Effective financial reporting frameworks share three characteristics:
- Transparency. Transparent financial statements facilitate investing in the same way that maps facilitate sailing - by clarifying the environment and therefore reducing the risk of the unknown. They permit investors to see clearly what's under the surface and what risks they might face.
- Comprehensiveness. Financial statements should encompass the full spectrum of transactions that have financial consequences.
- Consistency. Information about a particular company is more useful if an investor can compare it with similar information about other companies and with similar information about the same company for some other time period. The purpose of comparison is to detect and explain both similarities and differences. High-quality accounting requires accounting for similar transactions and circumstances similarly and accounting for different transactions and circumstances differently.
Barriers to a Single Coherent Framework
Effective standards can have conflicting approaches on valuation, the bases for standard setting, and resolution of conflicts between balance sheet and income statement focuses.
- Valuation. Some valuation approaches (non-historical-cost approaches) may require considerable judgment.
- Standard-setting approach.
- Simply stated, principles-based accounting provides a conceptual basis for accountants to follow instead of a list of detailed rules. One starts with laying out the key objectives of good reporting in the subject area and then provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable, the intent is not to try to provide specific guidance or rules for every possible situation. Rather, if in doubt, the reader is directed back to the principles.
- Rules-based approaches are characterized by a list of specific rules, numerical tests for classifying certain transactions, exceptions, and alternative treatments.
- IASB attempts to follow a principles-based approach to standard-setting, as such accounting standards are grounded in the IASB framework. The FASB is now adopting an objectives-oriented approach to U.S. standard-setting.
- Measurement. Financial reporting standards can be established taking an asset/liability approach or a revenue/expense approach.
- The asset/liability approach requires a definition of what constitutes an asset and what constitutes a liability. For example, it links profit to changes in assets and liabilities.
- The revenue/expense approach focuses more on the income statement. It relies on concepts such as the matching principle to determine profit.