Topic: Conceptual Framework
Tutorial Questions:
1. What is a conceptual framework, and what role does it have in accounting?
A conceptual framework is an underpinning set of basic ideas/concepts that
are designed to provide guidance to broader accounting practice.
The main role of conceptual frameworks is to provide a framework of ideas to guide
standard-setters when they create and revise accounting standards. This can
simplify the creation of standards (as each standard doesn’t have to define
everything differently (e.g. assets/liabilities).
It also ensures that standards are more consistent with one another, and improves
the consistency of reports between organisations. The IASB also argues that it
provides foundational ideas so that all parties can understand the standards.
Therefore, the primary role of the conceptual framework is to INDIRECTLY affect
accounting practice, through its influence on accounting standards In addition,
sometimes the CF may play a more DIRECT role on accounting practice, such as
when accountants are trying to account for something for which there is no
accounting standard yet (such as complicated new financial instruments) or for
auditors when assessing if financial reports are ‘true and fair’. In these instances,
the CF can provide general principles to guide accountants and auditors.
2. What is the difference between an accounting standard and a
conceptual framework of accounting?
A conceptual framework provides guidance at a much broader level than an
accounting standard.
The IASB Conceptual Framework provides general guidance about such issues as
the objective of financial reports, which entities should produce general purpose
financial reports, the qualitative characteristics that useful financial information
will possess, how the elements of financial accounting (assets, liabilities, equity,
income and expenses) should be defined, and when they should be recognised.
By contrast, accounting standards have a much narrower focus and tend to provide
guidance on how particular types of transactions, or how particular assets and
liabilities, should be accounted for. For example, different accounting standards will
provide guidance on how to account for inventory (IAS 2), property, plant and
equipment (IAS 16), biological assets (IAS 41), or employee entitlements (IAS 19).
Such detailed consideration on particular assets or liabilities is not provided in a
conceptual framework. Effectively, a central role of accounting standards is to apply
the concepts included within a conceptual framework to specific transactions and
events.
3. Review the proposed Conceptual Framework for Financial Reporting (from
the AASB) and use it to answer the following questions:
(a) What is a qualitative characteristic? How many qualitative characteristics
are defined in the proposed Conceptual Framework? Describe each, and
provide an example for each.
There are six qualitative characteristics, with two ‘fundamental’ qualitative
characteristics, and four ‘enhancing’ qualitative characteristics.
The fundamental qualitative characteristics define what information is useful:
relevance – “Relevant financial information is capable of making a difference
in the decisions made by users” e.g. revenue information is relevant to users
faithful representation – “information that faithfully represents the substance
of something…which is to the maximum extent complete, neutral, and free from
error” eg measurement approach chosen for an asset should be that which
best represents the asset
The ‘enhancing’ qualitative characteristics are secondary to the fundamental ones,
and may be
used to help support decision-making.
Comparability: “information about a reporting entity is more useful if it can be
compared with similar information about other entities and with similar information
about the same entity for another period or another date” – e.g. fair value for
property might be more comparable with other organisations than historical cost
Verifiability: “Verifiability means that different knowledgeable and independent
observers could reach consensus, although not necessarily complete agreement,
that a particular depiction is a faithful representation” – e.g. think about if an auditor
would arrive at a similar decision on an accounting treatment as the organisation.
Timeliness: “Timeliness means having information available to decision-makers in
time to be capable of influencing their decisions” e.g. producing reports at
least annually
Understandability: “Classifying, characterising and presenting information clearly
and concisely makes it understandable”e.g. providing detail or categories of PP&E
so that users can better understand the different aspects of this asset
(b) What is the cost constraint and how does it affect financial reporting?
“Cost is a pervasive constraint on the information that can be provided by financial
reporting.
Reporting financial information imposes costs, and it is important that those costs are
justified by the benefits of reporting that information.”
This constraint affects both the standard-setters and reporting entities themselves.
For standard-setters: they should consider the benefits to users from information
vs costs of any proposed standard on reporting entities
For reporting entities: they can consider the cost of producing certain information
when deciding whether they should produce it (i.e. when it offers a benefit to users)
This requires the exercise of judgement to be used – such as estimating how much
benefit a new standard may offer users, or how much cost a new form of
measurement/reporting may incur an organisation.
(c) What is the objective of financial reporting in the proposed
Conceptual Framework?
The objective of general purpose financial reporting is to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders
and other creditors in making decisions relating to providing resources to the entity.
Those decisions involve decisions about:
(a) buying, selling or holding equity and debt instruments;
(b) providing or settling loans and other forms of credit; or
(c) exercising rights to vote on, or otherwise influence, management’s actions that
affect the use of the entity’s economic resources.
(d) Who are the users of financial reports the proposed Conceptual
Framework?
What assumptions does the proposed Conceptual Framework make about
the knowledge/background of these users? What implications might this
have?
Users are defined as “existing and potential investors, lenders and other creditors” to
the organisation. They are users because they must rely on financial reporting for the
information they need to make decisions.
The CF assumes users have the following background: “Financial reports are
prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyse the information diligently. At
times, even well-informed and diligent users may need to seek the aid of an
adviser to understand information about complex economic phenomena.”
These definitions can be argued to be too narrow – because they focus on a
certain type of economic user, with assumptions made about their experience and
background. The implication is that many potential users of financial statements
are excluded – which may have further implications for the way that financial
accounting is undertaken. Some of these users may include employees, regulators,
the general public, or lobby groups. Those who do not have a background in
finance/economics are also not considered by standard setters when creating
standards.
(e) How are assets and liabilities defined in the proposed Conceptual
Framework? How is this different from previous recognition criteria (hint:
you may need to do additional research to answer this)? Which do you think
will be easier for accountants to apply?
Asset: “An asset is a present economic resource controlled by the entity as a result
of past events” . “An economic resource is a right that has the potential to produce
economic benefits”.
Former definition: “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”
Liability: “A liability is a present obligation of the entity to transfer an economic
resource as a result of past events”
Former definition: “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”
(f) What does recognition mean? What criteria are used to determine if an item
should be recognised in financial statements? How does this vary from the
former recognition criteria (i.e. from the previous Conceptual Framework)?
The recognition criteria in the new CF refers to the two fundamental qualitative
characteristics.
That is, that items should be recognised if they are both ‘relevant’ and able to
be ‘faithfully represented’.
Formerly, recognition criteria for an asset is if it is (a) probable and (b) reliably
measured.
The criteria vary slightly, which may have implications for whether or not certain
items are/not recognised in future financial statements (or appear in notes).
(g) Explain how the proposed Conceptual Framework is a normative approach
to accounting. Use examples drawn from the proposed Conceptual
Framework.
The CF is normative because it prescribes what should happen in accounting,
rather than describing or predicting what An example is the use of ‘qualitative
characteristics’ which prescribe what usefulness means for information. Here, the
CF defines certain terms to guide accountants/standard-setters to do specific
things, such as how they should make decisions about what goes into a financial
report.
For example, “If financial information is to be useful, it must be relevant and faithfully
represent what it purports to represent.”
4. Review the article by Ford, and answer the following questions:
(a) What are Ford’s concerns about the auditing profession?
Ford is concerned that auditors are too oriented towards ‘checking the boxes’ in
auditing – that is, following the specific directions of accounting standards: “audit
bosses argue that it’s enough to follow accounting standards to discharge their
accountabilities”. They do this to limit their liability.
This can be a problem because accounting standards cannot provide specific
instruction on every possible business transaction (e.g. dividend payouts). Ford
suggests that this means that auditors can avoid making assessments about the
general truth or fairness of financial statements, and that specific standards can
deflect auditors from their central purpose – “to assure investors that the company’s
capital is safe, and has not been abused by insiders”.
He suggests that specific accounting standards do not help auditors make this
holistic judgement, and provide assurance to investors.
(b) How could a conceptual framework address these concerns?
The CF could provide a broader set of principles about what quality looks
like in financial reporting. This may help to avert Ford’s concerns about auditors
focusing too much on whether companies have met specific accounting standards.
The CF could provide guidance/principles that auditors can use to determine if
financial reports are true and fair.
5. The new conceptual framework proposes that financial reports should be
‘neutral’.
Do you think this is possible? (hint: consider a critical theory perspective)
According to the CF, “A neutral depiction is without bias in the selection or
presentation of financial information”. This suggests that information should be as
objective as possible.
A critical perspective would argue that any information prepared by people
carries bias and therefore is not neutral. This view would suggest that neutrality is
impossible.
Some arguments as to how reports may not be neutral include the following:
Those responsible for accounting (accountants) are responsible for
determining what issues need to be accounted for and those that do not. This relies
upon a great deal of judgement. If something is not separately identified and
accounted for then it might be deemed unimportant. Attention will tend to be
directed towards those attributes of performance that are identified and
measured. Identifying what is important is a subjective process.
The recognition criteria of the elements of accounting relies upon a
consideration of probabilities, for example, the probability that an item of
expenditure will generate future economic benefits. The determination of
probabilities can be quite subjective.
. When accounting standards are developed, accounting standard-setters
consider the potential economic and social consequences that might result if the
standard is issued.
Once standard-setters allow such considerations to influence their standard-
setting activities it is questionable whether the standards are developed in an
objective manner.
If the accounting standards are not developed in an objective manner, then it
is also questionable whether the accounting reports which are developed in
accordance with those standards can be objective.
Related to the above point, the process involved in the development of
accounting standards can be considered to be a political process given that
constituents are encouraged to provide a lobbying submission during the
process of developing accounting standards. A political process is not generally
considered to be an objective process. To some extent, the ongoing existence of
standard-setting bodies is reliant upon constituent support.
Some accounting researchers use various economic theories to explain what
motivates
managers to support one accounting method in preference to another.
Proponents of Positive Accounting Theory assume that individual self-interest
motivates the selection of accounting methods within a firm. Self-interest and
objectivity are mutually exclusive.