In: Accounting
You have recently being asked to participate in a symposium at an accounting conference. One of the sessions at the conference is discussing concerns with the conceptual framework. You have been provided with a number of questions ahead of time so that you can be prepared for the debate.
1. The first discussion topic relates to prudence. Prudence (conservatism) was dropped from the conceptual framework when it was amended in 2010. Are we not still conservative in accounting policies? Provide some specific examples. The Exposure Draft recommends reintroduction of the term prudence, stating that it supports neutrality. The new definition of prudence would be the concern that assets and income not be overstated and expenses not beunderstated. Do you agree?
2. The second discussion topic relates to the question of how to measure assets and liabilities. What are the pros and cons of the use of historical costs compared to current values? Which method is more relevant for the statement of financial position compared to the income statement for users? Are certain types of assets more suited to the use of current values?
3. The final discussion topic relates to other comprehensive income (OCI) and comprehensive income. What is a concern with OCI and comprehensive income? Do you think OCI is useful? If so, in which situations?
Required:
In preparation for the symposium prepare notes to address the questions that might be asked concerning the conceptual framework.
Notes for Symposium
1. Prudence
There are many examples where we are conservative in our accounting standards. For example, we recognize contingent liabilities as provisions if they are probable but do not recognize a contingent asset as an asset unless it is virtually certain. We recognize all deferred income tax liabilities but we do not recognize deferred income tax assets unless they are probable. For goodwill we have impairment. (Students could discuss a number of other examples of accounting standards where there is conservatism).
Yes I agree with the new definition since there could be both understatement and overtstatement of assets especially where estimates are being made for financial statements. Both of these would be a bias in reporting. Neutrality supports the new definition of prudence. Financial reporting should not have a bias.
2. Measurement of Assets and Liabilities
Historical cost has many advantages. It is easy to measure on initial recognition. It is more difficult to measure after initial recognition since it requires a number of estimates e.g. number of years an asset should be depreciated over. Impairment testing involves subjectivity. Current values after initial recognition are more relevant to decisions of users since they can be customized to the needs of those users. However, there are many alternatives in determining current values and measurement uncertainty therefore subjectivity.
Current values will provide a more up to date Balance Sheet for the users of the financial statements. However, unrealized and realized gains and losses will impact the Income Statement and create more volatility. Historical cost will create an outdated Balance Sheet and the estimates related to depreciation and impairment testing involve subjectivity.
For certain assets current values are more relevant e,g, derivatives where hedge accouting is not elected and investments which are traded on a frequent basis.
3. OCI and Comprehensive Income
One concern with OCI and comprehensive income is that there is not clear definition about what belongs in OCI and comprehensive income. OCI is useful since it allows for unrealized gains and losses related to certain remeasurements to not impact the income statement which would create volatility and it avoids accounting mismatches. For example, with a cash flow hedge e.g. a forward contract to protect against the change in the Euro for a future purchase of a machinery in Europe. Without OCI you would have an accounting mismatch. Without OCI the forward contract would be classified as a derivative and impact net income but the forward contract would have no impact until the machinery is purchased in six months. So one side of the hedge would impact net income and the other side would have no impact. To solve this issue the forward contract would impact OCI only until the hedge is terminated. (Students could provide other relevant examples).