Topic 3 Conceptual Framework

6-1Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Topic 3 Conceptual Framework

Normative theories of accounting—the case of conceptual framework projects


Learning objectives

• In this chapter you will be introduced to:– the role that conceptual frameworks (CFs) can play in the

practice of financial reporting– the history of the development of the various existing

conceptual framework projects– the various building blocks that have been developed

within various conceptual framework projects


Learning objectives (cont.)

– perceived advantages and disadvantages that arise from the establishment and development of conceptual frameworks

– recent initiatives being undertaken by the IASB and the FASB to develop an improved conceptual framework

– factors, including political factors, that might help or hinder the development of conceptual framework projects

– groups within society which are likely to benefit from the establishment and development of conceptual framework projects


What is a conceptual framework?

• ‘A coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards’ (Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises 1978)

• Attempts to provide a structured theory of accounting


Conceptual frameworks as normative theories

• Conceptual frameworks:

‘Prescribe the nature, function and limits of financial accounting and reporting’ (Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises, 1978)

• Therefore, they are considered to be a normative theory of accounting


A revised conceptual framework

• in recent years the FASB and IASB have been jointly working towards the development of an improved conceptual framework

• in 2008 they released a document entitled: Exposure Draft of an improved Conceptual Framework for Financial Reporting


Rationale for conceptual frameworks

• To develop the practice of financial reporting logically and consistently we need to address such issues as– the ‘objective’ of financial reporting– qualitative characteristics financial information should

possess– what are the elements of financial reporting– what measurement rule should be employed

• Proponents argue that without agreement on these issues accounting standards will be developed in an ad hoc manner

• Limited consistency between accounting standards in the absence of a conceptual framework


The ‘building blocks’ of the conceptual framework

• The framework must be developed in a particular order– One obvious issue that needs early agreement would be

what is meant by ‘financial reporting’. – Other issues that would also need agreement early in the

process would be: Definition of a reporting entity Definition of the users of financial statements The objective of financial reporting

• Because the rest of the framework flows from assumptions about the ’objective’, if we reject the assumption, then we personally might be prepared to reject the prescriptions provided by the framework

• Refer to Figure 6.1 (p. 213)


Development of a CF in the UK

• Early moves towards guidance relating to objectives and identification of users provided by The Corporate Report (1976)

• 1991: ASB adopted the IASC’s CF• IASC framework was generally consistent with the

US and Australian frameworks—subsequently became known as the IASB Framework


Development of a CF in Australia

• Degree of progression was slow, only four Statements of Accounting Concepts (SACs) were released– SAC 1: Definition of the Reporting Entity– SAC 2: Objectives of General Purpose Financial

Reporting– SAC 3: Qualitative Characteristics of Financial

Information– SAC 4: Definition and Recognition of the Elements of

Financial Statements


Development of a CF in Australia (cont.)

• 2005: Australia adopted the IASB Framework as a result of the decision by the Financial Reporting Council that Australia would adopt IAS/IFRS by 2005

• SAC 3 and SAC 4 were abandoned• SAC 1 and SAC 2 were retained until such time

that a revised IASB Framework was developed


Current efforts of the IASB and the FASB

• From 2005 the IASB and the FASB have been jointly working towards the development of a revised conceptual framework that will be used by both parties

• The need for this revised framework has arisen because of the ‘convergence project’ in which the IASB and the FASB are working together to converge their two sets of accounting standards

• Will take several years to complete• The IASB and FASB are undertaking the work on the conceptual

framework in eight phases, these being:– Objectives and qualitative characteristics – Definitions of elements – recognition and de-recognition – Measurement – Reporting entity concept – Boundaries of financial reporting, and presentation and disclosure


Building blocks of the CF

• Building blocks of the various CFs have addressed– definition of the reporting entity

– objectives of general purpose financial reporting (GPFR)

– perceived users of GPFRs

– qualitative characteristics that GPFRs should possess

– elements of financial statements

– possible approaches to measuring the elements


Definition of the reporting entity

• The Conceptual Framework provides a definition of entities required to produce GPFRs– known as reporting entities


General purpose financial reports

• GPFRs are defined as reports– ‘… intended to meet the information needs common to

users who are unable to command the preparation of reports tailored so as to satisfy, specifically, all of their information needs’ (SAC 1, para. 6)

• GPFRs are reports that comply with accounting standards and other generally accepted accounting practices (GAAPs)


Entities required to produce GPFRs

• Not all entities are classed as reporting entities• SAC 1 states that GPFRs should be prepared

when there are users– ‘… whose information needs have common elements,

and those users cannot command the preparation of information to satisfy their individual information needs’ (para. 8)


Factors indicative of a reporting entity (SAC 1)

• Separation of management from those with an economic interest in the entity

• The economic or political importance/influence of the entity to/on other parties

• The financial characteristics of the entity


Objective of GPFRs embraced within CFs

• Objective of GPFRs in SAC 2 is deemed to be– to provide information to users that is useful for making

and evaluating decisions about the allocation of scarce resources

• Objective of decision usefulness calls into question usefulness of historical cost information


Other objectives of GPFRs

• Another objective is to enable reporting entities to demonstrate accountability between the entity and those parties to which the entity is deemed accountable

• Accountability is not generally embraced by CFs


Current thinking of the IASB and FASB

• In the 2008 conceptual framework exposure draft it is stated:– The objective of general purpose financial reporting is to provide

financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers. Information that is decision-useful to capital providers may also be useful to other users of financial reporting who are not capital providers.

• If we reject the assumptions about the objective of general purpose financial reporting then we would be inclined to reject the prescriptions made despite how logical the framework may appear

• Is this objective (above) too restrictive?


Users of financial reports

• SAC 2 identifies three primary user groups for GPFRs– resource providers

employees, lenders, creditors, suppliers, investors and contributors

– recipients of goods and services customers and beneficiaries

– parties performing review or oversight function parliaments, governments, regulatory agencies, analysts,

labour unions, employer groups, media and special interest groups


International perspectives on users of

GPFRs

• The IASB Framework – identifies GPFRs users as investors, employees, lenders,

suppliers, customers, govt. agencies and the public– states that information designed to meet the needs of

investors will usually meet the needs of the other groups

• US: SFAC 1– main focus is present and potential investors and other

users with either a direct financial interest or related to those with a direct financial interest

• UK: The Corporate Report– all groups impacted by an organisation’s operations have

rights to information about the reporting entity, not necessarily related to resource allocation decisions


Level of expertise expected of financial report readers

• Generally accepted that readers are expected to have some proficiency in financial accounting

• IASB Framework (para. 25)– ‘… users are assumed to have a reasonable knowledge

of business and economic activities and accounting and a willingness to study the information with reasonable diligence’


Qualitative characteristics of financial reports

• To ensure financial information is useful for economic decision making, we need to consider the attributes or qualities that financial information should have

• According to IASB Framework– primary qualitative characteristics are understandability,

relevance, reliability and comparability– related to relevance is materiality– IASB Framework appears to give greater prominence to

relevance and reliability– there are issues associated with the ‘trade-off’ between

relevance and reliability


Reliability

• Information is considered to be reliable if it ‘faithfully represents’ the entity’s transactions and events

• Should be free from bias and undue error• Reliability is a function of representational

faithfulness, verifiability and neutrality


Reliability—implications for traditional accounting

• Traditionally, the doctrine of conservatism and the acceptance of ‘prudence’ has been adopted– bias towards understating asset values and overstating

liabilities

• This doctrine is not consistent with notions of reliability or freedom from bias


Relevance

• Something is relevant if it influences decisions on the allocation of scarce resources– if it is capable of making a difference in a decision

• For information to be relevant it should have – predictive value, and– feedback value


Materiality

• A limiting factor on the disclosure of relevant and reliable material is the notion of materiality

• An item is material if (IASB Framework, para. 30)– ‘... its omission or misstatement could influence the

economic decisions of users taken on the basis of the financial statements’


Uniformity and consistency

• Uniformity and consistency imply advantages in restricting the number of accounting methods that can be used by reporting entities– has been argued that firms adopt particular accounting

methods because they best reflect their underlying performance

– restricting available methods imposes costs on reporting entities


Costs vs benefits

• Need to consider whether the cost of providing certain information exceeds the benefits to be derived from its provision

• Measuring potential costs and benefits involves professional judgement


Latest thinking of the IASB and the FASB regarding qualitative characteristics

• In the 2008 exposure draft released as part of the conceptual framework project it is stated:– For financial information to be useful, it must possess two

fundamental qualitative characteristics—relevance and faithful representation.

• the draft conceptual framework has reduced the four 'primary qualitative characteristics' to two 'fundamental qualitative characteristics'

• the qualitative characteristic of reliability was replaced by ‘faithfully representation’

• understandability and comparability have been renamed as ‘enhancing qualitative characteristics’

• Two additional 'enhancing qualitative characteristics' have also been included being verifiability and timeliness


Can GPFRs provide unbiased accounts of performance?

• The practice of accounting is heavily reliant on professional judgement

• Prior to accounting standards being released, standard setters attempt to determine the economic consequences of following the standards– if consider economic consequences then standards

cannot be considered objective or neutral


The elements of financial reporting

• The next building block considers the definition and recognition criteria of the elements of financial reporting

• Definition criteria—what attributes are required before an item can be considered as belonging to a particular class of element

• Recognition criteria—employed to determine whether the item can be included in the financial statements


Five elements of financial reporting in the IASB Framework

• Assets• Liabilities• Equity• Expenses• Income

– in the IASB Framework, income is further subdivided into revenues and gains

– ten elements identified in the US by FASB


Definition of assets

• ‘… a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’ (IASB Framework, para. 49(a))

• Three key characteristics– expected future economic benefit– the reporting entity must control the future economic

benefit– the transaction or other past event must have occurred


Definition of assets (cont.)

• The definition refers to the benefit and not its source– in the absence of future economic benefits, the object or

right will not qualify as an asset

• The benefits can result from ongoing use, not necessarily a value in exchange


The characteristic of control

• Control relates to the capacity to benefit from the asset and to deny or regulate others’ access to the benefit

• Legal enforceability is not a prerequisite for establishing the existence of control


Recognition of assets

• An asset—and all the other elements of accounting—shall be recognised when– it is probable that any future economic benefit associated

with the item will flow to or from the entity, and– the item has a cost or value that can be measured with

reliability (IASB Framework, para. 83)

• Probable is generally considered to mean ‘more likely rather than less likely’


Current thinking about assets

• The IASB and FASB developed the following draft definition:– An asset of an entity is a present economic resource to

which, through an enforceable right or other means, the entity has access or can limit the access of others

• This definition also seems to have limitations• Some of the above terms seem rather ambiguous


Definition of liabilities

• A liability is presently defined as – ‘… a present obligation of the entity arising from past

events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’ (IASB Framework, para. 49(b))

– present obligations not only refers to legally enforceable obligations but also those imposed by notions of equity and fairness, or by custom or other business practices


Recognition of liabilities

• Recognition criteria consistent with those of assets and the other elements of accounting

• A liability shall be recognised when– it is probable that the sacrifice of economic benefits will

be required, and– the amount of the liability can be measured reliably

• Has implications for disclosure of various provisions


Present thinking of the IASB and FASB in relation to liabilities

• The IASB and FASB proposed the following draft definition of a liability:– A liability of an entity is a present economic obligation

that is enforceable against the entity.

• as with the proposed definition of assets, the suggested change in the liability definition could potentially have significant implications for financial reporting. For example:– the above definition could act to exclude constructive or

equitable obligations that are not enforceable against the entity. This would be a major departure from existing practice.

– Would this be a good change?


Approaches to determining profit

• Two common approaches to determining profits– asset/liability approach links profit to changes in assets

and liabilities– revenue/expense approach relies on concepts such as

the matching principle

• The definition of expenses and revenues in the CF based on asset/liability perspective


Definition of expenses

• ‘… decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants’ (IASB Framework, para. 70(b))


Recognition of expenses

• An expense shall be recognised when– it is probable that the consumption or loss of future

economic benefits resulting in a reduction in assets and/or an increase in liabilities has occurred, and

– the consumption or loss of economic benefits can be measured reliably


Definition of income

• ‘… increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants’ (SAC 4, para. 70(a))


Definition of income (cont.)

• Income can be recognised from normal trading relations, as well as from non-reciprocal transfers such as grants, donations, bequests or where liabilities are forgiven

• IASB Framework further subdivides income into revenues and gains– revenue arises in the course of the ordinary activities of

an entity– gains represent other items that meet the definition of

income and may, or may not, arise in the ordinary activities of an enterprise

– not clear why there is a need to break income into two components


Recognition of income

• As with the other elements of accounting, income is recognised when– it is probable that the inflow or other enhancement or

saving in outflows of future economic benefits has occurred, and

– the inflow or other enhancement or saving in outflows of future economic benefits can be measured reliably


Definition of equity

• Equity is defined as ‘the residual interest in the assets of the entity after deducting all of its liabilities’ (IASB Framework, para. 49(c))

• As a residual interest it ranks after liabilities in terms of claims against the assets

• Definition is a direct function of the definitions of assets and liabilities


Current IASB and FASB work on measurement issues

• In 2005 the IASB and FASB stated:– Both frameworks indicate that use of different

measurement attributes is expected to continue. However, neither provides guidance on how to choose between the listed measurement attributes or consider other theoretical possibilities. In other words, the frameworks lack fully developed measurement concepts.

• Phase C of the joint IASB and FASB Conceptual Framework Project is to address measurement issues. In this work the IASB and FASB have identified nine potential measurement bases, these being: past entry price, past exit price, modified past amount, current entry price, current exit price, current equilibrium price, value in use, future entry price, and future exit price.


Benefits associated with conceptual frameworks

• Accounting standards should be more consistent and logical

• Increased international compatibility of accounting standards

• Standard-setters should be more accountable for their decisions

• Communication between standard-setters and their constituents should be enhanced

• Emphasise the ‘decision usefulness’ role of financial reports rather than restricting concern to stewardship


CFs as a means of legitimising standard-setting bodies

• Some (e.g. Hines and Solomons) have suggested that CFs have been used as devices to help ensure the ongoing existence of the accounting profession

• Increase the ability of the profession to self-regulate, thus counteracting government intervention


Tutorial Activities

• Case study: Central Uni• Tutorial questions: FAT: 6.4, 6.5, 6.11, 6.16

Documents

Topic 3 Conceptual Framework