The Role IASB Developing Accounting Standards
The 2007 financial crisis renewed attention on accounting standards as stakeholders sought possible contributors to the crisis (Hellenier, 2011). Accounting standards are set regulations that limit the manner in which transactions are made and accounted for. They are meant to instill sanity into the financial system. The 2007 financial crises has been attributed to weak financial regulations which encouraged accounting malpractices like mis-presentation of the financial situation of businesses in order to keep investors interested (Hellenier, 2011). Accounting standards set requirements for the preparation and reporting of financial information. They, therefore, help minimize such incidences by facilitating the flow of accurate financial information to investors, creditors, regulators, banks, etc (Hertog, 2003). Having an internationally acceptable system of presenting this information brings sanity to the financial system in addition to increasing investor and consumer confidence in banking institutions, businesses, governments, etc.
Financial standards have been quite efficient in improving the global financial transparency and stability. However, there still exist limitations in these standards, such as those manifested during the financial crisis where some financial institutions devised ways of evading regulation. In the event of such occurrences, accounting regulatory bodies are required to come up with new standards, or revise the existing ones so as to address the noted shortcomings. This paper will analyze the role of the IASB in developing and revising accounting standards, the use of normative, scientific and regulatory theories in the development of these standards as well as the role of accounting professionals in the development and implementation of accounting standards.
Accounting Standards and Regulation
Accounting theory is defined as logical reasoning which takes the form of a wide set of principles which provide a reference framework for evaluation of accounting practice and give directions on how new practices and procedures should be developed. It is important to note that a single universally accepted accounting theory does not exist. Instead, a number of logical propositions, which can be classified as normative, inductive and predictive theories, are used as a reference framework for accounting practice (Vorster, 2007). From these theories, regulatory guidelines, popularly known as accounting standards, have been developed (The application of these theories in the development of accounting standards will be discussed later). Accounting standards are regulations set by governments, enterprises and institutions as a guide on how financial information should be presented.
The idea of accounting regulation became more popular after the 1920-30s economic crash (Graffikin, 2005). Currently, accountants and corporations are subject to numerous forms of regulation which give guidelines on financial information disclosure. While there are opposing viewpoints on the need for regulation, regulatory guidelines exist for a number of reasons. Generally, accounting standards are developed with the aim of creating a universally acceptable way of preparing and reporting financial information so as to reduce confusion, increase transparency in financial reporting, and improve financial stability. They are more so important in protecting public interest by ensuring that businesses make regular public disclosure of financial information Martins, 2009).
Role of the International Accounting Standards Board (IASB) in Setting Accounting Standards
The IASB is an independent accounting standards setter, headquartered in London. The board was established in 2001 and replaced the International Accounting Standards Committee – IASC (McCallig & h’Ogartaigh, 2010). It is privately funded, and is made of sixteen representatives selected from nine nations. IASB’s aim is to bring uniformity to the world’s accounting standards. The board has the mandate of developing and approving the International Financial Reporting Standards (IFRSs) and is monitored by the IFRS foundation. Some of its roles include conducting field tests in various countries to determine the level of their established accounting standards, organizing public forums for discussion of proposed standards, development and issuing of IFRSs, as well s the preparation, approval and issuing of accounting standards (IAS Plus, 2015).
Shortcomings of IASB’s Accounting Standards
Revenue is an important indicator of an enterprise’s performance and market prospects. Revenue recognition requires a proper and standard way of identifying transactions and financial instruments as either liabilities or equities. For that reason, business entities are required to account their financial instruments as either liabilities or equities in their financial statements. This classification, in some cases, poses a challenge. Regulation IAS 32 of the IASB standards gives guidelines on the classification of financial instruments. However, the IASB regulation has shortcomings. The most evident of these is the fact that financial instruments are categorized on an accrual basis, where the assumption is that transactions are recorded immediately they occur, and not when returns from the transaction are received (Technical Line, 2014).
Classification of entities as liabilities has an impact on their gearing ratios and usually leads to the treatment of payments as profits which are charged to earnings (Grant Thornton, 2013). Additionally, this affects its ability to pay share dividends. If classified as equities, the impacts are avoided but investors see that as a dilution of their interests in existing equities. Additionally, regulation IAS 32 does not give consideration to the legal obligation of a financial instrument, but rather its contractual obligation. As a result, some instruments are classified as liabilities despite being seemingly equities. The IASB has tried making amendments to its accounting standards to address this but these efforts have resulted in more confusion (Grant Thornton, 2013).
Compound Financial Instruments
According to IAS 32, a financial instrument is considered a liability if the issuer has a requirement to give cash or equivalent financial assets to a holder, and an equity if it has a residual interest representation in the issuer’s net assets (PricewaterhouseCoopers, 2009). However, not all financial instruments can be classified as either equities or liabilities. Compound financial instruments are an example of entities that have both liability and equity elements. A compound financial instrument could exist in the form of a macro hedge fund acquiring a convertible cooperate bond with a cash obligation for the principal and coupon/ dividends and where the bondholder has a conversion option, from a company seeking to obtain funds for expansion. The acquisition of the bond is a liability for the hedge fund. The bond would also be an equity that has potential for generating profits upon conversion. Considering that such an entity would have both the liability and equity aspects, accounting for it would require splitting it into its constituent components; liability and equity. In that case, the ISB would be required to give directions on the appropriate way of accounting for such a financial instrument. This usually requires the development of a new regulation or a revision of an existing standard.
The IASB Process of Developing Accounting Regulation
The IASB uses an international consultation approach in developing new guidelines on accounting standards where interested stakeholders around the world are involved in decision making. The development of new guidelines seeks to address demand for better ways of presenting financial information so as to benefit the users of such information. The process consists of six stages (Foley, n.d, p. 1-5).
- Agenda Setting
The board first analyzes the existing guidelines on information presentation and determines whether there are possibilities of improving convergence, the quality and benefit of the information to be provided to users, the quality of the International Financial Reporting Standards to be developed, as well as the availability of resources for the process. IASB collects opinions from interested parties and standard-setters, after which board members identify and review issues that deserve consideration. The approval to add new agenda items is usually by a simple majority vote by board members (p. 2).
- Project Planning
After agenda setting, the board decides whether to involve other standard-setters in the new project through a simple majority vote. The board then determines whether the agenda will serve the purpose of clarifying or correcting wording errors, conflicts and oversights in the existing standard. It also determines whether the project will be completed in a timely manner. The board then drafts a project plan and sets up a project team to develop a new standard (p. 2).
- Development and Publishing of a Discussion Paper
The board drafts a discussion paper which describes the agenda, proposes possible approaches to settling the issue and outlines preliminary views of the board members. It also contains an invitation for comments from interested stakeholders. The draft is then published after which the board allows a period of not less than 120 days to allow stakeholders to make contributions through comment letters posted to IASB’s website (p. 3).
- Development and Publishing of an Exposure Draft
This draft is meant for consulting the public and contains an IFRS proposal, drafted after the board analyzes the posted comments as well as contributions from its members. The draft has to be vetoed by a minimum of nine members, after which it is published for a period of 120 days for public analysis and contribution. Field visits, public hearings and meetings may also be employed in getting pubic opinions. These are then analyzed by the board after the expiry of the stated duration (p. 4).
- Development and Publishing of the Standard
The board analyzes the comments submitted by the public, makes changes to the IFRS draft and posts the amended draft on the IASB website. The board also posts a feedback statement that gives a feedback to all the submitted comments, detailing the decision made by the board regarding those comments. Additionally, the board publishes an analysis of the likely impacts of the new IFRS. Upon getting satisfied that all issues pertaining to the new IFRS have been addressed, the new IFRS is issued (p. 4).
- Post-Issue Analysis
After issuing the IFRS, IASB holds meetings and discussions with stakeholders to help them understand the unanticipated implications of implementing the new provisions in addition to carrying out educational activities that ensure consistency in the implementation of the new IFRS. A post-implementation review of the new regulation is done after two years to address possible contentious issues arising from the implementation of the IFRS. Such an occurrence prompts the development of a new agenda and a repeat of the standards development process (p. 5).
Use of Normative and Scientific and Regulatory Theories in developing Accounting Standards
The International Accounting Standards Board (IASB) is one of the bodies that play the important role of developing accounting standards. IASB runs a research program for identification of financial reporting problems through the collection of evidence pertaining to the nature and magnitude of the problem. Through this program, possible solutions to problems are determined through normative and scientific approaches, in a process where new regulations are formulated. The IASB’s regulations form an accounting framework, and a reference point for accounting practice. Vorster (2007) argued that, despite being seemingly unstructured, the IASB’s accounting framework is part of the accounting theory, derived from both normative and inductive theories (p.33). In that case, formulation of standards should follow similar approaches to those used in formulation of accounting theories.
Normative (Prescriptive/Deductive) Theory
The deductive/prescriptive approach involves the use of assumptions, propositions and premises to develop logical conclusions and subsequently, accounting principles which are tested to determine whether they are practically acceptable. Normative theories are, therefore, based on what the proponent believes financial accounting should be: which equities should be liabilities/assets, or what should happen in particular circumstances. They are not based on past experience or observations and may not be in line with existing accounting standards. Deegan & Unerman, (2006) gave an example of the proposition to use current market values of assets at a period when historical cost accounting was standard practice (p. 10).
The existent scenario in this analysis features a macro hedge fund acquiring a convertible cooperate bond with a cash obligation for the principal and coupon/ dividends and where the bondholder has a conversion option, from a company seeking to obtain funds for expansion. The acquisition of the bond is a liability for the hedge fund. The bond would also be an equity that has potential for generating profits upon conversion.
In the application of the normative theory, the board would first consider the provisions of the current regulations. In this case, the assumption is that the existing regulations did not envisage a compound financial instrument and that current regulations direct that entities be categorized as either liabilities or assets. In this case, the IASB would be required to seek the opinions of its members, other standard-setters, financial institutions, and other stakeholders on the best way to account for such equities. The point of discussion in that case would be whether to record them as liabilities, equities, or whether to include both their liability and equity values in financial statements. Accounting standards must protect public interest by ensuring that businesses make public disclosure of all relevant financial information (Martins, 2009). Therefore, following the suggestions, the IASB would then come up with the most feasible accounting principle by considering the impact of the new regulation on the understandability of financial statements, its relevance to the needs of users, whether the inclusion or omission of new information influences the decisions of users, etc. The board would then come up with an accounting regulation/ theory on how the financial instrument should be reported in financial statements. Considering that such a decision would not be informed by past experience, IASB would be required to do a post-implementation review of the new regulation after two years to address possible contentious issues arising from the implementation of the IFRS.
Scientific (Empirical/Inductive) Theory
The inductive approach of theory formulation proceeds from a specific observation to a generalization (Vorster, 2007). The method requires empirical testing where sufficient observations and/or measurements lead to generalized conclusions. Vorster noted that accounting practices developed in a practical approach where observations led to generalizations and subsequent accounting theories. The existent scenario in this analysis features a macro hedge fund acquiring a convertible cooperate bond with a cash obligation for the principal and coupon/ dividends and where the bondholder has a conversion option, from a company seeking to obtain funds for expansion. The acquisition of the bond is a liability for the hedge fund. The bond would also be an equity that has potential for generating profits upon conversion.
In following the inductive approach, the IASB would have to make a decision from observations. This would, therefore, require that financial institutions and stakeholders make independent decisions on how to account for the new financial instrument. After this, the IASB would then collect information on how accountants report the new entity; whether as a liability, equity, or both. The IASB would then be required to make an analysis of the implications of the various methods of reporting to the users of financial information. It would also need to listen to suggestions from other standard-setters and shareholders on possible ways of reporting. By analyzing the collected data, the IASB would then be able to pick the method of reporting which has the least negative impact on users, that is, pick the method which gives the maximum possible relevant information and protects the interests of users. This would then be issued as the new accounting standard.
As stated earlier, the idea of accounting regulation became more popular after the 1920-30s economic crash (Graffikin, 2005). Currently, accountants and corporations are subject to numerous forms of regulation which give guidelines on financial information disclosure. While there are opposing viewpoints on the need for regulation, regulatory guidelines exist for a number of reasons. Generally, accounting standards are developed with the aim of creating a universally acceptable way of preparing and reporting financial information so as to reduce confusion, increase transparency in financial reporting, and improve financial stability. They are more so important in protecting public interest by ensuring that businesses make regular public disclosure of financial information (Martins, 2009). However, it is important to acknowledge that different interest groups have different interests and will, therefore, be interested in obtaining varying information from financial reports. For example, employees may be interested in determining the probability of getting a pay rise, while investors may be interested in knowing the enterprise’s ability to pay dividends. Therefore, accounting standards must harmonize these needs. Theories on regulation can be broadly categorized into public interest and private interest theories.
Public interest theories were more common prior to and during the 1960s and postulate that the purpose of accounting regulation should be to achieve collective interests as demanded by the public (Graffikin, 2005). These theories are seen as a reasonable approach of using scarce resources to benefit individual and group interests. Opponents to these theories argue that there are no set bases for identifying public interest. Private interest theories view regulation in terms of individual groups, industries or branches of industries and argue that regulations are acquired and designed by the individual groups or industries to suit their own benefits. Hertog (2003, p.30) argued that regulation is mostly as a result of market failures and are meant to improve competition by eliminating monopolies. In that case, the IASB develops regulations that protect both public and private interests, e.g. of investors, the general public and financial institutions, so as to ensure they all benefit from financial information, and to ensure that players in financial markets have equal opportunities.
The Role of Accounting Professionals in the Development and Implementation of Accounting Standards
The emergence of accountancy as a profession emerged in the early nineteenth century. Accountancy is concerned with analyzing, measuring and disclosing financial information to help users make informed decisions (BPP Learning Media, 2013). Corporations, investors and the general public rely on accounting professionals to prepare accurate financial reports and in a manner that is understandable (IFAC, 2010). Accounting practice is regulated by accounting standards. These standards exist to ensure that consumers of financial information benefit from financial reports. This means that accounting professionals have an immense responsibility of ensuring that they prepare and report financial information in accordance with the existing accounting standards. In addition to that, they have a duty to ensure the growth of the profession by contributing to the improvement of accounting standards. For example, they have a duty to report emerging issues to regulatory bodies like the IASB so that such issues can be addressed through the formulation of better accounting standards.
The importance of accounting professionals in the formulation of accounting standards by the IASB cannot be overlooked. Accounting professionals are part of the stakeholders who are consulted by the IASB in the event of new agendas, where they are required to give opinions and comment on draft regulations before they are issued. In addition, they have a duty to ensure that new regulations are implemented by corporations. Bodies of accounting professionals, e.g. the compliance advisory panel are important in accounting quality assurance through the investigation and monitoring corporations for compliance with IASB’s accounting standards (BPP Learning Media, 2013). Others, like the small and medium practices (SMP) committee play the important role of ensuring that the interests of SMEs are considered and protected by policy makers and regulators like the IASB (IFAC, n.d).
The IASB plays a major regulatory role in ensuring that corporations disclose accurate financial information to investors, creditors, regulators, banks, etc. In addition, IASB’s accounting standards regulate the manner in which transactions are made and accounted for, thereby, instilling sanity into the financial system. The regulations are mostly as a result of market failures and emergence of new issues and are meant to improve competition by eliminating monopolies, in addition to protecting consumer interests. The formulation of these accounting standards is a continued process which involves the modification of existing regulation, as well as the development of new ones as new issues emerge. It also requires concerted efforts, where accounting professionals, regulators, financial regulators, investors, the public and other stakeholders make contributions to new regulations before they are issued. This ensures that all concerns from interested parties are addressed. It is also important to note that accounting regulations form an important part of the accounting theory.