6.
Why do we need frameworks for financial reporting?

6.1 Introduction

For an extended period, accounting practice evolved organically and largely locally; that is, within each country that thought accounting regulation was of significance. However, recent times have marked a move towards increased regulation and the development of International Financial Reporting Standards (IFRS). This was a response to the globalisation of business activity and a need to reduce the complexity associated with financial reporting in large multinational organisations.

While IFRS have been adopted by over 100 countries, there remain notable exceptions, including the United States of America, India, Japan and China among other countries. Recently, international standards have been also developed for sustainability disclosures.

It is also important to note that most reporting entities do not apply IFRS as they are simply too small. Non-IFRS entities are typically subject to national accounting practices and regulations that drive consistency at a national level.

Importantly, even if a group entity prepares its group accounts using IFRS, this does not mean that the financial statements of all the entities within its group need to do so. Many will be prepared in accordance with local, generally accepted accounting principles (GAAP) even though the group reports using IFRS. There are inevitable conflicts that arise as a result.

Perhaps even more surprisingly, group parent companies are inconsistent in the accounting standards that they use. Many will use IFRS for group accounting but local GAAP for the reporting of the parent entity, even when referring to its own transactions reported within the same set of financial statements. The 2023 annual report of GlaxoSmithKline plc, based in the UK, provides an example of this.

6.2 Regulation

Why do we need to regulate financial reporting? There is an argument that regulation is unnecessary because organisations will provide investors with sufficient information to make an investment decision. In other words, it is in the reporting entity’s self-interest to provide relevant information. This rests on the free market doctrine of neo-classical economics.

However, regulation is often justified by either market failure or government failure, or a combination of both. It is argued that regulation can protect the general public (public interest theory), or alternatively, that it is a product of self-interest (private interest theory). As IFRS does not universally apply to all organisations, most jurisdictions also have national regulators that oversee local financial reporting standards and practices.

6.3 Conceptual frameworks

A conceptual framework serves as the organising framework for the creation of detailed accounting standards (or rules) as it is difficult to create a set of coherent standards without first setting some parameters. Yet accounting standards originally evolved internationally without a conceptual framework. This resulted in national standards being developed in an ad hoc and sometimes inconsistent manner.

An early conceptual framework was that developed by the Financial Accounting Standards Board (FASB) in the United States, and which was issued in 1978. While there have been protracted discussions about convergence between US standards and IFRS, the United States continues to operate with its own financial reporting standards.

From its inception, the International Accounting Standards Committee (IASC) – a forerunner to the International Accounting Standards Board (IASB) – sought to harmonise accounting standards by ceasing undesirable accounting practices and reducing options in existing standards. This was important to achieve recognition from the International Organization of Securities Organizations (IOSCO), the regulator of the world’s securities markets. The IASC needed this recognition to achieve legitimacy internationally and elements of its conceptual framework echoed the FASB framework, which emphasised investors as key users of financial reporting information. The IASB remains a private sector standard-setter that lacks the legal authority of a public body. This is why its standards need to be adopted by member bodies.

An international conceptual framework was first issued in 1989 by the IASC, and revised in 2010 and 2018. According to the Conceptual Framework for Financial Reporting, the objective of financial reporting is:

to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity.¹

The conceptual framework makes several assumptions about the goals of financial reporting and is based on a decision usefulness perspective that focuses on their expected returns. Even within this relatively narrow group of interested parties, different forms of information are relevant to different types of shareholders – for example, those with a long-term perspective will have different information needs from those who invest on a speculative basis.

Other key components of a conceptual framework include the qualitative characteristics outlined in the next section.

Qualitative characteristics

The qualitative characteristics of financial information were introduced in Unit 4.

The extent to which complete objectivity or neutrality can be achieved has been questioned because accounting often relies upon the application of professional judgement, for example, in assessing probabilities.

Accounting research known as positive accounting theory suggests that preparers of financial information will seek to maximise their own personal wealth or self-interest. This raises questions about how the ideal of neutrality can be achieved in practice. Other researchers have applied a critical accounting approach to highlight the ‘myth’ of accounting objectivity.²

Elements of financial statements

The conceptual framework³ outlines the five elements of financial statements:

• assets
• liabilities
• equity
• income
• expenses.

It is notable that income and expenses are defined in the IFRS in terms of changes in assets and liabilities. This is a marked contrast to most standards that existed before the introduction of IFRS; in those standards, the focus of definition for income and expenses was on the accruals principle and the fair reporting of profit in a period, with the statement of financial position (or balance sheet) being considered a secondary issue.

IFRS introduced a balance sheet approach that focuses on measuring assets and liabilities rather than the flow of income. As a result, there is significant interest in the measurement approaches applied to assets and liabilities and the extent to which they achieve their aims. For example, the conceptual framework permits different bases of measurement – which could be viewed as introducing a lack of consistency – into the statement of financial position. Furthermore, the move away from an income-based approach means that the income statement no longer reflects the trading results of the accounting period and potentially becomes a less reliable measure for users of the accounts.

The differing balance sheet and income statement focuses of IFRS and many local GAAPs remains a cause of considerable confusion in accounting.

6.4 Stewardship

The concept of stewardship first emerged with the employment of stewards or management to keep accounts of an owner’s assets and liabilities. This remains the case in many small and medium-sized organisations today, where owners are interested in how management has discharged its responsibilities, including the use of company resources. A second function of financial reporting is commonly accepted to be a valuation objective that allows interested parties to evaluate the future flows of a business alongside any uncertainties that may exist.

However, stewardship’s focus on a range of interested parties and long-term outlook contrasts with the conceptual framework’s focus on decision usefulness for investors. The word ‘stewardship’ was removed from the 2010 conceptual framework for financial reporting, only to be reinstated in the 2018 version. Rather than presenting stewardship as an objective (the responsible management of a company), the revised conceptual framework treats it as an input into resource allocation decisions. This implies that a stewardship approach can enhance decision usefulness.⁴ This view contrasts with research findings⁵ that question whether the same information is required for both valuation and stewardship purposes. It is argued that stewardship is focused on the impact of transactions on a firm, and this is captured in the income statement, with the statement of financial position recording residuals in line with the traditional accounting principles of matching and accruals. In this view, measurement reliability and prudence are also important.⁶ This tension between stewardship and decision usefulness continues to attract academic debate between regulators, standard setters and academics.

6.5 Diffusion of IFRS

IFRS has been developed from the perspective of the Global North, which, according to Hopper et al. (2017), leads to several potential issues. Firstly, aid can be dependent on adopting IFRS, which can lead to the marginalisation of the national accounting profession and local firms, while supporting firms from the Global North in accessing new markets.

Despite adoption of IFRS, differences that affect comparability include the following: culture, religion, law, ownership, colonial history/inheritance, institutions, professional education and language. Some examples are outlined below.

• Legal system. Whether a country is a civil law country or a common law country has been linked to enforcement and investor protection, in turn impacting the quality of accounting information.
• Culture and religion. IFRS assumes rational economic decisions from an Anglo-American perspective. In some societies, this may not be considered a relevant objective, and other priorities may be applied. For example, this is the case in Islamic cultures. In recognition of this difference, the IASB established an Islamic Finance Consultative Group in 2011. However, there remain other cultural and religious differences that may also affect the diffusion of IFRS.
• Financing. The balance between equity and debt financing can lead to differences in financial reporting. This can influence the orientation of the financial statements. The type of funding accessed by an organisation is often linked to the ownership structure of a business, with family-owned companies more prevalent in some jurisdictions than others, as is the case in Italy. In this instance, the owners (who are often also the providers of financing) have access to more detailed information than is publicly available.
• Relationship between accounting and taxation. In some countries (such as Germany), there is a close relationship between financial reporting and the tax system. In others – for example, the UK, USA and Netherlands – the relationship is more distant, with separate measurement and recognition approaches adopted for tax purposes.
• Language differences. Translation of IFRS into multiple languages can lead to subtle changes in meaning. See Nobes (2023) for an example of the impact of translation on financial reporting.⁷

As we highlight throughout this textbook, IFRS continue to permit choices in application, which can lead to differences in financial reports. The application of these choices is a key part of what is known as professional judgement and is one of the reasons accounting professionals are expected to adhere to a code of ethics.

6.6 Expanding the remit of the IFRS Foundation

In 2021, the International Sustainability Standards Board was created, with a remit to develop sustainability disclosure standards. This sought to bring reporting clarity to this increasingly important area, and has brought together several existing initiatives and frameworks that were in existence. It rapidly developed the first two sustainability standards, on sustainability disclosures and climate-related disclosures. Climate reporting standards are important because the climate crisis increasingly impacts investor evaluations of reporting entities.

6.7 Summary

• Financial frameworks support the regulation of financial reporting both locally and internationally.
• Regulation is largely local in nature and is dependent upon legal traditions.
• Frameworks, most notably the Conceptual Framework for Financial Reporting, offer structures to enhance comparability.
• Despite the presence of the conceptual framework and IFRS differences persist.