Enhancing Qualitative Characteristics, Reporting Entity Criteria, Historical Cost Measurement Limitations And Revenue Accounting Standards

Understanding Enhancing Qualitative Characteristics

Financial statements of the entity are prepared and presented with the objective of meeting the information needs of the stakeholders of the company. Stakeholders are the parties whose decision making processes are influenced by the financial performance of the reporting entity. There external stakeholders are not involved in the internal business functions. However, they use the annual reports of the company to undertake informed decision making on various matters related to the reporting entity. Hence, the financial information contained in the annual report must possess the basic qualitative characteristics as prescribed in the conceptual framework of financial reporting (Beest, Braam & Boelens, 2009). If the financial statements of the reporting entity do not possess the fundamental qualities, they would not enable the users of reports to take appropriate decisions. The basic qualitative characteristics as prescribed by the conceptual framework are: relevance, reliability and the fair-presentation of the accounting information. Along with these fundamental qualities, the framework also sets out certain enhancing qualitative characteristics of the financial information. These qualities are discussed below:

Understand ability:

Understand ability allows the readers to perceive the significance of information. International accounting standard board suggests that understand ability of the information is the first and foremost enhancing qualitative characteristic of the financial information. Understand ability is achieved when all the accounting information is classified, characterised as well as presented in the clear and concise manner so that users of annual reports can easily interpret such information. It does not only mean simplicity. Understand ability of the information is generally measured in terms of:

• How well the information is presented in the financial statements.
• The correctness of disclosure of financial information by way of notes to accounts;
• The presentation of financial information by way of graphs or tables and
• The inclusion of glossary for the technical and unusual terminologies used in financial reports

Presentation of information not only facilitates the user’s understanding but also it avoids the incorrect interpretation of such information contained in the annual reports. Understand ability attribute is necessary to prevent the situation which leads to wrong decision making by the stakeholders (Mbobo & Ekpo, 2016). 

Comparability:

The second most important enhancing qualitative characteristics of financial information is its comparability. Comparability is the attribute which is achieved when the users of financial report are able to identify the similarities as well as differences between the two or more sets of economic phenomena. Comparability includes consistency. Comparable financial information must enable the users to draw a comparative study of financial results of two financial periods by promoting the consistency of accounting procedures that are following in two different periods. It not only refers to the consistency in the accounting procedures of a single entity but it also refers to the comparable financial information between two different entities. While assessing the comparability of two or more annual reports of the entity, it is necessary that such annual reports are prepared using the same accounting policies and structure (AASB, 2015).

Primary Factors for Determining Reporting Entity Criteria

Comparable information allows the users to assess the financial strengths and weakness of the reporting entity so that decisions can be made by the stakeholders by considering the financial strengths and weaknesses of other competing entities.

Timeliness:

This is the final enhancing qualitative characteristic of the financial information. This is achieved when the financial information is made available to the users before the time it loses its capability of influencing the decisions of such users. In specific terms, the attribute of timeliness is related to the decision usefulness of the information contained in the financial reports of the entity. It is generally measured in terms of total number of days taken by the auditor to sign the financial statements at the year end.

If information is not provided on the correct time, it will not allow the users to take appropriate actions. All the above discussed qualities of the financial statements are the supporting qualities which enhances the decision usefulness of the information. Even the reliable, relevant and fairly represented information, is not understandable that it would lose its relevance for the readers. Moreover, if the reliable and relevant information is not conveyed to the users on the right time, it would lose its usefulness (Cuong, 2017). 

The term reporting entity has been defined in SAC 1 for the purpose of setting a standard for the minimum required financial reporting quality for such entities. Reporting entities are those entities that are required to prepare their financial statements as per the general purpose financial reporting framework. The financial reports are prepared by the reporting entities to meet the information needs of the users of such financial information of the company for the purpose of their informed decision making in relation to their economic relations with the reporting entity (Lont, et. al., 2010). SAC 1 sets out the fact that the reporting entity concept is independent of the type of sector whether private or public or type of business of the entity i.e. whether profit or a non-profit entity. Rather, this statement identifies those entities to be reporting entities on which users are dependent for the financial information to make and evaluate their decisions in regards to the allocation of their economic resources (SAC 1, 2001). The primary factors that are required to be taken into consideration in order to determine as to whether an entity is a reporting entity, are discussed in SAC 1. These factors are discussed below:

Limitations of Historical Cost Measurement

Separation of management from the economic interest of users of financial information:

The larger the gap between the management of the entity and the owners or other parties who have economic interest in the company, more likely are the chances of existence of the users that rely on the financial reports of the entity for their information needs for making the decisions relating to allocation of economic resources.

Economic or political influence:

The economic or political influence is the ability of the entity to make material impact on external party’s welfare. The higher the influence or importance of the entity, more are the chances of existence of the users that rely on the financial reports of the entity for their information need for making and evaluating the decisions regarding allocation of economic resources. Those organisations which holds dominant market positions or those entities which are concerned with maintaining the balance of interests of various significant groups such as employee-employer association or the public sector undertakings holding regulatory powers are required to consider this factor while determining their status as reporting entity. Generally, all the entities that belong to public sectors such as governmental department or other statutory authorities are therefore found to be reporting entities (Challen & Jeffery, 2005).

Financial characteristics:

The financial characteristics of the entity that must be considered while deciding whether an entity is a reporting entity are the size (such as sale or asset’s value, number of customers or entity’s employees etc.) or the indebtedness of the entity. The larger the entity’s size or the greater its indebtedness or the allocated resources, more are the chances of existence of the users that rely on the financial reports of the entity for the information that is required to them for making and evaluating the decisions regarding allocation of economic resources. Particularly, in the case of entities that are not existing for any business, the quantum of resources provided or allocated by the government or any other parties for the activities undertaken by such entities must be considered (Draft, 2015).

The above list of the factors is not exhaustive rather it is an inclusive list as the factors that are above discussed are not the only things that are required to be considered while determining whether an entity is a reporting entity or not in the given situation. Moreover, the classification of an entity as reporting may not be consistent in each reporting period. Therefore, the firms must check the eligibility criteria of being a reporting entity.

Comparison of Revenue Accounting Standards

Each entity that meets the eligibility criteria of reporting entity must prepare the financial statements in such a manner that such statements meet the absolute information needs of the stakeholders so that they can make sound decisions. All the reporting entities generally have to prepare general purpose financial statements. But, there are certain entities which require the preparation and presentation of specific purpose financial statements to meet the information needs of the specific users.  If the financial statements of the reporting entity are not prepared keeping in mind the information needs of the users then such statements do not serve the basic purpose (ACCA, 2018). 

Historical cost accounting is the method under which asset and liabilities of the entity are recorded at their original costs of acquisition. It is widely recognised accounting method as it meets the regulatory requirements of financial reporting (Taplin, Yuan & Brown, 2014). When enterprises follow historical costing approach, they record the business transactions in the books of accounts on the basis of their respective transaction price (Carroll, Linsmeier & Petroni, 2003). Though, the historical costing measurement method is convenient to be applied by the entities, it suffers from certain limitations which are discussed further.

Negligence towards changes in price levels:

Historical cost accounting does not take into account the changes in the realisable value of the assets owned by firm. The values of assets and liabilities are subject to the changes in the market conditions. If such changes in the value of assets and liabilities are not incorporated in the financial statements, then those statements would not depict the true state of the financial position of the business of the reporting entity. In the inflationary period the values of assets and liabilities increases and it is necessary for the firm to incorporate the effect of such price rise in the financial statements so as to allow such statements to depict true financial health of the business (Jaijairam, 2013).

Unrealistic profitability position:

When financial statements are prepared on the basis of historical costing approach, the expenses of the business are recorded at their transaction prices. However, the revenues are recognised in the income statement at the current values. This leads to distortion of true profitability position of the reporting entity which often misleads its stakeholders when they use such financial information to take economics decisions in regards to their association with the reporting entity. The historical cost accounting does not form a suitable measurement basis for main components of financial statements especially during the inflation.

No separation of capital gains and revenue profits:

The use of historical cost accounting leads to intermingling of capital gains and operational gains of the business. Capital gain arises when the company holds a fixed asset for a longer term and the realisable value of such asset in the market changes in the market due to change in the conditions of internal or external environment of the business such as asset obsolescence or inflation etc. However, operational gains are the normal profits earned by the business during the course of its core business operations. In order to allow the financial statements to depict true profitability position it is necessarily required to segregate operational gains and capital gains of the reporting entity, which is not possible under the historical cost accounting system (Liang & Riedl, 2013).

Incorrect or inappropriate asset valuation:

An entity’s balance sheet comprises of various monetary and non-monetary items. Monetary items like trade receivables, trade payables, bank loan, cash etc. are generally recorded at their respective monetary values while other assets which are non-monetary in nature like inventories, goodwill, land and building etc. are recorded at the historical values i.e. the value at which they are acquired from the market under historical cost accounting. The changes in the price level of such assets due to economic conditions leads to overstatement or understatement of their values in the accounting books which influences the position of true state of financial affairs of the entity.

Insufficient depreciation:

It is quite natural that when the assets are not valued at the correct values, the depreciation charged on such assets will not be appropriate because depreciation is generally changed on the basis of asset’s value that is being carried in the accounting books of the entity. Depreciation is charged to the assets in order to maintain a separate fund of cash for the replacement of non-current assets of the entity so that it may not have to face problem of sufficient availability of cash as and when its existing assets requires replacement.

Affects the fair view of financial statements:

The conceptual framework of general purpose financial reporting requires the financial information to present the fair view of true financial position of the business, in order to be called as qualitative information. However, historical cost accounting does not let the financial statements achieve the fair view by measuring the assets and liabilities at the historical costs. There can be significant difference between the fair values and the historical costs of the assets. The conceptual framework requires accounting for such differences but it is practically not done under historical cost accounting system (Zeff, 2007). 

Both the accounting standards are issued by the Australian board of accounting standards for the measurement and recognition of revenue earned by the business during a financial year (AASB, 2001). The AASB 15 has been issued by the board with the motive of replacing the AASB 118 due to certain limitations of the latter standard. In order to enhance the quality of the financial information present in the financial statements of the reporting entity, the new accounting standard in relation to entity’s revenues has been introduced with effect from 1^st January, 2018. The said accounting standard is applicable to the annual reporting period that begins on or after 1^st January, 2018.

AASB 15 is comparatively more complex than the AASB 118. The accounting treatment under AASB 15 will fundamentally change the period in which revenue is recognised in the entity’s accounting books than that of AASB 118, in many of the cases. The changes in the accounting treatment of revenue recognition are as follows:

 In respect of contract of producing any licensed services, licensee fees income has to be recognised in the financial statements of the entity which is earning such income. Previously, the entity had to recognise such fees in the income statement on the basis of straight line over all the 12 months of the financial year of the entity under AASB 118. However, as per AASB 15, the revenue income is only recognised at the point of time when the license is actually granted to the customer. In case of telecommunication industry, where the cable service providers collects an upfront activation fees which is non-refundable in nature, such fees was to be recognised over the total contracted period of service as per AASB 118 but now after the introduction of AASB 15, such fees is recognised as on the date of activation of cable services i.e. the date of contract without deferring it to the further service periods (Zeff, 2007).

Further, whenever any contract to sell certain units at some intervals during the period, is entered into by a vendor and modification to such contract are made thereafter, then the accounting treatment changes for the modifications made in the original contract. Moreover, there was diversity in the accounting practice when contract acquisition costs like commission were to be accounted for, under AASB 118. These costs were either capitalised as intangibles and then they were to be amortised over the total contract period or they were expensed upfront at the time of their incurrence. However, AASB 15 covers an explicit guidance in relation to accounting for such contract acquisition costs (Zabeti, 2018). It requires the capitalisation of incremental costs and the non-incremental costs to be expensed off.  Incremental costs are those which would have not occurred if the contract would have not been signed.

For example, a vendor had signed a contract to supply 100 units of a particular product for the total of $ 5000 at the rate of $ 50 per unit. The units were to be supplied evenly throughout the period of 10 months starting from 1^st April 2017. Each 10 units were to be supplied in each month. However, the contract was modified on 1^st December, 2017 when 80 units were already supplied. The modification in contract was made to supply additional 40 units over a further period of 4 months (10 units per month) along with those 20 units which were not yet supplied till date of contract modification. At the point when contract modification was undertaken, the stand alone selling price of each product unit was reduced to $ 35. As per AASB 15, those additional units are to be considered as distinct from the original units therefore their selling price would be $ 25. Following treatment would be given under both the standards:

Accounting treatment under AASB 118

Accounting treatment under AASB 15

Revenue recognised by the vendor of total amount of $ 5000 over the period of 10 months on an even basis. Revenue for additional 40 units to be recognised at $25 per unit, when such units are actually delivered to the customer. 2017: 90 units @ $ 50 + 10 units @ $ 25= $4750. 2018: 10 units @ $ 50 + 30 units @ $ 25= $1250.

As additional units are considered distinct from original units, the selling price will also be considered as different. Original contract will be considered as terminated from the date of modification. The remaining 20 units from original contract will be sold along with the 40 units of new contract and the revenue from both these sales will be merged and accounted for as a new sales contract. Amount to be recognised as revenue on the basis of average price of $ 35 and $ 25= $ 30 Revenue: 20 units @ $ 50 + (100-20 units) @ 25/ 60 units.

The introduction of AASB 15 in place of AASB 118 would not only change the pattern of revenue recognition but it will also significantly affect the covenants of the banks, performance based incentive plans, internal budgeting process as well as the communication between the market and the investors. Moreover, AASB 15 covers more specific guidance in relation to revenue recognition that the AASB 118. 

References:

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