Financial Accounting Theory
Craig Deegan
Chapter 5
Normative theories of accounting—the
case of conceptual framework projects
Slides written by Michaela Rankin
Copyright © 2000 McGraw-Hill Book Co. Aust.
PPT t/a Financial Accounting Theory by Deegan
5.1
Chapter 5: Conceptual framework projects
Learning Objectives
• In this chapter you will be introduced to
– the role that conceptual frameworks 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
Copyright © 2000 McGraw-Hill Book Co. Aust.
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5.2
Chapter 5: Conceptual framework projects
Learning Objectives
– perceived advantages and disadvantages that arise
from the establishment and development of
conceptual frameworks
– 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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Chapter 5: Conceptual framework projects
What is a conceptual
framework?
• ‘A coherent system of interrelated objectives
and fundamentals that is expected to lead to
consistent standards’
• attempts to provide a structured theory of
accounting
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Chapter 5: Conceptual framework projects
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’
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Chapter 5: Conceptual framework projects
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;
– what 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;
– what measurement rule should be employed
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Chapter 5: Conceptual framework projects
Rationale for conceptual
frameworks—continued
• 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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Chapter 5: Conceptual framework projects
The ‘building blocks’ of the
conceptual framework
• The framework must be developed in a
particular order
– some issues need to be resolved before moving
on to subsequent ‘building blocks’
• Refer to Figure 5.1 in the text for an
overview of the Australian Conceptual
Framework
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Chapter 5: Conceptual framework projects
History of the development
of CFs
• CFs are under development in a number of
jurisdictions including:
– US, UK, Canada, Australia, New Zealand,
International Accounting Standards Committee
• No standard-setters have developed a
complete CF
• Limited or no progress in recent years
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Chapter 5: Conceptual framework projects
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 APB Statement No. 4
– however accounting profession under criticism
for lack of any real framework
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Chapter 5: Conceptual framework projects
Development of frameworks of
accounting in the US—continued
• Led to formation of Trueblood Committee
in 1971which produced Trueblood Report
– report outlined 12 objectives of accounting and
7 qualitative characteristics which financial
information should possess
– objective 1 focussed on information needs of
financial statement users
– objective 2—need to serve users with limited
ability to demand financial information
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Chapter 5: Conceptual framework projects
Development of frameworks of
accounting in the US—continued
• 1974 APB replaced by FASB which then
embarked on its CF project
• 6 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
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Chapter 5: Conceptual framework projects
Development of a CF in
Australia
• Degree of progression has also been slow
• to date only 4 SACs have been released
– SAC 1: Definition of the Reporting Entity
– SAC 2: Objectives of GPFR
– SAC 3: Qualitative Characteristics of Financial
Information
– SAC 4: Definition and Recognition of the
Elements of Financial Statements
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Chapter 5: Conceptual framework projects
Development of a CF in
Australia—continued
• Fifth SAC relating to measurement issues is
yet to be released
• has a number of similarities to the US CF
project
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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
Development of a CF in the
UK—continued
• 1991—the ASB adopted the IASC’s CF
• IASC framework is generally consistent
with the US and Australian frameworks
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Chapter 5: Conceptual framework projects
Building Blocks of the CF
• Building blocks of the various CFs have
addressed:
– definition of the reporting entity
– objectives of general purpose financial
reporting
– perceived users of GPFRs
– qualitative characteristics that GPFRs should
possess
– elements of financial statements
– possible approaches to measuring the elements
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Chapter 5: Conceptual framework projects
Definition of the reporting
entity
• The Conceptual Framework provides a
definition of entities required to produce
general purpose financial reports (GPFRs)
– known as reporting entities
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Chapter 5: Conceptual framework projects
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 (SAC1: para. 6)
• GPFRs are reports that comply with
accounting standards and other GAAP
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Chapter 5: Conceptual framework projects
Special purpose financial
reports
• special purpose reports are provided to meet
the information demands of a particular
user, or group of users
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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
International perspectives
on users of GPFRs
• 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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Chapter 5: Conceptual framework projects
Level of expertise expected
of financial report readers
• Generally accepted that readers are
expected to have some proficiency in
financial accounting
• SAC 3 (para. 36):
– [GPFRs] ought to be constructed having regard
to the interests of users who are prepared to
exercise diligence in reviewing those reports...
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Chapter 5: Conceptual framework projects
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:
– primary qualitative characteristics are relevance
and reliability
– related to relevance is materiality
– secondary characteristics include comparability,
uniformity, consistency and timeliness
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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
Reliability—implications
for traditional accounting
• Traditionally, the doctrine of conservatism
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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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
Materiality
• A limiting factor on the disclosure of
relevant and reliable material is the notion
of materiality
• an item is material if (SAC 3, para. 28):
– ... omission, misstatement or non-disclosure of
an item of relevant and reliable information
could affect decision-making about the
allocation of scarce resources by the users of a
general-purpose financial report of an entity
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Chapter 5: Conceptual framework projects
Secondary characteristics—
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 impose costs on
reporting entities
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Chapter 5: Conceptual framework projects
Secondary characteristics—
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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Chapter 5: Conceptual framework projects
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 consider economic consequences then
standards cannot be considered objective or
neutral
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Chapter 5: Conceptual framework projects
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)
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Chapter 5: Conceptual framework projects
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 reports
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Chapter 5: Conceptual framework projects
Five elements of financial
reporting in Australia
•
•
•
•
•
Assets
liabilities
equity
expenses
revenues
– 10 elements identified in the US by FASB
– IASC adopts the five Australian elements plus
‘income’
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Chapter 5: Conceptual framework projects
Definition of Assets
• …future economic benefits controlled by
the entity as a result of past transactions and
other past events (SAC 4, para. 14)
• 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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Chapter 5: Conceptual framework projects
Definition of Assets—continued
• 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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Chapter 5: Conceptual framework projects
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 pre-requisite for
establishing the existence of control
– control (and not legal ownership) is required,
although controlled assets are frequently owned
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Chapter 5: Conceptual framework projects
Recognition of assets
• An asset shall be recognised when:
– it is probable that the future economic benefits
embodied in the asset will eventuate; and
– the asset possesses a cost or other value that can
be measured reliably (SAC 4, para. 38)
• probable is defined as ‘more likely rather
than less likely’ (SAC 4, para. 40)
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Chapter 5: Conceptual framework projects
Definition of liabilities
• Liabilities are defined as ‘future sacrifices
of economic benefits that the entity is
presently obliged to make to other entities
as a result of past transactions or other past
events’ (SAC 4, para. 48)
– 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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Chapter 5: Conceptual framework projects
Recognition of liabilities
• Recognition criteria consistent with those of
assets
• 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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Chapter 5: Conceptual framework projects
Approaches to determining
profit
• Two common approaches to determine
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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Chapter 5: Conceptual framework projects
Definition of expenses
• …consumptions or losses of future
economic benefits in the form of reductions
in assets or increases in liabilities of the
entity, other than those relating to
distributions to owners, that result in a
decrease in equity during the reporting
period (SAC 4, para. 117)
– consistent with definition provided by IASC
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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
Definition of revenues
• …inflows or other enhancements or savings
in outflows of future economic benefits in
the form of increases in assets or reductions
in liabilities of the entity, other than those
relating to contributions by owners, that
result in an increase in equity during the
reporting period (SAC 4, para. 111)
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Chapter 5: Conceptual framework projects
Definition of revenues—
continued
• Within Australian and IASC approaches,
revenues can be recognised from normal
trading relations, as well as from nonreciprocal transfers such as grants,
donations, bequests, or where liabilities are
forgiven.
• FASB definition restricts revenues to
transactions relating to ongoing major or
central operations
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Chapter 5: Conceptual framework projects
Recognition of revenues
• Within the Australian CF revenues are
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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Chapter 5: Conceptual framework projects
Definition of equity
• Equity is defined as ‘the residual interest in
the assets of the entity after deduction of its
liabilities’ (SAC 4, para. 78)
– consistent with IASC and FASB definitions
• 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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Chapter 5: Conceptual framework projects
Measurement principles
• To date very little prescription in relation to
measurement provided by CFs
• In Australia an SAC relating to
measurement has been expected for some
time
• FASB statement provides description of
various approaches to measuring elements
without providing prescription
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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
Benefits associated with
CFs—continued
• The development of accounting standards
should be more economical
• where SACs 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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Chapter 5: Conceptual framework projects
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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Chapter 5: Conceptual framework projects
CFs as a means of legitimising
standard-setting bodies
• Some (eg. 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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