Conceptual framework

Aims of the chapter

The aim of this chapter is to consider what a conceptual framework is and then to address some of the key principles related to setting up a conceptual framework. These principles have been examined by many different groups of standard-setters around the world (including in Australia, Canada, the UK and the USA). We will look at the UK’s Statement of Principles (SOP) and the US Concept Statements. The ASB modelled the SOP on the IASB Framework for the Preparation and Presentation of Financial Statements (FPPFS), which in turn was based on the US conceptual framework. It is strongly recommended that you review the FPPFS.¹

Learning outcomes

By the end of this chapter, and having completed the Essential readings and activities, you should be able to:

• define a conceptual framework

• identify the main efforts by the US, the IASC and the UK to introduce a conceptual framework

• describe the objectives of financial reporting as per the conceptual frameworks produced

• explain the ‘ideal’ qualitative characteristics of accounting information as suggested by these frameworks

• define assets and liabilities as suggested by these frameworks

• explain and describe recognition and measurement

• apply the conceptual frameworks to particular transactions; for instance, would they help in deciding how to account for research and development?

Essential reading

International Financial Reporting, Chapter 8.

Accounting Standards Board, 1999, Statement of Principles for Financial Reporting. (Reproduced in Accountancy, March 2000, pp.109–38). See below for the ASB website.

Websites

Definition of a conceptual framework

The quest for a conceptual framework for financial reporting has been undertaken (with varying degrees of success in terms of securing agreement) in many different countries. But what is a conceptual framework?

In the USA, one definition by the Financial Accounting Standards Board (FASB) is:

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 ASB in the UK states that their Statement of Principles (SOP) (equivalent to the US conceptual framework):

sets out the principles that the Accounting Standards Board believes should underlie the preparation and presentation of general purpose financial statements… A coherent frame of reference to be used by the Board in the development and review of accounting standards.

Macve (1981) stated that a conceptual framework would:

provide a consistent approach for making decisions about choices of accounting practice and for setting standards.

However, he also recognised that it would be difficult to implement such a conceptual framework.

All three definitions suggest that a conceptual framework provides an explicit description of how accounting rules should be formulated and the environment in which they apply. More specifically, a conceptual framework is supposed to address some fairly fundamental questions about financial statements themselves. For instance:

• What are the objectives of financial statements?

• For whom and by whom are these financial statements required?

• What information do the users of these financial statements require?

• What types of financial statement would best satisfy these users’ needs?

• Do current financial statements meet these requirements?

• How could current financial statements be improved?

Although these questions are fundamental, the extent to which they have been addressed varies among countries. However, in general:

the various standard-setting bodies around the world have too often attempted to resolve practical accounting and reporting through the development of accounting standards, without such an accepted theoretical frame of reference.

(Ernst and Young, 2001)

In other words, too often standard-setting is reactive (to particular problems) rather than proactive.

Rationale for a conceptual framework

The FASB states that the rationale for a conceptual framework is:

1. To facilitate decisions on controversial accounting issues –

providing a clear basis for reaching conclusions that those with vested interests would find it hard to resist.

2. To provide a common framework of reference on theoretical issues, so as to avoid both waste of effort in addressing such issues from first principles for each specific standard and the dangers of inconsistency.

3. To reduce the need for many detailed standards on specific issues – by enabling accountants to resolve issues by reference to general principles rather than detailed rules.

Advantages claimed for a conceptual framework

According to the UK Statement of Principles, a conceptual framework should:

• clarify the conceptual underpinnings of proposed accounting standards

• enable standards to be developed on a consistent basis

• reduce the need to debate fundamental issues each time a standard is developed or revised

• enable preparers and users of financial statements to understand the Board’s approach to setting standards and the nature and function of information in general purpose financial statements

• help preparers and auditors with new issues to carry out an initial analysis of the issues in the absence of applicable accounting standards.

Other advantages claimed for a conceptual framework are that it:

• facilitates decisions on controversial items, by reducing the scope for personal bias and political pressure

• may reduce the need for many detailed standards if accountants can resolve issues by general principles

• limits the bounds of judgement and hence increases comparability

• may protect accounting from intervention by governments

• helps justify accounting practices when they are under attack in the courts, if they can be shown to be derived from, and consistent with, a conceptual framework.

The US, IASC and UK initiatives compared

In this section we consider briefly some of the important milestones in the quest for a conceptual framework in the US, IASB and the UK. You need not know the exact detail as such, but you should be aware of the main considerations of each initiative and the main similarities and differences between each approach.

US initiative: FASB conceptual framework

The FASB issued six concept statements in the late 1970s/early 1980s, of which five are listed here:

• Statement of Financial Accounting Concept (SFAC) No. 1 Objectives of Financial Reporting by Business Enterprises.

• SFAC No. 2 Qualitative Characteristics of Accounting Information.

• SFAC No. 4 Objectives of Financial Reporting by Non Business Organisations.

• SFAC No. 5 Recognition and Measurement in Financial Statements of Business Enterprises.

• SFAC No. 6 Elements of Financial Statements (replacing SFAC No. 3).

• SFAC No. 7 Using Cash Flow Information and Present Value in Accounting Measurements.

This chapter will discuss four of these concept statements – 1, 2, 5 and 6 – which address some of the key conceptual issues.

IASC Framework for the presentation and preparation of financial statements

The IASC conceptual framework was introduced as an exposure draft in May 1988, and a final statement in September 1989, in an attempt to

‘explain the conceptual framework that underlies the preparation and presentation of financial statements.’ Apparently modelled on the FASB framework, it exhibits many of the strengths and weaknesses of that earlier framework (see discussions below).

UK: ASB’s Statement of Principles (SOP)

In the UK the ASB issued a Draft Statement of Principles, initially chapter by chapter but then as a whole, for general comment. In 1996, some aspects of the Draft Statement of Principles attracted adverse comment and as a result this framework was modified. The final version of the SOP was agreed in October 1999. Appendix II notes that the SOP was based on the IASC’s Framework. Appendix III points out that the Board does not regard the SOP as the final word on the principles underlying financial reporting and that, as accounting thought is continually evolving, it may need to be revised from time to time. Currently the SOP consists of eight chapters:

Chapter 1: The Objective of Financial Statements Chapter 2: The Reporting Entity

Chapter 3: The Qualitative Characteristics of Financial Information Chapter 4: The Elements of Financial Statements

Chapter 5: Recognition in Financial Statements Chapter 6: Measurement in Financial Statements Chapter 7: Presentation of Financial Information

Chapter 8: Accounting for Interests in Other Entities.

Although the main purpose of the SOP is to help set accounting standards, the Introduction to it notes that, due to other factors to be considered when setting standards (including legal requirements and cost/benefit considerations), a standard may still adopt an approach different from that suggested by the principles. The SOP has not been developed within the constraints imposed by company law so it may contribute to the future development of law.

Objectives of financial reporting

The underlying objective of all the conceptual frameworks discussed above in relation to financial reporting is to provide useful information so users can make business and economic decisions. This is sometimes contrasted with an alternative objective – to provide information on how the business has carried out its stewardship responsibilities.

There is an overlap, however, between these objectives. One may argue that information about historical stewardship, or accountability for past actions, is relevant for decision making and control and indeed the rationale for it may be expressed in these terms. Nevertheless the objective promoted in the conceptual frameworks is not as restricted. In principle, it goes beyond history, stewardship and accountability without limit.

This freedom results in threats as well as opportunities for and through accounting.

Decision usefulness appears to be a reasonable objective, although we have seen that it should be subject to our discussion in the last chapter of context and the imperfect nature thereof. To satisfy it two questions should be considered:

1. Who are the users?

2. What type of information do they need?

In the case of the FASB, the statement identifies many potential users of accounts and their interests, but argues that those most directly concerned with a business share a common interest in the company’s ability to generate favourable cash flows. In developing objectives for general-purpose external financial reports, the statement focuses on the needs of investors and creditors (though it suggests that information prepared to meet these needs is likely to be generally useful to other groups which have essentially the same interest) and argues that:

Financial reporting should provide information that is useful to present and potential investors, creditors and other users in making rational investment, credit and similar decisions.

Its principle conclusion is:

Financial reporting should provide information to help investors, creditors and others assess the amounts, timing and uncertainty of prospective net cash flows to the related enterprise.

The SOP requires that financial reports provide information about:

• the economic resources of an enterprise, its obligations and owners’

equity

• enterprise performance and earnings

• liquidity, solvency and funds flow

• management stewardship and performance.

It notes in relation to its requirement for information about enterprise performance that:

…interest in an enterprise’s cash flows and its ability to generate favourable cash flows leads primarily to an interest in information about its earnings rather than information directly about its cash flows… Information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than information about current cash receipts and payments.

The FASB then asserts that what investors want are balance sheets and income statements: inductively from the fact that this is what they currently actually get and politically because the FASB has no intention of undermining the very basis of present practice and thus has rationalised accrual accounting.

However, the FASB has actually steered away from trying to identify the kind of information that may assist users (e.g. current value information, management forecasts, etc.)

In the UK, the ASB’s SOP states that the objective is to provide information about the financial performance and financial position of an entity which would be useful to a wide range of users in assessing the stewardship of managers.

The ASB has selected the investor’s perspective as the one most likely to help in the preparation of general-purpose financial statements. It states that, whilst recognising a large number of potential users of financial statements, who usually require different information for the different decisions they must make, a statement based on such a perspective focuses on the common interest of all users – the entity’s cash-generating ability and financial adaptability. It therefore focuses on present and potential investors as the defining class of user, arguing that in meeting their needs financial statements will meet the common needs of other users. It notes that information that is not needed by investors need not be given in the financial statements.

The SOP details the information required by investors, which is very similar to the FASB, and is said to comprise the following:

• In relation to financial performance: the return obtained on its resources, the components of that return and the characteristics of those components.

• In relation to financial position: the economic resources controlled by the entity, its financial structure, liquidity and solvency, risk profile and risk management approach, and capacity to adapt to changes in the environment.

• Information about the generation and use of cash, which provides a further perspective on financial performance.

Outside commentators on the objectives of reporting delineated in conceptual frameworks:

Many practitioners and academics have commented on the above

approaches. For example, Bromwich (1992) pointed out that in the FASB’s Conceptual Framework the emphasis was strongly on information for decision-making. The same is true of the ASB Statement of Principles.

Depending on how information for decision making is understood and how stewardship is understood, it is possible that information useful for decision-making purposes may not be useful for assessing stewardship?

The ASB defines stewardship broadly so as to include accountability not only for the safekeeping of the resources, but also for their proper, efficient and profitable use. It therefore involves an economic decision on whether (for example) to hold or sell shares and to reappoint or dismiss the management. Some would take a narrower view of stewardship and the information deemed useful by the ASB may not stretch to this specific.

Similarly, by focusing on the assumed common need, does the FASB ignore the possibility of differing (and possibly conflicting) needs of different users? In focusing in particular on investors and creditors, many other groups could be harmed by standards promulgated to meet the needs of these particular groups. This is the ‘social choice’ problem.

As Macve (1981) stated:

[R]ecognition of the variety of users’ needs and of conflicts between different rights leads to the view that reaching agreement on the form and content of financial statements is as much a ‘political’ process, a search for compromise between different parties, as it is a search for the methods which are

‘technically’ best.

Activity 2.1

Do you think that the investor’s perspective is the most appropriate?

With reference to a selected ‘conceptual framework’, satisfy yourself that you are aware of the range of stated objectives of financial reporting.

Qualitative characteristics of accounting information

Although most conceptual frameworks identify many of the same

qualitative characteristics of accounting information, the hierarchy of these characteristics might vary. The overriding concern is that the information that is provided to users should be useful in relation to their decision-making process. To ensure that it is useful, this information should have certain characteristics. The characteristics considered here are:

• relevance

• reliability

• comparability

• understandability.

The FASB, in SFAC 2 Qualitative Characteristics of Accounting Infornation, examines the characteristics that make accounting information useful. It establishes a ‘hierarchy of accounting qualities’ (see Figure 2.1).

Decision makers

Figure 2.1 FASB’s hierarchy of accounting qualities

Similarly the ASB, in Chapter 3 of the SOP, sets out the qualitative characteristics of useful financial information in a diagram which is more detailed than the FASB but based on the same characteristics discussed above (see Figure 2.2).

Figure 2.2 ASB’s qualitative characteristics of useful financial information The various terms used in the two figures are discussed below.

Materiality

To begin with there must be some assessment of whether the information is material (i.e. could this information influence users’ decisions?).

Materiality is viewed as a threshold characteristic because if any information is immaterial then users are not interested in it whatever other characteristics it has. Immaterial information should not be given as this may impair understanding of the financial statements. But what is material? Does the assessment of materiality vary between users?

What makes financial information useful?

Threshold quality MATERIALITY

RELEVANCE RELIABILITY COMPARABILITY UNDERSTANDABILITY

Giving information that is not material may impair the usefulness

of the other information given

Information that

Complete Prudence Consistency Disclosure User’s abilities

Relevance

The FASB defines relevance as the capacity of information to make a difference in a decision by helping users to form predictions about the outcomes of past, present and future events to confirm or correct prior expectations. Similarly the ASB defines relevant information as that which is able to ‘influence the economic decisions of users and is provided in time to influence those decisions.’

Reliability

The ASB states that reliable information is:

• faithful representation (i.e. it can be depended upon to represent what it purports to represent or could reasonably be expected to represent – reflects the substance of a transaction or event)

• free from deliberate or systematic bias (i.e. is neutral)

• complete and free from material error

• prepared on a prudent basis (i.e. under conditions of uncertainty, a degree of caution has been exercised in making the necessary judgements or estimates).

The FASB states:

To be reliable, financial statements must portray the important relationships of the firm itself. Information is reliable if it is verifiable and neutral and if users can depend on it to represent that which it is intended to represent.

Comparability

The ASB states that comparability enables users to discern similarities in and differences between the effect and nature of transactions and events between entities, and over time for the same entity (very similar to the FASB definition). It requires consistency and disclosure of accounting policies. The SOP notes, however, that consistency should not prevent the introduction of improved accounting policies.

Understandability

To be useful, information must be understandable. This depends on the way in which it is aggregated, classified and presented, and on the ability of users (who are presumed to have reasonable knowledge of business and accounting and are prepared to study the information with reasonable

In document AC3091_vle Financial reporting (Page 37-57)