The two main general frameworks governing the preparation and presentation of the financial statements are the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP).
ACCOUNTING STANDARDS: IFRS are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.
These harmonised standards are a consequence of growing international shareholding and trade, and are particularly important for companies that have dealings in several countries. They are progressively replacing the many different national accounting standards. They are the rules to be followed by accountants to maintain books of accounts that are comparable, understandable, reliable and relevant to internal or external users.
IFRS began as an attempt to harmonise accounting across the EU, but the value of harmonisation quickly made the concept attractive around the world. However, it has been debated whether or not de facto harmonisation has occurred. Standards that were issued by the International Accounting Standards Committee (IASC), the predecessor of the International Accounting Standards Board (IASB), are still in use today and go by the name International Accounting Standards (IAS), while standards issued by the IASB are called IFRS. IAS were issued between 1973 and 2001 by the board of the IASC.
On April 1, 2001 the IASB took over from the IASC the responsibility for setting IAS. During its first meeting the new board adopted existing IAS and Standing Interpretations Committee (SIC) standards. The IASB has continued to develop standards calling the new standards the IFRS.
GAAP is the standard framework of guidelines for financial accounting used in any given jurisdiction, and is generally known as accounting standards or standard accounting practice. It includes the standards, conventions and rules that accountants follow in recording and summarising, and in the preparation of financial statements. Many businesses choose to opt out of GAAP practices as they operate on a cash basis, as opposed to an accrual basis. A comparison would be the way that most people balance their chequebooks: when a cheque is written, its amount is deducted from the total balance even though the funds have not yet left the account. Financial decisions made after the cheque is written are based on the balance after the cheque is deducted.
GAAP is rules-based, which means that it is full of very specific rules for how to treat a large number of transactions. This results in some gaming of the system, as users create transactions that are intended to manipulate the rules in order to achieve better financial results. The GAAP has a substantial number of rules. This has led to the GAAP being far larger than the IFRS and contains a great deal more text. IFRS is principle-based, so that general guidelines are set forth, and users are expected to use their best judgment in following the principles.
Though the organisations responsible for these two frameworks have engaged in talks to minimise the differences between the frameworks, there are still several significant differences between them, which are explained below.
LIFO INVENTORY: GAAP allows a company to use the last in, first out (LIFO) method of inventory valuation, while it is prohibited under IFRS. LIFO tends to result in unusually low levels of reported income, and does not reflect the actual flow of inventory in most cases, so the IFRS position is more theoretically correct.
WRITE-DOWN REVERSALS: GAAP requires that the value of an inventory asset or fixed asset be written down to its market value; GAAP also specifies that the amount of the write-down cannot be reversed if the market value of the asset subsequently increases. Under IFRS, the write-down can be reversed. The GAAP position is excessively conservative, since it does not reflect positive changes in market value.
DEVELOPMENT COSTS: GAAP requires that all development costs be charged to expense as incurred. IFRS allows for some of these costs to be capitalised and amortised over multiple periods.
The IFRS position may be too aggressive, allowing for the deferment of costs that should have been charged to expense at once.
We have noted some of the more significant differences between GAAP and IFRS. There are hundreds of smaller differences within each of the major topics of accounting, which are constantly being adjusted as the two standards are updated.
FRAMEWORK OF ACCOUNTING: There are a number of conceptual issues that one must understand in order to develop a firm foundation of how accounting works. These concepts are explained below.
ACCRUALS CONCEPT: This is the concept that accounting transactions should be recorded in the accounting periods in which they actually occur, rather than in the periods when there are cash flows associated with them. This is the foundation of the accrual basis of accounting.
This can be important for the construction of financial statements that show what actually happened in an accounting period, rather than being artificially delayed or accelerated by the associated cash flows. For example, if you ignored the accrual principle, you would record an expense only when you paid for it, which might incorporate a substantial delay caused by the payment terms for the associated supplier invoice.
Revenues are recognised when earned, and expenses are recognised when assets are consumed. This concept means that a business may recognise sales, profits and losses in amounts that vary from what would be recognised based on the cash received from customers or when cash is paid to suppliers and employees. Auditors will only certify the financial statements of a business that have been prepared under the accruals concept.
CONSERVATISM CONCEPT: This is the concept that you should record expenses and liabilities as soon as possible, but to record revenues and assets only when you are sure that they will occur. This introduces a conservative slant to the financial statements that may yield lower reported profits, since revenue and asset recognition may be delayed for some time. Conversely, this principle tends to encourage the recording of losses earlier, rather than later. This concept can be taken too far, where a business persistently misstates its results to be worse than is realistically the case. Revenues are only recognised when there is a reasonable certainty that they will be realised, whereas expenses are recognised sooner, when there is a reasonable possibility that they will be incurred. This concept tends to result in more conservative financial statements.
CONSISTENCY CONCEPT: This is the concept that, once you adopt an accounting principle or method, you should continue to use it until a demonstrably better principle or method comes along. Not following the consistency principle means that a business could continually jump between different accounting treatments of its transactions that makes its long-term financial results extremely difficult to discern. Once a business chooses to use a specific accounting method, it should continue using it on a go-forward basis. By doing so, the financial statements prepared in multiple periods can be reliably compared.
COST PRINCIPLE: This is the concept that a business should only record its assets, liabilities and equity investments at their original purchase costs. This principle is becoming less valid, as a host of accounting standards are heading in the direction of adjusting assets and liabilities to their fair values.
ECONOMIC ENTITY CONCEPT: This is the concept that the transactions of a business should be kept separate from those of its owners and other businesses. This prevents intermingling of assets and liabilities among multiple entities, which can cause considerable difficulties when the financial statements of a start-up business are first audited The transactions of a business are to be kept separate from those of its owners. By doing so, there is no intermingling of personal and business transactions in a company’s financial statements.
GOING CONCERN CONCEPT: This is the concept that a business will remain in operation for the foreseeable future. This means that one would be justified in deferring the recognition of some expenses, such as depreciation, until later periods. Otherwise, one would have to recognise all expenses at once and not defer any of them.
Financial statements are prepared on the assumption that the business will remain in operation in future periods. Under this assumption, revenue and expense recognition may be deferred until a future period, when the company is still operating. Otherwise, all the particular expense recognition would be accelerated into the current period.
MATCHING CONCEPT: This is the concept that, when one records revenue, one should record all related expenses at the same time. Thus, one charges inventory to the cost of goods sold at the same time that one records revenue from the sale of those inventory items. This is a cornerstone of the accrual basis of accounting. The cash basis of accounting does not use the matching principle.
The expenses related to revenue should be recognised in the same period in which the revenue was recognised. By doing this, there is no deferral of expense recognition into later reporting periods, so that someone viewing a company’s financial statements can be assured that all aspects of a transaction have been recorded at the same time.
MATERIALITY CONCEPT: This concept suggests that information is material if omitting or misstating it could influence decisions taken based on the financial statements of an entity. In other words, materiality takes into account the qualitative or quantitative, or both aspects, of the items to which the information relates in the context of an individual entity’s financial report.
All transactions that are material should be presented and disclosed in a way that it is useful for decision-making by the users of the financial information.
A worthy point to be kept in mind is that while a transaction of a similar amount and nature may be material for one entity/user, it may not be for another.
FULL DISCLOSURE PRINCIPLE: This is the concept that you should include in or alongside the financial statements of a business all of the information that may impact a reader’s understanding of those financial statements. The accounting standards have greatly amplified upon this concept in specifying an enormous number of informational disclosures.
MONETARY UNIT PRINCIPLE: This is the concept that a business should only record transactions that can be stated in terms of a unit of currency. Thus, it is easy enough to record the purchase of a fixed asset, since it was bought for a specific price, whereas the value of the quality control system of a business is not recorded. This concept keeps a business from engaging in an excessive level of estimation in deriving the value of its assets and liabilities.
RELIABILITY PRINCIPLE: This is the concept that only those transactions that can be proven should be recorded. For example, a supplier invoice is solid evidence that an expense has been incurred. This concept is of significant interest to auditors, who are constantly in search of the evidence supporting possible transactions.
REVENUE RECOGNITION PRINCIPLE: This is the principle that you should only recognise revenue when the business has substantially completed the earnings process. So many people have skirted around the fringes of this concept to commit fraud that a variety of standard-setting bodies have developed a large number of rules and guidelines regarding what constitutes proper revenue recognition.
TIME PERIOD PRINCIPLE: This is the concept that a business should report the results of its operations over a standard period of time. This may qualify as the most obvious of all accounting principles, but is intended to create a standard set of comparable periods, which is useful for trend analysis.
These principles are incorporated into a number of accounting frameworks, from which accounting standards govern the treatment and reporting of business transactions. FRAMEWORK FOR PREPARING & PRESENTING FINANCIAL STATEMENTS: Article 286 of the Bahrain Commercial Law, Decree Law No. 21 of 2001, requires all companies incorporated in Bahrain to maintain proper books of accounts and prepare — for each financial year and within at least three months from the end thereof — the company’s balance sheet, profit and loss account, and a report on the company’s activities and financial position, together with their recommendations as regards profit distribution.
The report, the balance sheet, the profit and loss account, and the other reports shall reflect the company’s true financial position.
Articles 217, 218, 219 and 220 of the Bahrain Commercial Law, Decree Law No. 21 of 2001 deal with appointment of auditors, and rules and regulations relating to them. The basic duties of an auditor have been prescribed as below: The auditor shall attend the general assembly and express his/her opinion in all matters pertinent to his/her work, and in particular the company’s balance sheet. He/she shall read his/her report to the general assembly.
The report shall be prepared in accordance with the international auditing principles and standards or the standards approved by the competent authority, and shall include in particular the following details:
• Whether the auditor obtained the information he deemed necessary for doing his work satisfactorily.
• Whether the balance sheet and the profit and loss account are conforming to the facts, and are prepared according to the IAS or to the standards approved by the competent authority; and whether they include all that is provided for in the law and in the company’s articles of association; and honestly and clearly reflect the actual financial position of the company.
• Whether the company maintains regular accounts.
• Whether the stocktaking undertaken by the company has been carried out in accordance with the accepted practices.
• Whether the data included in the report of the board of directors are in conformity with what is stated in the company’s books.
• Whether there have been violations of the provisions of the law or the company’s articles of association during the financial year in a way that affects the activity of the company or its financial position, and whether these violations are still existing to the extent of the information made available.
OBJECTIVES OF FINANCIAL REPORTING: Accurate and complete information is needed in order to operate efficient capital markets. The Financial Accounting Standards Board assumed that creditors and investors would be the primary users of financial reports, and so developed the following list of objectives that matches their needs.
• To provide useful information to the users of financial reports. The information should be useful from a number of perspectives, such as whether to provide credit to a customer, whether to lend to a borrower, and whether to invest in a business. The information should be comprehensible to those with a reasonable grounding in business, which means that it should not be laced with jargon or burdened with so much detail that it is impossible to extract the essentials about a business from its financial statements.
• To provide information about the cash flows to which an entity is subjected, including the timing and uncertainty of cash flows. This information is critical for determining the liquidity of a business, which in turn can be used to evaluate whether an organisation can continue as a going concern.
• To disclose the obligations and economic resources of an entity. There should be an emphasis on the changes in liabilities and resources, which can be used to predict future cash flows.
SUBSTANCE OVER FORM: This is the concept that the financial statements and accompanying disclosures of a business should reflect the underlying realities of accounting transactions.
Conversely, the information appearing in the financial statements should not merely comply with the legal form in which they appear.
The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company’s financial statements.
Substance over form is a particular concern under GAAP, since GAAP is largely rules-based, and so creates specific hurdles that must be achieved in order to record a transaction in a certain way. Thus, someone intent on hiding the true intent of a transaction could structure it to just barely meet GAAP rules, which would allow that person to record the transaction in a manner that hides its true intent.
Conversely, IFRS are more principles-based, so it is more difficult for someone to justifiably hide the intent of a transaction if they are using the IFRS framework. Thus far, the substance over form argument assumes that someone is attempting to deliberately hide the true intent of a transaction, but it may also arise simply because a transaction is extremely complex, which makes it difficult to ascertain what the substance of the transaction is even for a law-abiding accountant. Examples of substance over form issues are:
• Company A is essentially an agent for Company B, and so should only record a sale on behalf of Company B in the amount of the related commission.
However, Company A wants its sales to appear larger, so it records the entire amount of a sale as revenue.
• Company C hides debt liabilities in related entities, so the debt does not appear on its balance sheet.
• Company D creates bills and holds paperwork to legitimise the sale of goods to customers when the goods have not yet left the premises of Company D.
Outside auditors are continually examining the transactions of their clients to ensure that the substance over form criterion is being followed. The issue continues to be of some importance to auditors, because they are being asked to attest to the fairness of presentation of a set of financial statements, and fairness of presentation and the substance over form concept are essentially the same principle.
Read More from OBG
