Chapter 2
The Conceptual
Framework of Accounting
and its relevance to
financial reporting
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-1
Objectives
• Understand the role of a conceptual framework of
accounting
• Be able to define the elements of financial reporting
• Be able to explain the recognition criteria of the
elements of accounting
• Understand the desirable qualitative characteristics of
financial information
• Be able to critically evaluate the conceptual framework
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-2
Conceptual Framework (CF) – an
introduction
• Initially we had an Australian Framework developed by AASB
• Adoption of IFRSs required us to adopt the conceptual framework
developed by IASB
• Generally accepted, however, that the Australian Conceptual
Framework was more robust than IASB Framework – although
work is currently being undertaken to further develop IASB
Framework
• CF prescribes the nature, function and limits of financial
accounting and reporting
• Central goal in establishing CF is general consensus on
– scope and objectives of financial reporting
– qualitative characteristics that financial information should possess
– elements of financial reporting
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-3
Benefits of a Conceptual Framework
• Accounting standards more consistent
• Increased international comparability
• Should result in the Boards (eg IASB, AASB) being
more accountable for their decisions
• Enhanced process of communication between the
Boards and constituents
• More economical accounting standard development
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-4
Structure of the Conceptual Framework
Until 2004, four Statement of Accounting Concepts
(SACs) issued
• From 2005 we no longer used the entire conceptual
framework that was developed in Australia
– SAC3 and SAC4 were replaced by the ‘Framework for the
Preparation and Presentation of Financial Statements’
(released July 2004)— in Australia known as the AASB
Framework
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-5
Structure of the CF (cont.)
SAC1 and SAC2 to be temporarily retained but their requirements
expected to be incorporated in later document
• It would appear that the Framework must be adhered to by
preparers of GPFRs. As paragraph 11 of AASB 8 states
In making the judgement described in paragraph 10,
management shall refer to, and consider the applicability of, the
following sources in descending order:
– (a) the requirements and guidance in Australian Accounting
Standards dealing with similar and related issues; and
– (b) the definitions, recognition criteria and measurement concepts for
assets, liabilities, income and expenses in the Framework.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-6
Components of CF
1. Definition of financial reporting
2. Definition of the reporting entity
3. Definition of users of accounts
and their information needs
4. Objectives of financial statements
5. Underlying assumptions
6. Qualitative charateristics of
financial statements
7. Elements of financial
statements
8. Recognition criteria
9. Measurement basis and
techniques
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-7
What are GPFRs and reporting entities?
SAC1—Definition of the Reporting Entity
• Defines general-purpose financial reports (GPFRs)
– reports intended to meet the information needs common to
users who are unable to command the preparation of reports
tailored to their specific needs
– GPFRs to be produced by entities who have users who
cannot command the preparation of specific information
 Such entities are deemed to be ‘reporting entities’
 If an entity is not deemed to be a ‘reporting entity’ it will not be
required to produce GPFRs—and not necessarily be required to
comply with all accounting standards
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-8
Reporting entity (cont.)
Factors that may indicate a reporting entity
• Separation of management from those with an economic interest
in the entity
• Economic or political importance/influence
• Financial characteristics of an entity
–
–
–
–
–
amount of sales
value of assets
extent of indebtedness
number of customers
number of employees
• Small proprietary companies are frequently not considered to be
reporting entities—it is assumed that most people who require
financial information about the entity will be in a position to
specifically demand it
• We must understand the implications of being deemed to be a
reporting entity
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-9
Objectives of GPFRs
SAC2—Objective of GPFRs
• To provide relevant and reliable information to assist
users to make and evaluate decisions about the
allocation of scarce resources and to allow
management and governing bodies to discharge their
accountability
• Defines users of GPFRs
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-10
Qualitative characteristics of financial
reporting (cont.)
•
•
•
Previously covered by SAC3 – now addressed in The
Framework
Identifies the characteristics of financial information
necessary to allow users to make and evaluate
decisions about the allocation of scarce resources
Four principal characteristics of financial reporting
identified in AASB Framework:
1.
2.
3.
4.
understandability
relevance
reliability
comparability
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Slides prepared by Craig Deegan
2-11
Qualitative characteristics (cont.)
•
•
Understandable – to whom? What is the expectation
about accounting proficiency?
Relevance
– if information influences decisions about the allocation of
scarce resources
– consider relationship to concept of ‘materiality’ (consider
materiality thresholds shortly)
•
Reliability
– faithfully represents the entity’s transactions and events
– free from bias
– free from undue error
•
Comparability
across time and across organisations
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2-12
Qualitative characteristics (cont.)
• Relevant and reliable information is also subject to the
test of materiality
– omission, misstatement or non-disclosure can affect decision
making (AASB Framework, par. 30)
– definition of materiality consistent with AASB 1031 ‘Materiality’
– tests for materiality provided in AASB 1031 (par. 13)
– guidelines for materiality:
 An amount equal to or greater than 10% of the appropriate base
amount is considered material
 An item that is equal to or less than 5% of the appropriate base
amount not considered material
 Between 5 and 10%—grey area where professional judgment
required
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-13
Relevance versus reliability
• Is one more important than the other?
• Is there a trade-off between the two?
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-14
Elements of accounting
• Five elements of accounting are defined in the AASB
• Framework
–
–
–
–
–
assets
liabilities
equity
expenses
income
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2-15
Elements (cont.)
Definition and recognition of assets
• Assets are defined as (AASB Framework, par. 49)
– 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
•
Three key characteristics of definition:
1. There must be future economic benefits
2. The reporting entity must control the future economic
benefits
3. The transaction or other event giving rise to the control must
have occurred
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-16
Elements (cont.)
Definition and recognition of assets (cont.)
• An asset is to be recognised in the financial statements if (AASB
Framework. par. 83)
– it is probable that any future economic benefit associated with the
asset will flow to or from the entity; and
– the item has a cost or value that can be measured with reliability.
• ‘Probable’ not defined in AASB Framework but SAC4 (par. 40)
defines it as ‘more likely rather than less likely’
• If an asset or other element fails to meet the recognition criteria in
one period but satisfies them in another period, the asset can be
reinstated (subject to requirements in particular accounting
standards)—AASB Framework (par. 87)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-17
Elements (cont.)
Definition and recognition of liabilities
• Liabilities defined as (AASB Framework, par. 49)
– 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
•
There are three main characteristics
1. there must be a future disposition or sacrifice of economic
benefits to other entities
2. it must be a present obligation
3. a past transaction or other event must have created the
obligation
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-18
Elements (cont.)
Definition and recognition of liabilities (cont.)
• Recognition in financial statements consistent with
those of assets—AASB Framework (par. 91)
– a liability is recognised in the balance sheet when it is
probable that an outflow of resources embodying economic
benefits will result from the settlement of a present obligation
and the amount at which the settlement will take place can be
measured reliably
• Where a liability cannot be reliably measured but is
potentially material, the liability should be disclosed
within the notes to the financial statements
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-19
Elements (cont)
• What is a contingent liability and how is it different to a
liability?
• How would we disclose contingent liabilities?
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
2-20
Elements (cont.)
Definition and recognition of expenses
• The definition is dependent upon the definition of
assets and liabilities
• Expenses are defined as (AASB Framework, par. 70):
– 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 equity participants
• Usual tests of probability and measurability apply
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2-21
Elements (cont.)
Definition and recognition of expenses (cont.)
• Expenses are recognised in the income statement
when (AASB Framework, par. 94):
– a decrease in future economic benefits related to a decrease
in an asset or an increase in a liability has arisen that can be
measured reliably
• If a resource is used up or damaged by an entity but
that entity does not control the resource (not an asset
of the entity), to the extent that no liabilities or fines are
imposed, no expenses will be recorded by the entity
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
2-22
Elements (cont.)
Definition and recognition of income
• Again, the definition is dependent on those of ‘asset’
and ‘liability’
• Income defined as (AASB Framework, par. 70)
– 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
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Elements (cont.)
Definition and recognition of income (cont.)
• Income can be recognised in the financial statements
when
– it is probable that the inflow or other enhancement or saving in
outflows has occurred; and
– the inflow or other enhancement or saving in outflows of
economic benefits can be measured reliably
Copyright  2007 McGraw-Hill Australia Pty Ltd
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2-24
Elements (cont.)
Definition and recognition of income (cont.)
• ‘Revenues’ and ‘gains’ distinguished in AASB
Framework
– revenue arises in the course of the ordinary activities of an
entity and includes: sales, fees, interest, dividends, royalties,
and rent
– gains represent other items that meet the definition of income
and might or might not arise in the ordinary activities of an
entity, e.g. disposal of non-current assets
– some professional judgment is required to determine whether
a component of income should be classified as revenue or a
gain
Copyright  2007 McGraw-Hill Australia Pty Ltd
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2-25
Elements (cont.)
Definition of equity (AASB Framework, par. 49)
– residual interest in the assets of the entity after deducting
all of its liabilities
• Directly a function of the definitions given to assets
and liabilities
• No need for separate recognition criteria for equity
Copyright  2007 McGraw-Hill Australia Pty Ltd
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2-26
Implications of convergence with IFRSs
for our Conceptual Framework
• Standards issued by IASB are developed to be
consistent with the IASB Framework
• As we are embracing IASB standards, we must adopt
the IASB Framework
• IASB Framework has no equivalent for SAC1 or SAC2
• AASB retained (for the time being), SAC1 and SAC2
• IASB Framework adopts definition of ‘reporting
enterprise’—a narrower definition than that of
‘reporting entity’
• The Framework is currently in a period of
redevelopment so more changes to be expected
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-27
Critical review of conceptual
frameworks
• Objective of GPFRs in SAC2 implies that reports
should be primarily economic in focus
– should social issues be ignored in the annual report?
• An individual's view of business responsibilities
directly impacts on the perceptions of accountability
• In determining whether or not an entity is a reporting
entity, is the need for information to enable informed
‘resource allocation decisions’ the only or dominant
consideration?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-28
Critical review of conceptual
frameworks (cont.)
• Economic focus of GPFRs ignores transactions or
events not resulting from market transactions or an
exchange of property rights
• Ignores environmental externalities caused by
business
• Financial statements included within reports reflect
only financial performance and do not provide a
means of assessing social performance
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-29
Critical review of conceptual
frameworks (cont.)
• Financial press also generally use financial indicators
as a guide to a firm’s success
It has been argued that
• Conceptual frameworks simply codify existing practice
• Conceptual frameworks have been used as devices to
legitimise the existence of the accounting profession
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2-30