Rule Versus Principal Accounting Standards

PART ONE

Introduction

Accounting standards are the traditional standards for reporting financial reports and they do specify how the account prepares should prepare the financial transactions, disclose them, and present them (Filip et al., 2021). Accounting traditions and practices vary considerably worldwide due to the application of rule versus principle-based standards. The principle-based rules are fostered by the international financial reporting standards (IFRS), which provide general guidance on how the prepares and the auditors of the financial statement would carry out their duties to reflect the economic reality of the transaction (Buesa, Población, García, & Tarancón, 2020). In that context, the critical difference between the rule versus the principle is the details. The rule-based standards provide detailed and specific rules that the accountant and the auditors of financial statements should follow. This report will discuss the critical differences between the rule versus principal accounting standards, the meaning, advantages, and disadvantages of harmonization standards, and the progress of harmonization principles and rule-based accounting standards.

The differences between the rule versus principal standards accounting system

In principle-based accounting system requires the prepares and the auditors of the financial information to apply judgment when carrying out their duties (Filip et al., 2021). Therefore, the principle-based accounting approach considers substance over form. In that case, when recording the transactions in the financial statements, preparing the financial information should focus more on economic substance rather than the legal form of transactions. Thus, the principle-based standards allow the accountants to ignore the legal forms of transactions and to record the transaction to reflect the actual economic reality of the company. For example, the company may purchase assets using a lease agreement in the bank. First, the company pays the until costs and the remaining balance for a while, say, five years. During the payment period, the company does not legally own the assets, but from an economic point of view, the company owns the assets. In that case, the financial statement should recognize the assets to reflect the actual economic reality of the assets and iron out the legal form of the transactions.

Even though the legal forms of transactions, in this case, is critical, it would have needed to be more accurate to inform the users of the financial information that they do not own the assets. In reality, the company is extracting economic benefits from the same. In that account, the rule-based accounting system focuses on the legal aspect of a transaction, thus preventing the accountants from recording the economic substance of a transaction, thus giving a misleading image of the actual economic reality of the company. Consequently, the accountants and auditors should prepare the accounting information based on the principle-based approach because it allows them to ignore the legal forms of a transaction to capture the economic substance.

The rule-based accounting standard method provides users with an easy way to compare financial information. The rules are more specific and detailed, and the companies that use these methods can report the financial information similarly to the principle-based approach that uses the experts’ judgments, making it difficult to compare (Shimamoto & Takeda, 2020). companies using the rule-based accounting method, financial statements are similar because they do not follow opinions but rather the laid down rules that are applied to all the companies uniformly. the prepare and the auditors prefer to use the rule-based accounting standards methods because of their ease of comparing the financial reports. Investors easily select a more profitable company since the rule-based accounting method provides a uniform measurement and reporting standard.

When it comes to enforcement, it is difficult to enforce the principle-based accounting method compared with the rule-based system (Jawarneh, 2021). This kind of scenario is because the principle-based approach provides only general guidance compared to the rule-based approach, which provides more details. Thus, following the rules rather than the general details is easier. In case the preparers in the rule-based have errored in their works, it is easier to identify the specific rules that have been broken and thus easy to take action. Contrary to the principle-based method, it is difficult to trace an error since it relies on an individual’s judgment. Consequently, the individual may state that they were applying based on specific knowledge. In that regard, enforcing the rules and regulations may be difficult.

Despite the rule-based approach being viewed as having capabilities to minimize the risks of litigation, there has been debate in several countries worldwide to adopt a principle-based approach (Street, 2012). For instance, the Securities and Exchange Commission (SEC) approved foreign companies operating in the United States to use principle-based accounting standards without reconciling the existing GAAP rules. Therefore, there have been tremendous efforts to ensure that all companies use the principle-based approach. The reason for this push is that the principle-based approach provides a broad approach and thus allows the inclusion of vital policies that reflects the economic gains and losses in a timely fashion. However, adopting the IFRS, principle-based in the US and other countries, has been difficult because of the nature of the politics, tax systems, and the cost of migration from one system to another.

Also, there is an issue of politics that affects the implementation of IFRS in the US. IFRS is considered the European standard; thus, the US feels it should not be under European standards (Becker, Bischof & Daske, 2021). moreover, there is an issue of protecting the investors, and SEC believes that uniformity should not compromise quality. In that regard, the SEC believes that GAAP provides a quality measure of reporting financial statements, and to protect the investors, the IFRS should not be adopted. The cost issue in migrating from GAAP to IFRS also hinders the adoption of IFRS. Considering that IFRS requires many judgments, there is a need to have comprehensive training to ensure that the accountants have sufficient knowledge and expertise to apply the knowledge in making accounting judgments. Training will be required, which may affect the already established audit and accounting firms. Consequently, there is more resistance to implementing the IFRS in the US.

Discuss the meaning of the term international harmonization of accounting standards.

Harmonization is the procedure of making an action, circumstance, or process homogeneous and consistent with other projects of the same kind. Harmonization of Accounting Standards is the technique of decreasing global accounting standard variations. Harmonization aims to ensure that financial reporting can be compared and consistent. The primary purpose of this harmonization effort is to enhance the comparability and consistency of the accounting records, reports, and statements’ preparation and presentation (Schmidthuber et al., 2022). In the current era of globalisation, financial markets must depend on consistent accounting reporting. Countries may only realise international accounting standard harmonization through collaboration and mutual agreement. These nations must adhere to comparable recording and accounting methods and requirements when generating financial reports.

Zakari (2020) states that harmonizing accounting standards increases foreign investors’ confidence and understanding. Lenders and investors can read and analyse the financial information of any company in the world with relative ease. Investors and lenders can accurately recognize, evaluate, and identify firms with excellent financials that satisfy their investing criteria. This facilitates international investment. Additionally, it aids in objectively evaluating the firms to invest with. The key to gaining a competitive advantage and maximizing the investment’s return is to make good investment selections. Harmonization establishes constraints on the extent to which accounting processes may differ, allowing for comparable results. In the actual world, it is not easy to establish international accounting standards and uniformity. The challenge of establishing standardization in accounting is because of variations in thinking processes, methods, accounting requirements, and tax regulations. The harmonization process attempts to decrease these discrepancies on a global scale.

Discuss the advantages and disadvantages of the harmonization of accounting standards.

Advantages

Financial Statements are comparable.

Harmonization of accounting standards improves the worldwide comparability of financial reporting and statements across different organizations and sectors (Mattei et al., 2020). Organizations adhere to various accounting standards following the administrative requirements of their countries of business. In terms of the procedure of preparing and presenting accounting reports, this certainly alters the outcome.

For instance, a global firm operating in multiple countries must comply with each country’s accounting norms and laws independently. It cannot compile the financial statements of all its businesses under the accounting requirements of a single nation or its home country. This circumstance causes considerable uncertainty among stakeholders, including management, investors, shareholders, and lenders. They need to be able to contrast the financial records of local and multinational enterprises. In addition, it is difficult for inexperienced investors to comprehend the reports of firms operating in other nations. Harmonisation of accounting standards offers a remedy for the aforementioned issues. Harmonisation allows financial reporting to be comparable, reduces the disparities between global accounting standards, and renders them interoperable. With consistent sequencing and terminology for reporting, the financial reports become comparable. Investors find it far easier to comprehend the financials and operations of foreign firms. It assists individuals in making wise investment choices. Therefore, it leads to an international free movement of money.

Improves Professionals’ Efficiency

The harmonization of accounting standards enhances the efficiency of financial accountants, reporters, and auditors. In the lack of harmonization, experts working on organizations’ financial statements from different nations and regions encounter several obstacles (Kurauone et al., 2021). When working in a new nation, their skill sets are limited, and much time is spent conforming to local reporting norms.

Harmonising resolves the aforementioned issues. While engaging in financial reports for several nations or relocating to a different country for employment, professionals are not required to acquire every country’s formats, vocabularies, and standards. This boosts efficiency, financial data processing speed, and final statement creation speed. Furthermore, these experts may work anywhere globally without encountering any understanding or unfamiliarity issues.

Cost-effective and time-saving

Harmonising accounting standards saves both professional and non-professionals substantial resources, money, and time (Walker, 2022). Investors and other consumers of financial reports would no longer be required to read incomparable and incompatible reports and comprehend each separately. Harmonization greatly simplifies and accelerates the whole evaluation procedure. The elements of the financial reports will show in almost the exact location and order in financial reports from throughout the globe (Bogopolsky, 2015). Additionally, the terminology will be roughly equivalent.

Harmonising accounting standards also contribute to the consistent use of numerous financial ratios. Accounting information users will understand that the ratio computation is consistent across organizations and nations and that the same materials have been utilized. Utilising financial ratios to evaluate numerous firms can save a great deal of time compared to computing the ratios after reviewing each company’s financials separately.

Consistency in Disclosures

Harmonisation of accounting standards will lead to comparable financial information in accounting reports. This contributes to the regularity and uniformity of all essential information across its global consumers. There will be reduced transaction fees and time spent reading through lengthy declarations, which will help all parties involved.

Disadvantages

While the objective is commendable and a step in the right direction, there are several limits to adopting standardised accounting practices. One of the disadvantages of harmonising accounting standards is that firms may be needed to make new capital expenditures to adopt harmonization (Carneiro et al., 2017). The training and education of professionals throughout the globe following the new accounting norms may incur substantial expenses, time, and resources. Moreover, academic institutions must alter their curriculum to accommodate the changes.

Corporations across the globe will be required to update their accounting systems to comply with the new regulations. Furthermore, small businesses that still depend on manual bookkeeping and make minimal or do not utilise computers must purchase costly software to comply with the new accounting standards. Before their adoption, these obstacles to the harmonisation of accounting standards must be addressed appropriately.

International harmonisation

The process of international harmonisation has been underway for many decades, with numerous organisations and projects seeking to encourage convergence and eliminate variation in accounting procedures globally.

The International Accounting Standards Board (IASB), founded in 2001, is among the primary bodies engaging in this initiative (Deloitte, 2022). The International Accounting Standards Board (IASB) is responsible for designing and releasing the International Financial Reporting Standards (IFRSs), a collection of internationally accepted accounting standards. The IASB and the United States Financial Accounting Standards Board (FASB) initiated a cooperative endeavor to converge their accounting standards between 2002 and 2006. More than 110 nations require and authorise the adoption of International Financial Reporting Standards (IFRSs) as established by the IASB in 2010.

In 2011, the United States Security and Exchange Commission recommended a road map allowing overseas private issuers to prepare financial reports using IFRS without referencing US GAAP.

2016: The Security and Exchange Commission issued a revised edition of the guideline designed to facilitate the adoption of IFRS in the financial information of public U.S. corporations.

The IASB and FASB published updated lease accounting standards in 2019, IFRS 16 and ASC 842, to enhance the transparency and consistency of lease accounting among nations.

India, Japan, Canada, Singapore, South Africa, and numerous others have embraced IFRS as their reporting standard as of 2021. However, nations such as the United States continue to adopt Generally Accepted Accounting Principles (GAAP), which differ somewhat from IFRS. However, most U.S. corporations may also submit their financial accounts using IFRS. The movement towards worldwide accounting standard harmonisation is underway and will generally continue to develop in the future.

Several potential barriers exist to the present and future adoption of global accounting standards. These consist of the following:

Cultural Differences

One of the barriers to adopting global accounting standards is the failure to adequately account for political, cultural, and social variations across nations. This is especially pertinent to its implementation in developing nations, where language challenges, attitudes toward accounting, and other sociocultural factors may influence their interpretation and execution (Mnif Sellami & Gafsi, 2017).

Global Acceptance

Global accounting standards are generally highly political, and there is a typical inclination to prioritise the national economy’s concerns above the global economy. Most corporations in the private sector and professional accounting organisations are intensely interested in accounting methods and financial reporting. Political decision-makers may be highly influenced by pressure to alter or reject specific standards. In developing nations, adopting global accounting standards presents significant obstacles. They need more infrastructure and resources to change their legislative and legal frameworks to accommodate the standards, creating a barrier to practical implementation.

Training and Retraining

When a nation adopts global accounting standards, its businesses, accountants, and auditors must be retrained on the appropriate standards and financial statement reporting methods. The training requires creating new instructional resources and curricula, new tests for professional licensure, and changes in reporting systems and accounting software. This complex transition creates a barrier to the adoption of global accounting standards.

PART TWO

Transaction one

IFRS 2 applies whenever the company acquires or receives goods and services that are paid using share-based payment (International Accounting Standards Board, 2018). In the case of the goods, it includes inventories, intangible assets, tangible assets such as plant and equipment, and non-financial assets. However, there is an exception of the share issued on the business combinations and the contracts of the goods, which falls in the scope of IAS 32 and 139. The services that can be accounted for within the scope of IFRS2 include a share ownership scheme, call option, and services rendered to external consultants based on company equity.

In that context, IFRS 2 requires the business to recognise the expenses for goods and services it receives based on a share-based scheme (International Accounting Standards Board, 2018). In that case, the corresponding entry will increase the liability or the equity based on how the company settles the payment: cash or using equity. When goods and services are received, according to IFRS2, they should be recognised immediately if the payment is based on a share-payment scheme(International Accounting Standards Board, 2018). For the case of shares that vest immediately, it is assumed that the services were rendered in the past, and in the case of the shares that vest in the future, it is assumed that services will be rendered in the future and the shares are recognised and spread on the period.

The payment scheme contains conditions that must be met for the share’s entitlement. (Vesting conditions). Thus, the market prices of shares are typically ignored since they have already been considered when doing the fair value. In this context, the fair value increase and decrease should be ignored, but the employment condition must be considered.

As of 1 October 2020, the fair value per option was £4(the increase or decrease is ignored)

Larch granted 15,000 share options to each of its 20 Directors

On 30 September 2021

Two had left, and four were estimated to leave (a total of six)

Thus, the amount to be expensed is

£4*15000*14(20-6) * 1year/3 years =£280,000

The company should have expensed £280,000 in profit and loss account and increased equity with the same amount instead of expensing £1,260,000 in September 2021.

Transaction two

IAS 37 defines and specifies how a company or accountants should measure and disclose the provisions, contingents’ labilities, and assets .in this context, the question about the provision of training costs of £600,000 has been made in the financial statements. Therefore, it will be prudent to analyse if the provision was in line with the scope of IAS 37, which stipulates the provision’s disclosures.

Provision is a liability that uncertain in time and amount. Thus, a provision can be constructive or legal. In the legal context, the provision is a liability due to the company violating the rules and the laws of the land; .it would be employment or environmental laws, and so on. The constructive provision arises from the company’s action, from which the firm states that it will accept the responsibilities of such activities, such as warranties, payment of allowances, and training costs, among other expenses.

According to IAS 37, the company or accounting firms should recognise the provision if it is probable that there will be an outflow of cash or economic benefit. For example, if there is a 50% chance of cash outflow on past events, then the company should set aside the provision for such liability. However, if there is no probability, the company should consider such liability contingent liability.

Once it is probable that there will be an economic benefit outflow or cash flow, then the provision should not only be set aside, but the company should measure it reliably based on past transactions and estimates.

The estimates then should be discounted and measured in today’s value. By so doing, it will be helpful for the organization to set the correct provision.

In the case of a provision made by the Group finance director, it has met the three criteria for recording the provision. One is that it is a liability arising from past events. Second, the liability is legal; that is, the act of employment will require the company to retrain the employees, and then there is probable that there will be an outflow of cash since the training must happen to comply with the law. Lastly, the retraining cost can be measured reliably.

In that regard, the provision of training costs of £600,000 aligns with the scope of IAS 37 of accounting and disclosing provisions.

Transaction three

IAS 36 is concerned with the organization carrying the value of an asset more than its recoverable amount, that is the amount that the assets can be sold and the value that can be derived from the assets used. IAS 36 scope applies to land, buildings, machinery and equipment, intangible assets, and goodwill except for inventories, financial assets, and differed tax asset tax, among others.

IAS 36 paragraph six defines impairment of assets as the amount by which the cash-generating unit or carrying amount of an asset is greater than the recoverable amount. The carrying amount is the amount that is recorded in a balance sheet after the reduction of accumulated deprecation and impairment losses. In that regard, the recoverable amount is the higher value of the fair value, less the cost of disposal (net selling value) and asset value in use (VIU).

The fair value is the amount that is agreed by the market participants to buy or sell an asset or to transfer a liability. The VIU is the present value of the future expected cash flow of an asset; also, it can be the cash-generating unit when it is not possible to record one asset.

When there is an indication that an asset’s carrying amount is more significant than an asset’s recoverable amount, then IAS 36 stipulates that it is essential to perform an impairment test and estimate the recoverable amount. There are external and internal factors that are indicators of impairment. The internal indicators are an idle asset and a decline in asset performance. The external indicators are market values and adverse technological, political, and economic changes.

In the case of Larch’s new item of plant, there is an internal indication that the asset will need impairment since the carrying amount of the asset may be greater than the recoverable amount, given that the sales will decline due to external factors such as competition. In that regard, the company needs to perform the impairment test outlined in IAS36. Therefore, when the fair value less the cost of disposal or value in use is greater than the carrying amount, no impairment test will be conducted. Also, if it is difficult to establish the fair value, the recoverable amount is the value in use (VIU).

Therefore, the following steps show how to impair an asset;

The first step is to calculate the depreciation value of an asset

=£650,000/5=£130,000 per year; in September 2021, it will be two years which will be £260,000

Thus, the carrying cost in September 2021 =£390,000

The next step involves calculating the recoverable amount, which can be calculated using the fair value method or the value in use.

The fair value or market value =£80,000

The value-in-use method indicates the recoverable amount as follows;

The value in use is equal to the discounted cash flow value, which is $378.3

Comparing the value in use with the carrying cost, the value in use is smaller than that of £13700. Using the fair value, it is less than the carrying cost of £310,000. Therefore, there is a need to impair the asset as its value is less than the carrying cost.

The impairment amount should be expensed in the profit and loss account, and the recoverable asset amount should be recorded in the balance sheet.

Transaction four

IAS 2 provides the business with a method to measure its inventories. This is critical as it gives the business ample time to measure and value the inventories across the business to make decisions. The standard indicates that the inventories are measured at their lower cost value or net realisable value. Also, IAS 2 outlines how businesses should assign a cost to the inventories. In the case of Larch, the company can assign the cost within the scope of IAS 2 using the First in, first out (FIFO), last in, first out (LIFO), and weighted average cost.

According to IAS2, the cost of the inventories should consider the following: purchasing price, the costs of conversations, storage, and transportation costs. Therefore, based on this information, the cost of each of the inventory based on each region can be given as follows;

Inventory cost = purchasing cost + transaction cost + transport cost)

1)North America + (50,000-(600+1100)) =£48300

2)Europe = (60,000-(400+800) =£58500

3) Asia = (45000-(500+100)) =£43500

The company plans to value each carne based on the Europe market price, which in this context is the highest. Thus, by IAS 2, the fair value of the inventory should be 120 cranes multiplied by £58500, which is £7,056,000

Transaction five

Signing up for the services means customers subscribed to the company services. Therefore, this is a subscription revenue. Before, the Subscription revenue was under IAS 18, which previously provided guidance on how to measure and account for the sale of goods and services rendered. IFRS15 superseded the IAS 18 because it provides more detailed information on how the accounting information prepares should account for and disclose the subscription revenue arising from customer contracts (International Accounting Standards Board, 2018). IFRS 15 core principle is that the entity should recognise the revenue that represents the amount under consideration between the customers and the entity (International Accounting Standards Board, 2018).

The revenue recognition of contracts and subscription under the IFRS 15 can be accounted for using five steps framework. First, the entity should identify the contract with the customer. In the case of the Larchs, the contract has already been established to supply the software’s services for three years, including free hardware for customers who sign up for the software services for three years. The second step is identifying the performance obligation (International Accounting Standards Board, 2018). This involves the role each party will play in the contract execution. The customer, in this case, will sign up, and the company will provide the services for three years under the contract. The third step involves determining the price of the transaction. In this case, the price has already been established whereby the company will charge £36000 for three, including free hardware. The fourth step is to allocate the transaction price to the performance of the contract, which has been accomplished in this case. Lastly, it is to recognise the revenue within the scope of IFRS15(International Accounting Standards Board, 2018).

On 1 April 2021, the Larch received a total of £36000 for software services for three years. Also, the customers were given a gift of £4000 worth of hardware.

Since the revenue is for three years, the entity should recognise the revenue of (£36000/3) each year which is £12000 per financial year. However, the company needs to recognise the hardware gift of £4000 as an expense in its profit and loss account. This means the company will only recognise the software services as revenue of £12000 each year and record the remaining balance as the contractual liability for the remaining two years since the customers have not yet received the services. However, the company has received the money already.

Transaction six

IAS 19 outlines how employees should account for all the employees’ benefits. The principle of this standard is that the employees’ benefits should be accounted for when the benefits are the cost earned and not when it is paid or received (International Accounting Standards Board, 2011).

IAS 19 paragraph 63 requires the entity to recognise the defined benefits assets and the liability of employees in its financial statement (International Accounting Standards Board,2011). Thus, when it comes to measuring the defined benefit plan, it is the lower of the surplus. In that account, when the entity determines the net deficit or surplus of the defined benefit, the fair value is deducted from the net present value.

Thus, the defined benefit surplus /deficit as at

1 October 2020

Fair value =£7.0

Present value =£8.0

Defined benefit =8-7= £1 million deficit fund

On 30 September 2021

Fair value =£7.5

Present value =£8.2

Defined benefit =8.2-7.5= £0.7 million deficit fund

IAS19 outlines that the defined measurement should be conducted using the actuary’s assumption and calculation. In that regard, the cost of service, the contribution, and benefits during the period were as follows;

year ended 30 September 2021

cost of service =£0.6

employee’s contribution=£0.8

employees’ benefits =£0.5

actual return (7.5-7.0+0.8-0.5) =£1.8

actuarial gain/loss= (8.2-8-0.6+0.8-0.5-5.5) = £0.1(loss)

Thus, based on the actuarial analysis, the company will still lose $0.1 million in the end, to be recorded in the comprehensive income statement of the company. However, the actual benefit is £1.8 million. The larch deficit has reduced from one million in 2020 to 0.7 in 2021. The interest cost in September 2021 was £0.8(10%*8.0), which should be recorded in the income statement.

Transaction seven

The 12-year lease is an example of an operating lease; thus, it is a form of a legal contract between the lessor and the lessee (Larch). Since the company established that the transaction is by the IFRS 15 contracts with customers, it means that in each year the company recorded rental expense for each year as an expense and the present value of the lease payment as the contract liability in the balance sheet (International Accounting Standards Board, 2018). in that regard, the lease impacts the balance sheet; the present value of the lease is recorded as the long-term liability. Also, the lease transaction impacts the income statement where £0. 8 million has been recorded as an expense. This is correct, as the IFRS 15 outlines that the revenue or expense should be recognised when earned and not when paid. Thus, the company should record the expense in the income statement for 12 years each year. The present value should be indicated as a liability in the statement of financial position since it is an obligation the company will pay in the future. Once the payment has been made, the same would reduce the liability and increase the expense of the income (International Accounting Standards Board, 2018). The recording of the £0.6 is also correct as it is the difference between the fair value and carrying amount, and it was recorded in the period of sale as it is with the case of customer contracts.

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