Download PowerPoints Chapter 06

Financial Accounting Theory
Craig Deegan
Chapter 6
Normative theories of accounting—the case
of conceptual framework projects
Slides written by Craig Deegan
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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 provide prescription so
they are considered normative theories of
accounting
• 'Prescribes 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)
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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
• This phase of the project specifically addressed
the objective of financial reporting and the
qualitative characteristics and constraints of
decision-useful financial reporting information.
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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:
– what we mean by 'financial reporting' and what should be
its scope;
– which organisational characteristics indicate that an entity
should produce financial reports;
– the 'objective' of financial reporting;
– qualitative characteristics financial information should
possess;
– what are the elements of financial reporting; and
– what measurement rule should be employed.
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Rationale for conceptual frameworks
(cont.)
• 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
– some issues (or assumptions) need to be resolved or
made before moving on to subsequent 'building blocks'
– 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
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The 'building blocks' of the
conceptual framework (cont.)
• 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) in the text for an
overview of the IASB Framework for the
Preparation and Presentation of Financial
Statements (which in 2005 replaced the Australian
Conceptual Framework)
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History of the development of CFs
• CFs were developed in a number of jurisdictions
including
– US, UK, Canada, Australia, New Zealand, International
Accounting Standards Committee
• In recent years many countries have adopted the
IASB Framework given that they have decided to
adopt the accounting standards released by the
IASB
• No standard-setters had developed a complete
CF; measurement issues typically unaddressed
• Limited or no progress in recent years, although
there is now a joint IASB/FASB project to develop
a new and improved conceptual framework
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Development of frameworks of
accounting in the US
• 1961 and 1962: Moonitz, and Moonitz and
Sprouse prescribed that accounting practice
should be based on current values
• 1965: Grady developed theory based on
description of existing practice
– led to the release of Accounting Principles Board (APB)
Statement No. 4
– however, accounting profession under criticism for lack of
any real framework
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Development of frameworks of
accounting in the US (cont.)
• Led to formation of Trueblood Committee in 1971
which produced Trueblood Report
– report outlined 12 objectives of accounting and seven
qualitative characteristics which financial information
should possess
– objective 1: focused on information needs of financial
statement users
– objective 2: need to serve users with limited ability to
demand financial information
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Development of frameworks of
accounting in the US (cont.)
• 1974: APB replaced by FASB which then
embarked on its CF project
• Six Statements of Financial Accounting Concepts
(SFACs) released from 1978 to 1985
• Initial SFACs normative in nature, but SFAC No. 5
relating to recognition and measurement largely
descriptive of current practice
– received much criticism
– since 2005 FASB and IASB have been jointly working
towards the development of a revised conceptual
framework that would be used by both boards—referred
to as the 'convergence project'
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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)
– concerned with addressing the rights of the community in
terms of their access to financial information (broader
than notion of users adopted in other frameworks)
– ultimately contents generally not accepted by the
accounting profession
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Development of a CF in the UK (cont.)
• 1991: ASB adopted the IASC's CF
• IASC framework was generally consistent with the
US and Australian frameworks—subsequently
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.)
• Fifth SAC relating to measurement was never
released
• Had a number of similarities to the US CF project
• 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
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Current efforts of the IASB and the
FASB (cont.)
• 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
– purpose and status of the framework
– application of the framework to not-for-profit entities
– remaining issues, if any
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Building blocks of the CF
• The following discussion is based on the IASB
Framework currently in place
• Where appropriate, reference will also be made to
current work being done by IASB and FASB given
that this gives an indication of what might come in
the future
• 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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Special purpose financial reports
• By contrast, special purpose reports are provided
to meet the information demands of a particular
user, or group of users
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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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Objectives of GPFR
• Traditional objective was to enable outsiders to
assess the stewardship of management
• Recent commonly accepted goal of financial
reporting is to assist report users' economic
decision making
– less emphasis placed on the stewardship function
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Objective 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 defined as
– the duty to provide an account or reckoning of those
actions for which one is held responsible
• 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 decisionuseful to capital providers may also be useful to other
users of financial reporting who are not capital providers.
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Current thinking of the IASB and
FASB (cont.)
• As we know from previous lectures, before we are
prepared to accept the prescriptions provided by a
normative theory we must be satisfied with the
underlying assumptions made
• Hence, 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 organisation's 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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Current thinking of the IASB and the
FASB in relation to 'users'
• The 2008 exposure draft stated:
– The primary user group includes both present and
potential equity investors, lenders and other creditors,
regardless of how they obtained, or will obtain, their
interests…. Other users who have specialised needs,
such as suppliers, customers and employees (when not
acting as capital providers), as well as governments and
their agencies and members of the public, may also find
useful the information that meets the needs of capital
providers; however, financial reporting is not primarily
directed to these other groups because capital providers
have more direct and immediate needs
• Is this perspective of 'users' too restrictive?
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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 entity's 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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Reliability—implications 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 …. Materiality provides a cut-off
rather than being a primary qualitative characteristic
which information must have if it is to be useful
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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
– costs include collection, storage, retrieval, presentation,
analysis and interpretation
– benefits come from sound economic decision making by
users
• 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 characteristics—relevance and
faithful representation.
• The draft conceptual framework has reduced the
four 'primary qualitative characteristics' to two
'fundamental qualitative characteristics'
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Latest thinking of the IASB and the FASB
regarding qualitative characteristics (cont.)
• The qualitative characteristic of reliability was
replaced by 'faithfully representation'
• The other two primary qualitative characteristics
identified in the IASB Framework, these being
understandability and comparability, have been
renamed as 'enhancing qualitative characteristics'
in the draft document released by the IASB
• Two additional 'enhancing qualitative
characteristics' have also been included (thereby
giving a total of four enhancing qualitative
characteristics), these 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 they consider economic consequences then standards
cannot be considered objective or neutral
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Can GPFRs provide unbiased
accounts of performance? (cont.)
• If we accept the notion that preparers will be driven
by self-interest (from Positive Accounting Theory)
notions of objectivity or neutrality are unrealistic
• Political nature of standard setting process also
affects neutrality and objectivity
• In communicating reality accountants construct
reality (Hines 1988)
– That is, if accountants identify something and start to
place a monetary value on it then it gains importance – it
becomes visible (and 'real')
– Conversely, if accountants ignore it – such as many
externalities caused by business entities – then for many
people the 'issue' does not exist
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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 criteria—what attributes are required
before an item can be considered as belonging to
a particular class of element
• Recognition criteria—employed 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
– must be an expected future economic benefit
– the reporting entity must control the future economic
benefit
– the transaction or other past event giving rise to the
reporting entity's control 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
– control (and not legal ownership) is required, although
controlled assets are frequently owned
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Recognition of assets
• An asset—and all the other elements of
accounting—shall 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' of the IASB and
FASB in relation to assets
• Within the 2008 exposure draft the IASB and FASB thought
there were shortcomings with the existing asset definition.
They stated:
– Some users misinterpret the terms 'expected' (IASB definition)
and 'probable' (FASB definition) to mean that there must be a
high likelihood of future economic benefits for the definition to
be met; this excludes asset items with a low likelihood of future
economic benefits.
– The definitions place too much emphasis on identifying the
future flow of economic benefits, instead of focusing on the item
that presently exists, an economic resource.
– Some users misinterpret the term 'control' and use it in the
same sense as that used for purposes of consolidation
accounting. The term should focus on whether the entity has
some rights or privileged access to the economic resource.
– The definitions place undue emphasis on identifying the past
transactions or events that gave rise to the asset, instead of
focusing on whether the entity had access to the economic
resource at the balance sheet date.
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Current thinking about assets (cont.)
• 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
• According to the exposure draft released in 2008 the IASB
and FASB believe that the existing liability definition has
limitations:
– Some users misinterpret the terms 'expected' (IASB definition)
and 'probable' (FASB definition) to mean that there must be a
high likelihood of future outflow of economic benefits for the
definition to be met; this excludes liability items with a low
likelihood of a future outflow of economic benefits
– The definitions place too much emphasis on identifying the
future outflow of economic benefits, instead of focusing on the
item that presently exists, an economic obligation
– The definitions place undue emphasis on identifying the past
transactions or events that gave rise to the liability, instead of
focusing on whether the entity has an economic obligation at
the reporting date
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Present thinking of the IASB and
FASB in relation to liabilities (cont.)
• 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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Measurement principles
• To date there is very little prescription in relation to
measurement provided by CFs
• FASB statement provides description of various
approaches to measuring elements without
providing prescription
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Current IASB and FASB work on measurement
issues
• In 2005 the IASB and FASB stated:
– Measurement is one of the most underdeveloped areas of the
two frameworks . . . Both frameworks (the IASB and FASB
Frameworks) contain lists of measurement attributes used in
practice. The lists are broadly consistent, comprising historical
cost, current cost, gross or net realizable (settlement) value,
current market value, and present value of expected future
cash flows. 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.
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Current IASB and FASB work on
measurement issues (cont.)
• 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
• It is expected that it will be a number of years
before any conclusion is reached about the most
appropriate measurement basis for assets and
liabilities
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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
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Benefits associated with CFs (cont.)
• The development of accounting standards should
be more economical
• Where conceptual frameworks cover a particular
issue, there might be a reduced need for additional
standards
• Emphasise the 'decision usefulness' role of
financial reports rather than restricting concern to
stewardship
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Disadvantages of conceptual
frameworks
• Smaller organisations may feel overburdened by
reporting requirements
• Typically economic in focus, so ignore transactions
that have not involved market transactions or
exchange of property rights
– further reinforces the importance of economic
performance relative to social performance
• Represent a codification of existing practice
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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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