Any effective financial reporting system needs to be a coherent one (i.e., a framework in which all the pieces fit together according to an underlying logic). Such frameworks have several characteristics:
A framework should enhance the transparency of a company’s financial statements. Transparency means that users should be able to see the underlying economics of the business reflected clearly in the company’s financial statements. Full disclosure and fair presentation create transparency.
To be comprehensive, a framework should encompass the full spectrum of transactions that have financial consequences. This spectrum includes not only transactions currently occurring, but also new types of transactions as they are developed. So an effective financial reporting framework is based on principles that are universal enough to provide guidance for recording both existing and newly developed transactions.
An effective framework should ensure reasonable consistency across companies and time periods. In other words, similar transactions should be measured and presented in a similar manner regardless of industry, company size, geography, or other characteristics.
Balanced against this need for consistency, however, is the need for sufficient flexibility to allow companies sufficient discretion to report results in accordance with underlying economic activity.
Barriers to an Effective Financial Reporting Framework
Although effective frameworks all share the characteristics of transparency, comprehensiveness and consistency, there are some inherent limitations in any financial reporting standards framework. It is not possible to always satisfy all these characteristics at once. Valuation, standard-setting approach and measurements are the main barriers in this process.
There are many bases available for the valuation of assets and liabilities, such as historical cost, current cost, market value, present value and so on.
Financial reporting standards can be established based on:
- A combination of principles and rules
A principles-based approach offers a broad financial reporting framework with little specific guidance on how to report a particular element or transaction.
On the other hand, a rule-based approach establishes specific rules for each element or transaction.
The balance sheet presents elements at a point in time, whereas the income statement reflects changes during a period of time. Because these statements are related, standards regarding one of the statements have an effect on the other statement.
Financial reporting standards can be established taking an “asset/liability” approach, which gives preference to the proper valuation of the balance sheet, or a “revenue/expense” approach that focuses more on the income statement.
This conflict can result in one statement being reported in a theoretically sound manner, but the other statement reflecting less relevant information. In recent years, standard setters have predominantly used an asset/ liability approach.