8 TA Normative —the Case of Conceptual Framework Projects

ACCOUNTING Financial and Organisational Decision MakingCopyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan
5.*
Normative theories of accounting—the case of conceptual framework projects
Slides written by Michaela Rankin
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
PPT t/a Carnegie et al; Financial and Organisational Decision Making
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
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
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’
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
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
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
History of the development
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
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
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
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
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
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
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
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
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
elements of financial statements
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
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
Special purpose financial reports
special purpose reports are provided to meet the information demands of a particular user, or group of users
Entities required to
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)
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
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
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
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
Users of financial reports
resource providers
recipients of goods and services
customers and beneficiaries
parliaments, governments, regulatory agencies, analysts, labour unions, employer groups, media and special interest groups
International perspectives
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
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...
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
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
Reliability—implications
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
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
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
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
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
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
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)
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
Five elements of financial reporting in Australia
Assets
liabilities
equity
expenses
revenues
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:
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
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
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
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)
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
Recognition of liabilities
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
Approaches to determining profit
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
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
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
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)
Definition of revenues— continued
Within Australian and IASC approaches, revenues can be recognised from normal trading relations, as well as from non-reciprocal transfers such as grants, donations, bequests, or where liabilities are forgiven.
FASB definition restricts revenues to transactions relating to ongoing major or central operations
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
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
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
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
Benefits associated with
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
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
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

8 TA Normative —the Case of Conceptual Framework Projects

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