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A conceptual
framework for
financial
accounting and
reporting
Conceptual framework
A conceptual framework is a formal
set of interrelated concepts
specifying the function, scope and
purpose of financial accounting and
reporting
In Australia, the SACs represent the
conceptual framework or constitution
for financial reporting
The Committee on
Accounting Procedure (CAP)
The first standard-setting body, which
was established by the American
Institute of Accountants in 1936
The CAP published bulletins that
provided authoritative opinions or
recommendations on preferred
accounting practices
The CAP, however, failed to provide a
conceptual framework
Objectives according to
APB Statement No. 4
Paul Grady was commissioned by the APB
in 1963 to develop a more descriptive
framework, which was reflected in the
objectives of APB Statement No. 4:
1. Particular objectives of financial
statements are to present fairly, and in
conformity with GAAP, financial position,
results of operations and other changes in
financial position
Objectives according to
APB Statement No. 4 (contd)
2. The general objectives are:
a. to provide reliable information about the
economic resources and obligations of a
business enterprise in order to:
i. evaluate its strengths and
weaknesses
ii. show its financing and investments
iii. evaluate its ability to meet its
commitments
iv. show its resource base for growth
Objectives according to
APB Statement No. 4 (contd)
b. to provide reliable information about
changes in net resources resulting from
a business enterprises profit-directed
activities in order to:
i. show expected dividend return to
investors
ii. demonstrate the operations ability to
pay creditors and suppliers, provide
jobs for employees, pay taxes and
generate funds for expansion
iii. provide management with information
for planning and control
Objectives according to
APB Statement No. 4 (contd)
c. to provide financial information that
can be used to estimate the
earnings potential of the firm
d. to provide other necessary
information about changes in
economic resources and obligations
e. to disclose other information
relevant to statement users needs
Objectives according to
APB Statement No. 4 (contd)
3. The qualitative objectives of financial
accounting are:
a. relevance
b. understandability
c. verifiability
d. neutrality
e. timeliness
f. comparability
g. completeness
Developments in Australia
The development of a conceptual
framework in Australia followed a
similar pattern to that in the USA
Australia was able to evaluate and
adapt APB and FASB initiatives for
Australian conditions
Exposure drafts
Six exposure drafts were release between 1987
and 1990:
1. ED 42A (objectives of financial reporting)
2. ED 42B (qualitative characteristics of
financial information)
3. ED 42C (definition and recognition of assets)
4. ED 42D (definition and recognition of
liabilities)
5. ED 46A (definition of the reporting entity)
6. ED 51A (definition of equity)
7. ED 51B (definition and recognition of
revenues)
SACs
Three SACs were released in August
1990:
1. SAC 1 Definition of the Reporting
Entity
2. SAC 2 Objectives of General
Purpose Financial Reporting
3. SAC 3 Qualitative Characteristics of
Financial Information
SAC 4
Specifies the definition of and rules for
recognition of assets, liabilities, equity,
revenues and expenses in companies
financial reports
Corporate backlash to SAC 4 resulted in
the mandatory status of SACs being
withdrawn in December 1993
Corporate backlash also resulted in
amendments to SAC 4 being released in
March 1995
FASB definition
A conceptual framework is a constitution, a coherent
system of interrelated objectives and fundamentals
that can lead to consistent standards and that
prescribes the nature, function and limits of financial
accounting and financial statements. The objectives
identify the goals and the purposes of accounting.
The fundamentals are the underlying concepts of
accounting concepts that guide the selection of
events to be accounted for, the measurement of
those events and the means of summarizing and
communicating to interested parties. Concepts of
that type are fundamental in the sense that other
concepts flow from them and repeated references to
them will be necessary in establishing, interpreting
and applying accounting and reporting standards.
Description of a conceptual
framework
A conceptual framework is therefore
intended to act as a constitution for the
standard-setting process
The AARF described the conceptual
framework in similar terms, as:
a set of inter-related concepts which will
define the nature, subject, purpose and
broad content of financial reporting. It
will be an explicit rendition of the
thinking which is governing the decisionmaking of (standard-setters)
Advantages of a conceptual
framework
A conceptual framework is useful in the
development of more consistent and logical
standards and in removing the necessity to
re-debate conceptual issues when preparing
new accounting standards
The issue of standards overload can be
potentially reduced because a conceptual
framework can enable resolution of
particular accounting problems, which avoids
the necessity of issuing new accounting
standards
Advantages of a conceptual
framework (contd)
Can lead to better communication
among accountants, auditors and users
because all parties are using a common
set of definitions and criteria
Has potential to reduce the activities
and influence of lobbies and interest
groups
Conflicts of interest
Financial statements result from the interaction
of three groups:
firms, which by their operational, functional
and extraordinary activities, justify the
production of financial statements
users, which include investors, financial
analysts, bankers, creditors, consumers,
employees, suppliers and government
agencies
the accounting profession, which acts
principally as auditor in charge of verifying
that financial statements conform to generally
accepted accounting principles
Criticisms of the
asset/liability view
It excludes debit and credit items
because they do not constitute economic
benefits or resources to the entity
It is unwilling, therefore, to recognise as
revenues and expenses anything except
current changes in economic resources
and obligations to transfer resources,
making it incapable of dealing with the
complexities of the modern business
world
Criticisms of the
revenue/expense view
It has led to the recognition in the
statement of financial position of such
items as deferred charges, deferred
credits, and reserves, none of which
represent economic resources and
obligations
It places much emphasis on the
importance of the historical cost and
revenue realisation principles
5.
Definitions of liabilities
According to the asset/liability view,
liabilities are the obligations of the firm to
transfer economic resources to other
entities in the future
According to the revenue/expense view,
liabilities comprise not only the liabilities
defined from the asset/liability viewpoint
but also certain deferred credits and
reserves that do not represent obligations
to transfer economic benefits but that are
required for proper matching and income
determination
Definitions of income
According to the asset/liability view,
income is the net assets of the firm except
for capital changes
According to the revenue/expense view,
income results from the matching of
revenues and expenses and, perhaps, from
gains and losses:
gains and losses, therefore, may be
distinguished from the revenues and
expenses, or they may be considered
part of these
Relationships between
income and components of
income
Three major relationships exist between
income and the components of income:
1. Income = Revenues Expenses +
Gains Losses
2. Income = Revenues Expenses
3. Income = Revenues (including gains)
Expenses (including losses)
Accrual accounting
Accrual accounting measures the effects
of transactions having cash
consequences for an entity as they are
incurred, not simply as cash is received
or paid they are recorded in
accounting records, and reported in the
financial statements of the reporting
period to which they relate
Accrual accounting rests on the
concepts of accrual, deferral, allocation,
amortisation, realisation and recognition
FASB definitions
Accrual is the accounting process of
recognizing non-cash events and
circumstances as they occur; specifically,
accrual entails recognizing revenues and
related increases in assets and expenses
and related increases in liabilities for
amounts expected to be received or paid,
usually in cash, in the future ...
Deferral is the accounting process of
recognizing a liability for a current cash
receipt or an asset for a current cash
payment (or current incurrence of a
liability) with an expected future impact on
revenues and expenses ...
Measurement options
The five options for measurement of a
particular attribute are as follows:
1. historical cost method
2. current cost
3. current exit value
4. expected exit value
5. present value of expected cash
flows
Definition of a reporting
entity
SAC 1 defines a reporting entity as:
entities (including economic entities) in
respect of which it is reasonable to
expect the existence of users dependent
on GPFRs for information which will be
useful to them for making and
evaluating decisions about the allocation
of scarce resources
Determination of dependent
external users
SAC 1 provides three general
guidelines to assist in determining the
existence of dependent external users:
1. separation of management from
economic interests
2. economic or political
importance/influence
3. financial characteristics
Qualitative characteristics of
financial information
Primary characteristics
Relevance is defined in SAC 3 to mean that
quality of financial information which exists
when information influences the decisions of
users about the allocation of scarce resources
Reliability is defined as:
that quality of financial information which
exists when the information can be
depended upon to represent faithfully, and
without bias or undue error, the transactions
or events that it either purports to represent
or could reasonably be expected to
represent
Qualitative characteristics of
financial information (contd)
Secondary and interactive qualities
Comparability is defined in SAC 3 as:
that quality of financial information which
exists when users of that information are
able to evaluate similarities in and differences
between, the nature and effects of
transactions and events, at one time and
over time, either when assessing aspects of a
single reporting entity or a number of
reporting entities
Understandability means that quality of financial
information which exists when users of that
information are able to comprehend its meaning
Qualitative characteristics of
financial information (contd)
Constraints on relevance
Timeliness: SAC 3 cautions that information
will lose its relevance if there is a delay in
the reporting of that information
Costs versus benefits: Financial information
will be sought if the benefit to be derived
from the information exceeds its cost
Qualitative characteristics of
financial information (contd)
Materiality
Materiality is defined in SAC 3 as:
the extent to which relevant and reliable
information may be omitted, misstated or
not disclosed separately without having
the potential to adversely affect the
decisions made about the allocation of
scarce resources made by users
SAC 3 emphasises that consideration must
be given to whether or not the information is
likely to have a significant, or material,
impact on decisions
Measurement
SAC 4 does not explicitly deal with how
assets and liabilities should be measured
The AARF now seems aware of the need to
address publicly the critical issue of
measurement in financial statements
In mid-1994, the AARF released a public
Invitation to Comment on a Proposed
Program for the Development of Concepts on
Measurement of the Elements of Financial
Statements
Display of
financial information
This level of the conceptual framework
considers in detail the nature of the
information to be displayed in financial
reports
This involves identifying the appropriate
information groupings (financial
position, performance, investing and
financing, and compliance) and
analysing the components of those
groupings
Corporate backlash
The only aspect of the Australian
conceptual framework to attract significant
corporate concern was SAC 4
Many of the concerns were captured in a
statement from a submission by Caltex Oil
Australia:
(SAC 4) is a laudable aim but I contend
it does not address commercial reality,
or focus on that very important issue of
the credibility of the accounting
profession in Australia
Substantive amendments
to SAC 4
1. Removal of mandatory status and
transitional provisions
2. Removal of an operative date
3. Removal of the detailed Appendix that
provided guidance on the interpretation
and application of SAC 4 concepts to a
number of specific accounting
transactions
Substantive amendments
to SAC 4 (contd)
4. Changes to the commentary sections,
including a tightening up in the
classification of liabilities, greater
discussion on the nature of reciprocal
and non-reciprocal transfers and greater
discussion on when an increase in asset
value would constitute an item of
revenue or an equity adjustment
5. Greater attention given to conventional
accounting principles, such as matching
and periodicity
Development of the US
conceptual framework
In 1971, The American Institute of
Certified Practicing Accountants
formed two study groups:
1. the Wheat Committee, which was a
study group on the establishment of
accounting principles, and which
was charged with the task of
improving the standard-setting
process
Objectives of financial
statements
The Trueblood Report identified six
objective-levels:
1. The basic objective to provide
information on which to base economic
decisions
2. Four objectives that specify the diverse
users and uses of accounting information
3. Two objectives that specify enterprise
earning power and management ability
as the type of information needed
Qualitative characteristics of
reporting
The Trueblood Report mentioned seven
qualitative characteristics of reporting:
1. relevance and materiality
2. form and substance
3. reliability
4. freedom from bias
5. comparability
6. consistency
7. understandability
Additional statements
1. A statement
2. A statement
government
3. A statement
currency
4. A statement
5. A statement
of value added
of money exchange with
of transactions in foreign
of future prospects
of corporate objectives
Objectives of corporate
financial reporting
1.
2.
3.
4.
Conceptual framework
conclusions
In order to be effective, a conceptual framework
must gain general acceptance, represent
collective behaviour, and protect the public
interest in areas in which it is affected by
financial reporting
One prevailing idea is that it is impossible to
develop a set of accounting standards that can
be applied to accounting alternatives in a way
that will satisfy everybody, and that such
standards could be hampered by the level of
abstractness in definition and recognition criteria