firms, this may ultimately result in some decrease in time spent on engagements, but I don’t think the change will be so noticeable or extensive that it will impact gross revenues. It will just mean that we will be able to get jobs done more timely with some increase in margins.”

6. New education and communication

Firms may have to address new and different available frameworks and standards in their training, procedures, and quality control.

“In firms with no centralized oversight of rules or system for dealing with new literature, like a national office standards group, new reporting models have the potential to be more challenging,” Duckwitz said.

It is important for CPAs to communicate with their clients about the new simplified frameworks that exist. Smaller companies may not be aware of options that are available to them and that would benefit their financial statement users, because they may not allocate resources to following emerging standards, Duckwitz said.

“Particularly in the area of FRF for SMEs, where preparers and users may be confused about the framework, CPAs can explain the differences upfront and why it may be a good fit, because it helps to eliminate some GAAP complexities,” he said.

7. Obstacles will remain—and emerge

While there is much going on to make financial reporting simpler, new standards on revenue recognition and leasing will add accounting complexity during implementation, as well as new disclosure requirements. The impact of such new standards intended to simplify accounting and improve consistency of financial reporting will need to be assessed over time as implementation and disclosure issues are addressed.

A challenge to companies that want to streamline their disclosures and remove information is their audit firm’s risk management and preference for more disclosure and reluctance to remove previously reported information. It may be easier for auditors to document companies’ compliance with standards when more disclosure is provided. This issue is more difficult for public company auditors subject to PCAOB inspections.

Standard setters and regulators are delivering a clear message through their simplification initiatives that they believe consistent, relevant, effective financial information is a goal with clear benefits to all. Preparers and auditors need to be vigilant in order to be prepared for the changes and take advantage of opportunities that simplification of standards may present.

Drawbacks -

1) Not Globally Accepted -

The United States has not yet adopted International Financial Reporting Standards and other countries continue to hold out as well. This makes accounting by foreign-based companies that do business in America difficult as they often have to prepare financial statements using IFRS and another set using American Generally Accepted Accounting Principles.

2) Standards Manipulation -

There is a downside to the flexibility that IFRS allows: companies can utilize only the methods they wish to, allowing the financial statements to show only desired results. This can lead to revenue or profit manipulation, can be used to hide financial problems in the company and can even encourage fraud. For example, changing the method of inventory valuation can bring more income into the current year's profit and loss statement, making the company appear more profitable than it really is.

While IFRS requires that changes to the application of the rules must be justifiable, it is often possible for companies to "invent" reasons for making the changes. Stricter rules would ensure that all companies are valuing their statements the same way.

3) Increased Costs -

A small company would be impacted by a country's adoption of IFRS in the same way a larger one would. However, small businesses do not have as many resources at their disposal to implement the changes and train staff. This results in smaller companies bringing in accountants or other outside consultants to help make the changeover. These smaller companies will bear more of a financial burden than larger ones in this area.

Q2. In which direction should standard setters move (more or less rigid) over the next several years?

ANS-

As regulators and standard setters work to simplify rules, preparers and auditors can prepare themselves by:

1) Being aware of emerging GAAP and financial reporting developments, along with what’s going on in private company accounting, including the Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs), and changes that the Financial Accounting Foundation’s Private Company Council is developing.

2) Not getting caught by surprise. Watch the timing of pending literature, as certain standards can be adopted early or may affect prior-year financial statements. Early adoption might be risky. Evaluate whether these standards work for your company, and discuss them with primary users of your financial statements in advance.

3) Auditors: Becoming knowledgeable and able to discuss the standards with clients.

4) Preparers: Taking a fresh look at the notes to financial statements each year to make sure they are still relevant and comply with disclosure requirements. Then assess them from an operational and investor perspective to ensure they are useful and clear.

5) Auditors: When reviewing disclosures, thinking not only about the rules but about what FASB intended the rules to disclose.

6) Getting more involved with simplification initiatives. Read more. Choose continuing education in these areas. Get involved with professional organizations such as the AICPA. Volunteer to give back to the profession, and it will also help you to stay current on emerging developments in GAAP and financial reporting.