For a financial reporting framework to be effective, the first requirement is that it must be coherent, i.e., all components should work together logically.
Such a framework will have several characteristics:
- Transparent: The framework should increase the transparency of the financial aspects of a business, i.e., the users of the financial statements should be able to get a clear understanding of the underlying economics by reading the financial statements.
- Comprehensive: The framework should be comprehensive, i.e., it should be able to capture all kinds of transactions having financial consequences.
- Consistent: The framework should be able to bring consistency in financial reporting across companies and time periods. This means that all companies in different time periods should measure and present transactions in a similar manner.
Barriers to a Coherent Framework
Even though such a coherent system is possible, there are several barriers that limit a financial reporting standard. Specifically, there are three areas of conflict:
- Valuation: There are several methods for measuring the value of assets an liability, namely, historical cost, current cost, realizable value, and present value. Methods such as historical require little judgement, while others require a good amount of judgement.
- Standard-setting approach: For setting there standards there are three approaches: Principles-based, Rules-based, and Objectives-oriented. Each approach follows a different philosophy. The principles-based approach follows a broad framework, for example, IFRS. A rules-based approach provides specific rules for classifying transactions, for example, the US GAAP. The objectives-oriented approach blends the two approaches. FASB’s US GAAP is moving towards the objectives-oriented approach.
- Measurement: The balance sheet provides information at one point in time, while the income statement reflect the changes in financial performance during the period. There is a conflict in these two and a financial reporting standard will tend to be biased towards one. An asset/liability approach will focus more on balance sheet while the revenue/expense approach will focus more on income statement.