Lecture 2 The Conceptual Framework in

Financial Accounting

Contemporary Issues In Financial Accounting

Objectives

To explain what a conceptual framework of financial accounting is

To discuss the accounting principles set out in the accounting framework

To explain the benefits and criticisms of the conceptual framework in accounting

To comment critically on rule-based and principles-based approaches

What an accounting conceptual framework is An accounting conceptual is a set of guiding principles

used to plan and decide financial accounting standards. Those guidelines/principles are designed to provide

guidance and help make decisions relating to the financial accounting treatments.

Those guidelines/principles can be used as a basis for forming the accounting standards and interpretations used for financial reporting.

A conceptual framework differs from an accounting standard. Accounting standards state specific requirements for a particular area of financial reporting.

History and evolution of the conceptual framework From 1920s and 1930s, there were attempts to draft

statements of principles to guide accounting in response to reporting failure. Principles suggested in this period focused on the area of accounting measurement.– In 1936, the American Accounting Association issued a

Statement of accounting principles.– In 1959, a set of basic principles for accounting standards

was established by the American Institute of Certified Public Accountants.

– In 1962, A tentative set of broad accounting principles of business enterprises published by Sprouse and Moonitz.

History and evolution of the conceptual framework The development of more comprehensive and

formal conceptual frameworks begins in the 1970s in response to corporate failure the 1960s.– The Financial Accounting Standards Board (FASB)

established 6 concept statements between 1978 and 1989 in the US.

– During this period the UK, Canada and Australia were also developing their own conceptual frameworks.

– The Framework for the preparation and presentation of financial statement issued by the IASC (now IASB) is developed directly from those previous conceptual framework projects.

IASC Framework for the Presentation and Preparation of Financial Statements

Overview of the IASC Framework – Questions that the Framework answers:

1. What statements are we considering?– General purpose financial statements.

• The financial reports aims to meet the information needs common to users

• Not for particular users. (Some lenders, taxation authorities and management may require specific reports for special purposes.)

• The Framework is aimed at financial statements prepared by commercial, industrial and business reporting enterprises.

Overview of the IASC Framework – Questions that the Framework answers:

2. Who are the financial statements for?– There is a very wide range of users.

• Investors• Employees• Lenders• Suppliers and trade creditors• Customers• Governments and their agencies• The public

Overview of the IASC Framework – Questions that the Framework answers:

3. What is the purpose of financial statement? Stewardship or accountability

=>managers are required to report to the providers of the resources in order to explain how well they have managed the companies.

Decision usefulness=>the financial statements should provide information

about the financial position, performance, generation and use of cash, and financial adaptability of an enterprise that is useful to users in making decisions.

Overview of the IASC Framework – Questions that the Framework answers:

4. What are the assumptions to be made when preparing financial statements?

The accrual basis. ‘The effects of transactions and other events are recognised when

they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate’ (para. 23).

The going concern basis. ‘The financial statements are normally prepared on the assumption

that an entity is a going concern and will continue in operation for the foreseeable future’ (para. 23).

Overview of the IASC Framework – Questions that the Framework answers:

5. What type of information should be included? Ans: Useful information But what makes financial information useful????Þ Four main elements (qualitative characteristics)

Information Content Relevance Reliability

Information Presentation Comparability Understandability

Additionally, information need to be material.

5. What type of information should be included?

Relevance: This characteristic ensures that the information included in the financial statement has the ability to influence the economic decisions of users. It must have:– predictive value, i.e. help users to evaluate past and

present event, or predict future event.– confirmatory value, i.e. help users to confirm or correct

their past evaluation.

5. What type of information should be included?

Reliability: This characteristic ensures that users have confidence in the information stated in the financial statements/reports. Five components affect the reliability of accounting information:– Faithful representation: this requires making sure that

ensure that what is shown in the financial statement corresponds to the actual events and transactions that are being represented.

– Free from material error: transactions have been accurately recorded and reported.

– Substance over form: this requires item to be accounted for and presented in accordance with their substance and economic reality and not merely their legal form.

5. What type of information should be included?

– Neutrality: this aims to ensure that there is no attempt to promote and particular view; the financial statements provide an impartial description of the events and transactions.

– Prudence: The inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.

– Completeness: Users require all relevant information to be included in the financial statements, if there are to be useful for decision making.

5. What type of information should be included?

Comparability: The accounting information needs to be comparable over time and between companies. Therefore, the similarities and differences can be determined and evaluated. Comparability would be achieved with:– Consistent measurement– Disclosure of accounting policy used in preparing

financial statements.

5. What type of information should be included?

Understandability: – Users’ abilities: the information is capable of being

understood by a user with a reasonable knowledge of business activities and accounting.

– Aggregation and classification

5. What type of information should be included?

Threshold quality - Materiality: no information can be useful if it is not material. ‘An item of information is material to the financial statements if its misstatement or omission might reasonably be expected to influence the economic decisions of users of those financial statements, including their assessment of management’s stewardship.’– Materiality depends on the size of the item or error

judged in the particular circumstances of its omission or misstatement.’

– Avoid unnecessary costs on preparers– Impede decision makers by obscuring material

information with excessive detail

5. What type of information should be included? Unresolved trade-offs and relative importance between

qualitative characteristics: In practice, the accounting information provided may not always

be possible meet all of these qualitative characteristics. Therefore, there will often be a need to ‘trade off’ to determine which should be given more importance. For example,– Historic cost => more reliable, less relevant. Present or fair value => more relevant, less reliable– Disclosing details to improve relevance may reduce

understandability. Therefore, the Framework proposes that when the conflict

occurs, the qualitative characteristics of relevance and reliability should override understandability and comparability (In theory, it is still an unresolved question).

Constraints on information

Two constraints may limit the ability to provide information that is relevant and reliable.– Timeliness: Accounting information needs to be

provided on a timely basis. Delaying the issue of the financial statements is likelihood to reduce its usefulness to users.

– Benefits versus costs: The benefits to users from better decisions should outweigh the costs in preparing the statements.

The element of financial statements

The Frameworks give guidance on the items that could appear in financial statements and provides definition for the essential elements of the financial statements:– Assets: a resource controlled by the enterprise as a result of past

events and from which future economic benefits are expected to flow to the entity.

– Liabilities: a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits

– Equity: the residual interest in the assets of the enterprise after deducting all its liabilities.

The element of financial statements

The definitions of the elements relating to financial performance are:– Income: is increases in economic benefits during the accounting

period in the form of inflows or enhancements of assets or decreases of liabilities that result in increase in equity, other than those relating to contributions from equity participants

– Expenses: are 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.

*The definitions of those elements do not refer to legal form but to economic benefits. This reflects the substance over form approach required by the Framework.

Recognition criteria

Recognition is the process of recording an item in the balance sheet or income statement. An item should be recognised if it meets two criteria:– Probability: There is always some uncertainty as to when to

recognise an event or transaction. It is necessary to take into account there being some uncertainty about many items in the financial statements. Sufficient evidence to support the existence of the new asset or liability.

– Reliable measurement: the item has a cost or value (monetary amount) that can be measured with reliability. In many cases, the use of estimates in the accounting information does not mean that a measure is unreliable.

Items that do not meet both of recognition criteria cannot be recognised, although information may be disclosed in notes to the statements where this is useful to users.

Rules-based versus principles-based standards• The characteristics of the rules-based and principles-based

standardsRules-based Standards Principles-based Standards

Standards that contain specific details and mandatory definitions that attempt to meet as many potential contingencies and situations as possible.

Standards that contain a substantive accounting principle that focuses on achieving the accounting objective of the standard.

The principle is based on the objective of accounting in the conceptual framework.

Very prescriptive Much more broad and flexible

FASB IASB

Rules-based versus principles-based standards

Advantages and disadvantages of rules-based standards:• Advantage:

– Consistent on adopting accounting treatment for the same commercial activity.

– Financial statements are more comparable.

• Disadvantage:– Can be very complex => allow confusion and even manipulation.– Detailed rules => Companies are able to structure their

transaction in order to circumvent unfavourable reporting mask unfavourable financial position.

– Detailed standards are likely to be incomplete or out of date.– Manipulated compliance with rules makes auditing more difficult.

Rules-based versus principles-based standards

Advantages and disadvantages of principles-based standards:• Advantage:

– Simpler than rules-based standards.– Supply broad guidelines => can be applied to many

situations.– Broad guidelines may improve the representational

faithfulness of financial statement.– Allow accountants to use professional judgement in

assessing the substance of a transaction.– Evidence shows that managers (auditors) are less likely

to attempt (permit) earnings management when faced with principles-based standards.

Rules-based versus principles-based standards

Advantages and disadvantages of principles-based standards:• Disadvantage: The incentive, ability and judgment of managers, audit committee

members and auditors may affect the quality of the accounting statements.– Managers are able to select treatments both that reflect the

underlying economic substance of a transaction and that do not.– Rely on the incentive and ability of managers, audit committee

members and auditors: managers, audit committee and auditors must have the desire for unbiased reporting and expertise to achieve treatments that reflect the underlying economic substance.

– The judgement and choice of the treatment may reduce comparability.

Seminar 1 Discussion Questions

Please explain the purpose and possible advantages of a conceptual framework and also discuss the potential problems with and criticisms of the conceptual framework in financial accounting.

(Please bring your answers to this discussion to the seminar.)

Readings

E&E Ch7 (13ed) or CH6 (14ed)Drever, Stanton and McGowan (2007):

Contemporary Issues in Accounting. Ch2Lewis and Pendrill (2004): Advanced Financial

Accounting, 7th ed. Ch1.