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Topic 3 Conceptual Framework

Normative theories of accountingthe case


of conceptual framework projects

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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

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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

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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

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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

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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

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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

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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)

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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 IASCs CF
IASC framework was generally consistent with the
US and Australian frameworkssubsequently
became known as the IASB Framework

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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

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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

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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

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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

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Definition of the reporting entity


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

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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)

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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)

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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

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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

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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

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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?

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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

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

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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

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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

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Reliability
Information is considered to be reliable if it
faithfully represents the entitys transactions and
events
Should be free from bias and undue error
Reliability is a function of representational
faithfulness, verifiability and neutrality

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Reliabilityimplications 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

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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

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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

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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

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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

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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 characteristicsrelevance 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

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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

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The elements of financial reporting


The next building block considers the definition
and recognition criteria of the elements of financial
reporting
Definition criteriawhat attributes are required
before an item can be considered as belonging to
a particular class of element
Recognition criteriaemployed to determine
whether the item can be included in the financial
statements

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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

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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

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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

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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

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Recognition of assets
An assetand all the other elements of
accountingshall 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

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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

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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

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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

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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?

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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

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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))

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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

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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))

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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

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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

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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

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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.

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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
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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 selfregulate, thus counteracting government
intervention

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

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