Chapter 5

1. Chapter 5 A conceptual framework for financial accounting and reporting

2. 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

3. Conceptual framework (cont’d) • A conceptual framework can be descriptive, prescriptive or a mixture of both: • a descriptive framework attempts to develop a set of interrelated concepts, which serves to codify and explain existing financial reporting practices • a prescriptive framework attempts to develop a conceptual basis for what financial accounting practices should be

4. History of the conceptual framework • The need for a conceptual framework was recognised in the USA after the stock market crash of 1929 • Leaders of the profession recognised the need to: • establish basic principles on which to base company reporting • correct permissive accounting practices of the 1920s • restore public confidence in professional accountants

5. 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

6. Discontent in the 1950s Academic and professional opinion of the mid-1950s stressed the inadequacies of company financial reporting: • The historical cost model, generally accepted in accounting practice at the time, was not being applied consistently, nor were its underlying principles well understood • A tradition was developing among academics that was against the whole principle of historic cost accounting

7. The Accounting Principles Board (APB) • The APB was established in the USA in 1959 to accelerate the development of a conceptual framework • The APB set itself the following tasks: • to establish basic postulates • to formulate a set of broad principles • to establish rules to guide the application of principles in specific situations • to base the entire program on research

8. APB Statement No.4 • This statement was titled ‘Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises’ • Basically descriptive, it did not provide a conceptual framework, but influenced Australian attempts to formulate objectives of financial statements and to develop a conceptual framework

9. 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: • 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

10. Objectives according to APB Statement No. 4 (cont’d) • The general objectives are: • to provide reliable information about the economic resources and obligations of a business enterprise in order to: • evaluate its strengths and weaknesses • show its financing and investments • evaluate its ability to meet its commitments • show its resource base for growth

11. Objectives according to APB Statement No. 4 (cont’d) • to provide reliable information about changes in net resources resulting from a business enterprise’s profit-directed activities in order to: • show expected dividend return to investors • demonstrate the operation’s ability to pay creditors and suppliers, provide jobs for employees, pay taxes and generate funds for expansion • provide management with information for planning and control

12. Objectives according to APB Statement No. 4 (cont’d) • to provide financial information that can be used to estimate the earnings potential of the firm • to provide other necessary information about changes in economic resources and obligations • to disclose other information relevant to statement users’ needs

13. Objectives according to APB Statement No. 4 (cont’d) • The qualitative objectives of financial accounting are: • relevance • understandability • verifiability • neutrality • timeliness • comparability • completeness

14. 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

15. The conceptual framework in Australia • Australian academics such as Mathews and Grant, and Chambers, proposed abandoning the historical cost system in favour of some form of current cost accounting system • In response, the accounting profession commissioned John Kenley, director of the Accountancy Research Foundation (later the AARF) to adapt Paul Grady’s AICPA studies to Australian conditions • A largely prescriptive approach was adopted, which has been very influential to this day

16. Elements of the Australian strategy Elements of the Australian strategy to develop a conceptual framework were stated by a previous AARF director as: • maximising the use of FASB thinking • influenced by the notion that the importance of a conceptual framework would not be oversold, but gradually unveiled • the first stage of development was to be the tentative identification of the building blocks of a workable framework

17. Elements of the Australian strategy (cont’d) • the second stage was to be the selection of certain building blocks to formalise specific projects • the third stage was to be the investigation of interrelationships between the building blocks and any consequential redefinition of those blocks • the fourth stage was to be the commissioning of projects for the remaining blocks • publication of the SACs would then commence

18. Exposure drafts Six exposure drafts were release between 1987 and 1990: • ED 42A (objectives of financial reporting) • ED 42B (qualitative characteristics of financial information) • ED 42C (definition and recognition of assets) • ED 42D (definition and recognition of liabilities) • ED 46A (definition of the reporting entity) • ED 51A (definition of equity) • ED 51B (definition and recognition of revenues)

19. SACs Three SACs were released in August 1990: • SAC 1 ‘Definition of the Reporting Entity’ • SAC 2 ‘Objectives of General Purpose Financial Reporting’ • SAC 3 ‘Qualitative Characteristics of Financial Information’

20. The early 1990s • Section 226(1) of the Corporations Law (1991) specifically charged the AASB with the responsibility of developing a conceptual framework • SAC 4 ‘Definition and Recognition of Elements of Financial Statements’ was released in March 1992

21. 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

22. The need for a conceptual framework • According to standard setters, the following situations demonstrate the need for a conceptual framework: • Two or more methods of accounting are accepted for the same facts • Less-conservative accounting methods are used rather than earlier, more conservative methods • Reserves are used to artificially smooth earnings fluctuations • Financial statements fail to warn of impending liquidity crunches

23. The need for a conceptual framework (cont’d) • Deferrals are followed by ‘big bath’ write-offs • There is unadjusted optimism in estimates of recoverability • Off balance-sheet financing is common • An unwarranted assertion of immateriality has been used to justify non-disclosure of unfavourable information or departures from standards • Form is relevant over substance

24. 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.’

25. 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 decision-making of (standard-setters)’

26. 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

27. Advantages of a conceptual framework (cont’d) • 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

28. Potential benefits according to the AARF According to the AARF’s Guide to Proposed Statements of Accounting Concepts, the potential benefits are: ‘a. reporting requirements should be more consistent and logical, because they will stem from an orderly set of concepts ‘b. avoidance of reporting requirements will be much more difficult because of the existence of all-embracing provisions

29. Potential benefits according to the AARF (cont’d) ‘c. the Boards which set down the requirements will be more accountable for their actions in that the thinking behind specific requirements will be more explicit, as will any compromises that may be included in particular accounting standards ‘d. the need for specific accounting standards will be reduced to those circumstances in which the appropriate application of concepts is

30. Potential benefits according to the AARF (cont’d) • not clear-cut, thus mitigating the risks of over-regulation ‘e. preparers and auditors should be able to better understand the financial reporting requirements they face ‘f. the setting of requirements should be more economical because issues should not need to be re-debated from differing viewpoints’

31. Strategic objectives for a conceptual framework • The literature indicates that conceptual-framework projects have been developed as an instrument for the accounting profession’s self-preservation • One test used by Hines to determine whether conceptual frameworks could be viewed as strategic manoeuvres was to ascertain whether these projects were undertaken at times of threat to accountancy’s legitimacy or at times of competition • Hines concluded that ‘the major rationale for undertaking conceptual frameworks was not functional or technical, it was a strategic manoeuvre for providing legitimacy to standard-setting bodies …’

32. 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

33. Cyert and Ijiri’s three approaches • Simply stated, these are: • the firm-oriented approach • the profession-oriented approach • the user-oriented approach • The user-oriented approach is employed by the SACs in Australia, by the FASB in the USA and by The Corporate Report in the UK

34. Conceptual framework issues • In the process of developing a conceptual framework, the AARF and its Boards have had to resolve several fundamental conceptual issues • These issues have determined the nature and content of SACs

35. Issue 1: Balance sheet versus profit and loss account orientation • There are two distinct approaches to determining an entity’s income during a reporting period: • the asset/liability view, which maintains that revenues and expenses result only from changes in the value of assets and liabilities • the revenue/expense view, which holds that revenues and expenses result from the need for a proper matching

36. 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

37. The revenue/expense view Matching comprises two steps: • revenue recognition or timing through the realisation principle • expense recognition in three possible ways: • associating cause and effect, such as for the cost of goods sold • systematic and rational allocation, such as for depreciation • immediate recognition, such as for selling and administrative expenses

38. 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

39. Issue 2: Definition of assets, liabilities, equity, revenues and expenses • Based on the asset/liability view, assets are restricted to the economic resources of the firm, which are: • productive resources of the enterprise • contractual rights to productive resources and products • money • claims to receive money • ownership interests in other enterprises

40. Issue 2: Definition of assets, liabilities, equity, revenues and expenses (cont’d) • According to the revenue/expense view, assets include not only the assets defined from the asset/liability viewpoint, but also all items that do not represent economic resources, but that are required for proper matching • A third view of assets arises from the perception of the balance sheet not as a statement of financial position, but as ‘a statement of the sources and composition of company capital’. According to this view, assets constitute the ‘present composition of invested capital’.

41. Issue 2: Definition of assets, liabilities, equity, revenues and expenses (cont’d) • If we exclude the element of ‘deferred charges’ on the statement of financial position, the definitions of assets presented in these three different views have the following characteristics in common: • An asset represents potential cash flow to a firm • Potential benefits are obtainable by the firm

42. Issue 2: Definition of assets, liabilities, equity, revenues and expenses (cont’d) 3. The legal concept of property may affect the accounting definition of assets 4. The way an asset is acquired may be part of the definitions 5. Exchangeability may be an essential characteristic of assets

43. Definitions to take into account for a conceptual framework • An asset represents only economic resources and does not include ‘deferred charges’ • An asset represents potential cash flows to a firm • Potential benefits are obtainable by the firm • An asset represents the legal binding right to a particular benefit, results from a past or current transaction, and includes all commitments, as in wholly executory contracts • Exchangeability is not an essential characteristic of assets except for ‘deferred charges’

44. 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

45. Definitions of liabilities (cont’d) • A third view arises from the perception of the balance sheet as ‘a statement of the sources and composition of company capital’: • according to this view, liabilities constitute sources of capital and include certain deferred credits and reserves that do not represent obligations to transfer economic resources

46. Definitions of liabilities (cont’d) • If we disregard the element of ‘deferred credits’, the definitions of liabilities presented in these three different views have the following characteristics in common: • A liability is a future sacrifice of economic resources • A liability represents an obligation of a particular enterprise • A liability may be restricted to legal debt • A liability results from past or current transactions or events

47. 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

48. Revenues and expenses • According to the asset/liability view, revenues are defined as increases in the assets or decreases in the liabilities that do not affect capital • Expenses are defined as decreases in the assets or increases in the liabilities arising from the use of economic resources or services during a given period

49. Revenues and expenses (cont’d) • According to the revenue/expense view, revenues result from the sale of goods and services and include gains from the sale and exchange of assets other than inventories, interests and dividends earned on investments, and other increases in owners’ equity during a period other than capital contributions and adjustments • Expenses comprise all of the expired costs that correspond to the revenues of the period. If gains and losses are defined as a separate element of income, however, revenues are defined as measures of an entity’s outputs that result from the production or delivery of goods and the rendering of services during a period

50. Gains and losses • According to the asset/liability view, gains are defined as increases in net assets other than increases from revenues or from changes in capital • Losses are defined as decreases in net assets other than decreases from expenses or from changes in capital • Thus, gains and losses constitute that part of income not explained by revenues and expenses