Contemporary Issues In Financial Ac

counting

Lecture 2
The Conceptual Framework in
Financial Accounting
 Objectives
 To explain what a conceptual framework of fin
ancial accounting is
 To discuss the accounting principles set out in
the accounting framework
 To explain the benefits and criticisms of the co
nceptual framework in accounting
 To comment critically on rule-based and princi
ples-based approaches
What an accounting conceptual framew
ork is
 An accounting conceptual is a set of guiding principles u
sed to plan and decide financial accounting standards.
 Those guidelines/principles are designed to provide guid
ance and help make decisions relating to the financial ac
counting treatments.
 Those guidelines/principles can be used as a basis for for
ming the accounting standards and interpretations used
for financial reporting.
 A conceptual framework differs from an accounting stan
dard. Accounting standards state specific requirements f
or a particular area of financial reporting.
History and evolution of the conceptual fra
mework
 From 1920s and 1930s, there were attempts to draft s
tatements of principles to guide accounting in respons
e to reporting failure. Principles suggested in this peri
od focused on the area of accounting measurement.
– In 1936, the American Accounting Association issued a Stat
ement of accounting principles.
– In 1959, a set of basic principles for accounting standards w
as established by the American Institute of Certified Public
Accountants.
– In 1962, A tentative set of broad accounting principles of bu
siness enterprises published by Sprouse and Moonitz.
History and evolution of the conceptual fra
mework
 The development of more comprehensive and formal
conceptual frameworks begins in the 1970s in respons
e to corporate failure the 1960s.
– The Financial Accounting Standards Board (FASB) establishe
d 6 concept statements between 1978 and 1989 in the US.
– During this period the UK, Canada and Australia were also d
eveloping their own conceptual frameworks.
– The Framework for the preparation and presentation of fi
nancial statement issued by the IASC (now IASB) is develop
ed directly from those previous conceptual framework proj
ects.
 IASC Framework for the Presentation and Prep
aration of Financial Statements
Overview of the IASC Framework – Questions that the Frame
work answers:
1. What statements are we considering?
– General purpose financial statements.
• The financial reports aims to meet the information needs com
mon to users
• Not for particular users. (Some lenders, taxation authorities a
nd management may require specific reports for special purpo
ses.)
• The Framework is aimed at financial statements prepared by c
ommercial, industrial and business reporting enterprises.
 Overview of the IASC Framework – Questions that the F
ramework 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 F
ramework 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 manage
d the companies.
 Decision usefulness

=>the financial statements should provide information abo

ut the financial position, performance, generation and us
e of cash, and financial adaptability of an enterprise that
is useful to users in making decisions.
 Overview of the IASC Framework – Questions that the Framew
ork answers:
4. What are the assumptions to be made when preparing fina
ncial 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) a
nd they are recorded in the accounting records and reported in th
e financial statements of the periods to which they relate’ (para. 2
3).
 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 Framew
ork 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 influen
ce the economic decisions of users. It must have:
– predictive value, i.e. help users to evaluate past and pres
ent event, or predict future event.
– confirmatory value, i.e. help users to confirm or correct t
heir past evaluation.
5. What type of information should be included?
 Reliability: This characteristic ensures that users have confi
dence in the information stated in the financial statements/
reports. Five components affect the reliability of accountin
g information:
– Faithful representation: this requires making sure that e
nsure that what is shown in the financial statement corre
sponds to the actual events and transactions that are bei
ng represented.
– Free from material error: transactions have been accura
tely recorded and reported.
– Substance over form: this requires item to be accounted
for and presented in accordance with their substance an
d 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 t
o promote and particular view; the financial statements
provide an impartial description of the events and transa
ctions.
– Prudence: The inclusion of a degree of caution in the exe
rcise of the judgements needed in making the estimates
required under conditions of uncertainty, such that asset
s 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 co

mparable over time and between companies. Therefore, th
e similarities and differences can be determined and evalua
ted. Comparability would be achieved with:
– Consistent measurement
– Disclosure of accounting policy used in preparing financi
al statements.
5. What type of information should be included?

 Understandability:
– Users’ abilities: the information is capable of being under
stood 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 usef

ul if it is not material. ‘An item of information is material to
the financial statements if its misstatement or omission mig
ht reasonably be expected to influence the economic decisi
ons of users of those financial statements, including their as
sessment of management’s stewardship.’
– Materiality depends on the size of the item or error judg
ed in the particular circumstances of its omission or miss
tatement.’
– Avoid unnecessary costs on preparers
– Impede decision makers by obscuring material informati
on with excessive detail
5. What type of information should be included?
 Unresolved trade-offs and relative importance between qualita
tive characteristics:
In practice, the accounting information provided may not alway
s be possible meet all of these qualitative characteristics. There
fore, there will often be a need to ‘trade off’ to determine whic
h 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 understandab
ility.
Therefore, the Framework proposes that when the conflict occ
urs, the qualitative characteristics of relevance and reliability sh
ould override understandability and comparability (In theory, it
is still an unresolved question).
Constraints on information

Two constraints may limit the ability to provide i

nformation that is relevant and reliable.
– Timeliness: Accounting information needs to be p
rovided on a timely basis. Delaying the issue of th
e financial statements is likelihood to reduce its us
efulness to users.
– Benefits versus costs: The benefits to users from b
etter decisions should outweigh the costs in prepa
ring the statements.
 The element of financial statements

The Frameworks give guidance on the items that could appe

ar in financial statements and provides definition for the esse
ntial elements of the financial statements:
– Assets: a resource controlled by the enterprise as a result of past e
vents and from which future economic benefits are expected to flo
w 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 de
ducting all its liabilities.
 The element of financial statements
The definitions of the elements relating to financial perf
ormance are:
– Income: is increases in economic benefits during the accounti
ng period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increase in equity, other t
han those relating to contributions from equity participants
– Expenses: are decreases in economic benefits during the acco
unting period in the form of outflows or depletions of assets o
r incurrences of liabilities that result in decreases in equity, ot
her than those relating to distributions to equity participants.
*The definitions of those elements do not refer to legal f
orm but to economic benefits. This reflects the substanc
e over form approach required by the Framework.
 Recognition criteria
Recognition is the process of recording an item in the balance s
heet or income statement. An item should be recognised if it m
eets 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 bein
g some uncertainty about many items in the financial statements. Su
fficient evidence to support the existence of the new asset or liability.
– Reliable measurement: the item has a cost or value (monetary amou
nt) that can be measured with reliability. In many cases, the use of es
timates in the accounting information does not mean that a measure i
s unreliable.
Items that do not meet both of recognition criteria cannot be re
cognised, although information may be disclosed in notes to th
e statements where this is useful to users.
 Rules-based versus principles-based standards
• The characteristics of the rules-based and principles-based
standards
Rules-based Standards Principles-based Standards
 Standards that contain specific  Standards that contain a
details and mandatory definitions substantive accounting principle
that attempt to meet as many that focuses on achieving the
potential contingencies and accounting objective of the
situations as possible. 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 comm
ercial activity.
– Financial statements are more comparable.
• Disadvantage:
– Can be very complex => allow confusion and even manipulation.
– Detailed rules => Companies are able to structure their transactio
n in order to circumvent unfavourable reporting mask unfavourabl
e 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 situa
tions.
– Broad guidelines may improve the representational faith
fulness of financial statement.
– Allow accountants to use professional judgement in asse
ssing the substance of a transaction.
– Evidence shows that managers (auditors) are less likely t
o attempt (permit) earnings management when faced wi
th 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 co
mmittee members and auditors may affect the quality of t
he 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 com
mittee members and auditors: managers, audit committ
ee and auditors must have the desire for unbiased repor
ting 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 adva
ntages of a conceptual framework and also dis
cuss the potential problems with and criticism
s of the conceptual framework in financial acc
ounting.

(Please bring your answers to this discussion t

o the seminar.)
 Readings
 E&E Ch7 (13ed) or CH6 (14ed)
 Drever, Stanton and McGowan (2007): Conte
mporary Issues in Accounting. Ch2
 Lewis and Pendrill (2004): Advanced Financial
Accounting, 7th ed. Ch1.