In Chapter 3 we established that accounting theory consti tutes
the frame of reference on which the development of accounting
techniques is based
In Chapter 3 we established that accounting theory constitutes
the frame of reference on which the development of accounting
techniques is based. This frame of reference, in turn, is based
primarily on the establishment of accounting concepts and
principles. Of vital importance to the accounting discipline is
that the accounting profession and other interest groups accept
these concepts and principles. To ensure such consensus, a
statement of the reasons or objectives that motivate the
establishment of the concepts and principles must be the first step
in the formulation of an accounting theory.
A statement of the objectives of financial statements has always
been recognised as urgent and essential if debate over alternative
standards and reporting techniques is to be resolved by reason and
logic. For example, in 1960, Devine argued that:
... the first order of business in constructing a theoretical
system for a service function is to establish the purpose and the
objectives of the function. The objectives and purposes may shift
through time, but for any period, they must be specified or
specifiable.'
Watts and Zimmerman note that financial accounting theory has
had little substantive, direct impact on accounting theory and
practice, and offer the following explanation:
Often the lack of impact is attributed to basic methodological
weaknesses in the research. Or, the prescriptions offered are based
on explicit or implicit objectives that frequently differ from
writers. Not only are the researchers unable to agree on the
objectives of financial statements, but they also disagree over the
methods of deriving the prescriptions from the objectives.2
Aware of their importance, the accounting professions in
Australia, the United States, the United Kingdom and Canada have
made various attempts to formulate the objectives of financial
statements. In Australia, the accounting profession has formalised
the objectives of financial statements in the release of various
discussion papers and in Statements of Accounting Concepts (SACs).
Together, the SACs represent the Australian conceptual framework or
constitution for financial reporting. In the United States, the
importance of the development of financial statements objectives
was first expressed by the report of the Study Group on the
Objectives of Financial Statements,3 and later in the attempts of
the FASB to develop a conceptual framework4 In the United Kingdom,
the importance of these objectives was highlighted by the
publication of The Corporate Report by the Institute of Chartered
Accountants in England and Wales'> In Canada, interest in the
subject resulted in the publication of Corporate Reporting: Its
Future Evolution.6 Although relatively recent, all of these efforts
have been directly influenced by Chapter 4 of APB Statement No.4
'Basic Concepts and Accounting Principles Underlying Financial
Statements of Business Enterprises'. 7
In this chapter, we will elaborate on the attempts by the AARF,
the AASB and the accounting profession to formulate the objectives
of financial statements and to develop a conceptual framework for
financial reporting in Australia. Emphasis is also given to the
conceptual framework in the United States because developments in
this jurisdiction proved influential on the development of the
Australian SACs. Furthermore, this chapter considers the
development of conceptual framework projects in the United Kingdom
and Canada.
5.1 The search for a conceptual framework: historical
origins
In its simplest form a conceptual framework is a formal set of
interrelated concepts that specify the function, scope and purpose
of financial accounting and reporting. A conceptual framework can
be descriptive, prescriptive or a mixture of both. A descriptive
framework is one that attempts to develop a set of interrelated
concepts which serves to codify and explain existing financial
reporting practices. A prescriptive framework is one that attempts
to develop a conceptual basis for what financial accounting
practices should or ought to be. In other words, it seeks to modify
or change existing accounting practices. It will be seen that the
level of description and prescription applied in various conceptual
framework projects tends to vary across different accounting
jurisdictions.
Concern with a conceptual framework that would guide company
financial reporting practices and accounting standard setting has
occupied the attention of professional accountants, academics and
regulators for over fifty years. Historically considered, the Wall
Street crash in 1929 has had much to do with a professional push
for a conceptual framework. The share market crash resulted in an
international economic depression and the collapse of numerous
companies worldwide. Professional accountants in the United States,
and to a lesser extent in the United Kingdom, were criticised and
assigned considerable blame for the events of 1929. These
criticisms related to a lack of self-regulation on the part of the
profession. There was also much criticism of permissive accounting
practices adopted by accountants during the 1920s, especially in
connection with the notorious asset valuation practices of this
period. 8
Nevertheless, around 1953 the Roosevelt administration envisaged
a great potential for the accounting profession to participate in
national economic recovery. Moreover, it was recognised that
professional accountants, by producing reliable company financial
reports and adopting consistent accounting practices, could help
restore investor confidence in the nation's shattered capital
markets.9 The needs of the Roosevelt administration and the
aspirations of the accounting profession were well synchronised.
Following the events of 1929, the accounting profession in the
United States experienced one of the most introspective phases of
its history. Prominent leaders within the profession, notably Eric
Kohler and George O. May, were conscious of the need to establish
the basic principles on which company reports were based, to
correct the permissive accounting practices of the 1920s and to
reaffirm public and investor confidence in professional
accountants. There was a consensus at this time that improved
financial reporting by companies and the development of coherent
set of accounting principles and concepts was a pivotal factor in
creating this confidence, This resulted in the American accounting
profession sponsoring a number of research initiatives to identify
and codify the accounting principles and concepts underlying
financial accounting practices and reports. This was exemplified by
the 1936 publication of 'A Tentative Statement of Accounting
Principles Affecting Corporate Financial Reports' by the American
Accounting Association, largely under the influence of its
president, Eric Kohler. This early statement anticipated future
research and policy positions of the profession. It also stated a
desire on the part of the profession to distance itself from the
'valuation follies' of the 1920s. To some extent the accounting
profession achieved this objective by establishing the historical
cost principle as the cornerstone of financial accounting
practice.
This was expanded further in the classic studies of Sanders,
Hatfield and Moore, Paton and Littleton, and further still in
Littleton's treatise on accounting principles 'Structure of
Accounting Theory'. 10.11,12 Since these formative efforts to
develop a coordinated body of accounting concepts and principles,
there has been a flurry of research interest devoted to
establishing a uniform and internally consistent body of accounting
theory to guide the development and implementation of accounting
practice and policy.
The first standard-setting body was established in 1936 when the
American Institute of Accountants formed a Committee on Accounting
Procedure. The Committee published accounting research and
terminology bulletins that provided authoritative opinions or
recommendations on preferred accounting practices. A less formal
standard-setting arrangement was observable in the United Kingdom,
where professional debate over preferred or 'best' accounting
practices had been in progress since the inception in 1871 of the
Institute of Accountants' prestigious journal, The Accountant.
Although the bulletins of the Committee on Accounting Procedure
provided recommended solutions to particular financial reporting
problems, they did not result in a conceptual framework. This
failure on the part of the committee was in fact much criticised,
and its authority in accounting matters was diminished.
By the mid-1950s, there was a good deal of academic and
professional opinion that stressed the inadequacies of company
financial reporting. The discontent arose from two directions.
First, the historical cost model, generally accepted in accounting
practice at this time, was not being applied consistently, nor were
the principles underlying historical cost accounting well
understood or properly explained in research writings.
Second, a tradition was developing amongst academics, including
some practitioners in the United States, that was against the whole
principle of historical cost accounting. For example, the early
studies of Sprague and Hatfield were critical of historical cost
accounting because the model did not reflect the economic reality
of changing price levels.13,14 The accounting profession rook steps
in this period to redress these concerns by sponsoring research
projects to consider some alternative accounting models or, at the
very least, make the historical cost model more logical and
internally consistent. On the whole, the accounting profession's
early attempts to redress criticism had met with some success. This
was partly due to the influence of Littleton's 1953 monograph,
which answered concerns about the internal consistency and logical
coherence of the historical cost model. In particular, Littleton
provided extensive justifications for its continued use.
Littleton's study, however, was insufficient to quell widespread
concerns that the historical cost model was flawed. It was not
until the early 1960s that this controversy would be addressed by
the accounting profession. The AICPA established the Accounting
Principles Board (APB) in 1959. The objective of the APB was, inter
alia, to accelerate the development of a conceptual framework.
Specifically, the APB set itself the following tasks:
1 to establish basic postulates;
2 to formulate a set of broad principles;
3 to establish rules to guide the application of principles in
specific situations; and 4 to base the entire program on
research.
The Accounting Research Division of the AICPA commissioned
studies by Moonitz, and Sprouse and Moonirz.l5,'6 It was hoped that
these studies would answer some specific problems and concerns on
the issue of changing price levels. These studies, intet alia,
proposed that the accounting profession adopt some form of current
cost accounting.
However, the works met with the same fare as previous current
cost studies, including Henry Sweeney's 'Stabilized Accounting' in
1936 and Hatfield's 'Modern Accounting' in 1928. The studies of
Moonitz, and Sprouse and Moonitz, were regarded as too radical and
normative in their approach. Subsequently, the APB recommended that
the objectives of accounting be defined in more descriptive terms.
In 1963, the APB commissioned Paul Grady to develop this more
descriptive framework. This approach was reflected in APB Statement
No.4, 'Basic Concepts and Accounting Principles Underlying
Financial Statements of Business Enterprises', which was based on
Grady's study and served to codify existing accounting practices.
Although Statement No.4 was basically descriptive, which diminished
its chances of providing the first accounting conceptual framework,
it did influence Australian attempts to formulate the objectives of
financial statements and to develop a basic conceptual framework
for the field of accounting. Chapter 4 of APB Statement No.4
classifies objectives as particular, general and qualitative, and
places them under a set of constraints.
The particular objectives of financial statements are to present
fairly and in conformity with generally accepted accounting
principles, financial position, results of operations and other
changes in financial position.
2 The general objectives of financial statements are:
a To provide reliable information about the economic resources
and obligations of a business enterprise in order to:
i evaluate its strengths and weaknesses; ii show its financing
and investments;
iii evaluate its ability to meet its commitments; and iv show
its resource base for growth.
b To provide reliable information about changes in net resources
resulting from a business enterprise's profit-directed activities
in order to:
i show ex peered dividend return to investors;
ii demonstrate the operation's ability to pay creditors and
suppliers, provide jobs for employees, pay taxes and generate funds
for expansion;
iii provide management with information for planning and
control; and iv show its long-term profitability.
C To provide financial information that can be used to estimate
the earnings potential of the firm.
d To provide other needed information about changes in economic
resources and obligations.
e To disclose other information relevant to statement users'
needs. 3 The qualitative objectives of financial accounting
are:
a relevance. which means selecting the information most likely
to aid users in their economic decisions;
b understandability, which implies not only that selected
information must be intelligible, bur also that the users can
understand it.;
C verifiability, which implies that the accounting results may
be corroborated by independent measures, using the same measurement
methods;
d neutrality, which implies that the accounting information is
directed toward the common needs of users, rather than the
particular needs of specific users;
e timeliness. which implies an early communication of
information, to avoid delays in economic decision making;
comparability, which implies that differences should not be the
result of different financial accounting treatments; and
9 completeness. which implies that all the information that
'reasonably' fulfils the requirements of the other qualitative
objectives should be reported.
The objectives expressed by APB Statement No.4 appear to provide
a rationale for the form and content of conventional financial
reports. The statement even admits that the particular objectives
are stated in terms of accounting principles that are generally
accepted at the time the financial statements are prepared. It is
noteworthy that the general objectives fail to identify the
informational needs of users. The statement implicitly recognises
these limitations when it admits that 'the objectives of financial
accounting and financial statements are at least partially achieved
at present'. Despite these limitations, APB Statement No.4 has been
a necessary step toward the development of a more consistent and
comprehensive structure of financial accounting and of more useful
financial information, both in the United States and elsewhere. In
1973, the APB was replaced by the FASB, which continued and
extended the conceptual framework project initiated by the APB.
ill- The Australian conceptual framework: background and
issues
In Australia, the development of a conceptual framework followed
a similar pattern to that of the United States. The Australian
accounting profession also recognised the need to develop a system
of coordinated concepts and objectives which would guide the
development of consistent and improved accounting practices. The
absence of what Paton and Littleton called 'a coherent,
coordinated, consistent body of doctrine' within which to develop
accounting standards was widely believed to be a cause of perceived
inconsistencies and inadequacies in Australian accounting
practices, particularly during the 1960s and beyond. 17 When the
FASB accelerated work on the development of a conceptual framework,
the Australian profession followed suit. However, because the
conceptual framework project had already been in motion in the
United States for some time, the Australian accounting profession
was in a position to evaluate and adapt APB and FASB initiatives
for Australian conditions.
In a similar vein to the works of Sprouse and Moonitz,
Australian academics such as Mathews and Grant, 18 and Chambers, 19
were also conscious of the problem of changing price levels and
proposed that the accounting profession abandon the conventional
historical cost system in favor of some form of current cost
accounting system. Chambers was particularly forceful in his
criticisms of the inconsistencies and conceptual deficiencies
underpinning the historical cost mode1.20 Largely as a response to
this academic push the accounting profession commissioned John
Kenley, the then director of the Accountancy Research Foundation
(later reconstituted as the AARF), to adapt the AICPA studies of
Paul Grady to Australian conditions. This adaptation by Kenley was
followed by a further study by Kenley and Staubus2122 While the
study was intended to be an Australian adaptation of APB Statement
No.4, the book ended up adopting a largely prescriptive approach to
accounting concepts and objectives. The adoption of this more
normative or prescriptive approach represented a fundamental
departure from the United States model, which has attempted to
blend descriptive and prescriptive elements to enhance the
operationality and general acceptance of their conceptual
framework. In hindsight, the works of Kenley and Kenley and Staubus
have proved very influential as the AARF to this day have persisted
with the development of a largely prescriptive framework.However,
the Australian conceptual framework did not make significant
progress until the 1980s. One reason for the tardiness is that
during the 1970s standard-setters were preoccupied with the issue
of current cost accounting. As we will see in Chapter 12, this was
a period when current cost accounting attracted considerable
interest and debate among academics, international standard-setting
bodies and some practitioners. During the 1970s, standard-setters
expended considerable resources to develop comprehensive current
cost regulations for Australian companies. However, in the late
1970s and early 1980s, it became apparent that the AARF's current
cost initiatives were not welcomed by the industry. This caused the
AARF to refocus its attention on a narrower range of topics,
including the conceptual framework. The Australian strategy to
develop a conceptual framework has been stated by a previous
director of the AARF.23 The elements of this strategy included the
following:
1 The use of FASB thinking would be maximised.
2 The importance of a conceptual framework would not be
over-sold, but unveiled gradually.
3 The first stage of development would be the tentative
identification of the building blocks of a workable framework.
4 The second stage would be the selection of certain building
blocks to formalise specific projects.
5 The third stage would be the investigation of
interrelationships between the building blocks and any
consequential redefinition of those blocks.
6 The fourth stage was to be the commissioning of projects for
the remaining blocks. 7 Publication of Statements of Accounting
Concepts would begin.
The AARF kept to its game plan. In the late 1980s, six exposure
drafts were released for public comment. Exposure drafts ED 42A
(objectives of financial reporting), ED 42B (qualitative
characteristics of financial information), ED 42C (definition and
recognition of assets) and ED 42D (definition and recognition of
liabilities) were all released simultaneously in December 1987.
Exposure drafts ED 46A (definition of the reporting entity) and ED
46B (definition and recognition of expenses) were released together
in May 1988. Exposure drafts ED 51A (definition of equity) and ED
51B (definition and recognition of revenues) were released in
August 1990. All these exposure drafts were preceded by discussion
papers and accounting theory monographs commissioned by the AARF
from academics within Australia and overseas. Furthermore, in
August 1990, three 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'.
In the early 1990s, the development of a conceptual framework
was given greater momentum by certain amendments to Australian
corporations law. In addition to developing accounting standards,
Section 226(1) of the Corporations Law (1991) specifically charged
the AASB with the responsibility of developing a conceptual
framework for financial reporting. This gave added authority to the
AARF to develop further SACs. The controversial SAC 4, 'Definition
and Recognition of Elements of Financial Statements' (which
combined exposure drafts ED 42B-D, ED 46B and ED 51A-B), was
released in March 1992, but was amended in March 1995. (Both
versions of SAC 4 will be discussed in this chapter) SAC 4
specifies the definition of and rules for the recognition of
assets, liabilities, equity, revenues and expenses in the financial
reports of companies. The first release of SAC 4 in 1992 symbolised
the AARF's ideological commitment to a largely prescriptive or
normative conceptual framework. Implicit in the requirements of
SAC 4 would be significant departures from conventional accounting
practices. (In a later seer ion we will show that Australia's
experimentation with a radical prescriptive framework has been
vigorously challenged by companies and other interest groups in the
past two years.) The corporate backlash to SAC 4 resulted in the
mandatory status of the SACs being withdrawn in December 1993,
followed by significant amendments to the Statement. The SACs had
initially been made mandatory under APS 1 'Conformity with
Statements of Accounting Concepts and Standards' and AASB Release
100 'Nature of Approved Accounting Standards and Statements of
Accounting Concepts and Criteria for the Evaluation of Proposed
Approved Accounting Standards'.
Finally, it should be noted that the Australian conceptual
framework is still evolving.
Important aspects of the framework, particularly in the areas of
measurement and the scope of financial reporting, are yet to be
addressed by the AARF and its Boards.
The nature and goals of a conceptual framework
Standard-setters in Australia, the United States and elsewhere
have given explicit justifications fot theit respective conceptual
framework projects. For example, in the process of embarking on a
conceptual framework project, the FASB (as did the AASB)
acknowledged the erosion of the credibility of financial reporting
in recent years and specifically criticised the following
situations:
t Two or more methods of accounting are accepted for the same
facts.
t Less conservative accounting methods are being used rather
than the earlier, more conservative methods. t Reserves are used to
artificially smooth earning fluctuations.
t Financial statements fail to warn of impending liquidity
crunches. t Deferrals are followed by 'big bath' write-offs.
t Unadjusted optimism exists in estimates of recoverability.
t Off balance-sheet financing (that is, disclosure in the notes
to the financial statements) is common.
t An unwarranted assertion of immateriality has been used to
justify non-disclosure of unfavorable information or departures
from standards.
t Form is relevant over substance.24
Standard-setting bodies have attracted particular criticism
because they are authorities charged with the primary
responsibility for promoting 'best' financial reporting practices.
The absence of a coherent and rigorous body of accounting theory to
guide accounting practice has been seen as a major factor leading
to a de-professionalisation of accounting in different
jurisdictions.25 Gerboth notes: 'suffice it to say that accounting
is now painfully self-conscious about the intellectual standing of
its reasoning process,26
The FASB and the AASB have instituted conceptual framework
projects to correct some of these situations and to provide a more
rigorous way of setting standards and increasing financial
statement users' understanding and confidence in financial
reporting. The FASB described a conceptual framework as
follows:
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
objectives identity the goals and the purposes of accounting. The
fundamentals are the underlying concepts of accounting - concepts
that guide the selection of events to be accounted for, the
measurement of those events and the means of summarizing and
communicating to interested parties. Concepts of that type are
fundamental in the sense that other concepts flow from them and
repeated references to them will be necessary in establishing,
interpreting and applying accounting and reporting standards.27
The conceptual framework, therefore, is intended to act as a
constitution for the standard-setting process. The AARF's Guide to
Proposed Statements of Accounting Concepts (issued in December 1987
with Series 1 of the proposed Statements of Accounting Concepts),
defines the conceptual framework in similar terms: 'a set of
inter-related concepts which will define the nature, subject,
purpose and broad content of financial reporting. It will be an
explicit rendition of the thinking which is governing the
decision-making of (standard-setters).'
5.2.1Advantages of a conceptual framework
The AASB and the AARF expect the conceptual framework to have a
number of advantages28 The framework is perceived to be
particularly useful in the development of more consistent and
logical standards and in removing the necessity to re-debate
conceptual issues when preparing new accounting standards.
Furthermore, the issue of standards 'overload' can be potentially
reduced because a conceptual framework can enable resolution of
particular accounting problems which avoids the necessity of
issuing new accounting standards. A conceptual framework can also
lead to better communication among accountants, auditors and users
because all parties would be using a common set of definitions and
criteria. Another potential benefit of a conceptual framework is
that it can potentially reduce the activities of lobbies and
interests groups (who may have self-serving motivations) in
attempting to influence the standard-setting process. 29 As
suggested by Solomons, conflicts between economic interests could
be avoided if the theoretical foundations of accounting were more
soundly based. 30
A conceptual framework can also lead to specific improvements in
accounting practice and financial reporting by companies. For
example, comparability in company financial reports can be enhanced
by a reduction in the amount of accounting alternatives available
to preparers.
The AARF's Guide to Proposed Statements of Accounting Concepts
explicitly states the potential benefits of the conceptual
framework as follows:
(a) reporting requirements should be more consistent and
logical, because they will stem from an orderly set of
concepts;
(b) avoidance of reporting requirements will be much more
difficult because of the existence of all-embracing provisions;
(c) the Boards which set down the requirements will be more
accountable for their actions in that the thinking behind specific
requirements will be more explicit, as will any compromises that
may be included in particular accounting standards;
(d) the need for specific accounting standards will be reduced
to those circumstances in which the appropriate application of
concepts is not clear-cut, thus mitigating the risks of
over-regulation;
(e) preparers and auditors should be able to better understand
the financial reporting requirements they face; and,
(f) the setting of requirements should be more economical
because issues should not need to be re-debated from differing
viewpoints.
5.2.2 Strategic objectives for a conceptual framework
Political motivations and pressures for a conceptual framework
also need to be considered. Literature indicates that conceptual
framework projects have been developed as an instrument for the
self-preservation of the accounting profession. That is,
standard-setters assert their authority and legitimacy in setting
accounting standards as a defensive measure against public
criticism of the profession. 31 Hines, for instance, asserted that
conceptual framework projects are undertaken as a 'strategic
manoeuvre to assist in socially constructing the appearance of a
coherent differentiated knowledge base for accounting standards,
thus legitimising standards and the power, authority and
self-regulation of the accounting profession'. 32 One test Hines
used to determine whether conceptual framework projects can more
appropriately be viewed as technical enterprises or as strategic
manoeuvres was to ascertain whether these projects were undertaken
at times of threat to their legitimacy (public criticism of
accounting standards and/or company financial reporting
deficiencies), or at times of competition from other regulators
(possible intervention by government, stock exchange regulations).
Hines concludes:
A brief study of the countries and circumstances of the
conceptual framework projects suggested that the major rationale
for undertaking conceptual frameworks was not functional or
technical, it was a strategic manoeuvre for providing legitimacy ro
standard-setting boards during periods of competition or threatened
government intervention33
The same conclusion was forged by Dopuch and Sunder, who argued
that disagreements which are centred on diverse accounting
standards are always the target of public criticism of the
profession and threaten their authority and control over the
standard-setting process.''! Solomons noted that ' ... an
explicitly theoretical foundation is an indispensable defence
against political inrerference,.35 Horngren suggests that: 'The
more plausible the assumptions and the more compelling the analysis
of the facts, the greater the chance of winning support of diverse
interests- and retaining and enhancing the Board's (FASB)
power,.36
Finally, although preparers, auditors and external users are
expected to gain from the conceptual framework, it appears that
standard-setters are likely to be the primary beneficiaries.37
However, whether the conceptual framework can achieve some or all
of its stated benefits will depend heavily on the ultimate
acceptance of the framework by the Australian business community
and other commercial interest groups. Later we will see that some
essential features of the Australian conceptual framework have been
strongly criticised by commercial interests. Furthermore, the
AARF's future position on more contentious issues, notably
measurement in the financial statements, will undoubtedly attract
opposing positions and viewpoints from within the business
community. These issues are important for evaluating the present
and future viability of conceptual framework projects.
5.3 Classification and conflicts of interest
Formulating the objectives of accounting depends on resolving
the conflicts of interest that exist in the information marker.
More specifically, financial statements result from the interaction
of three groups: firms, users and the accounting profession38
t Firms comprise the main party engaged in the accounting
process. By their operational, financial and extraordinary (that
is, non-operational) activities, they justify the production
of financial statements. Their existence and behavior produce
financial results that are partly measurable by the accounting
process. Firms are also the preparers of accounting
information.
t Users comprise the second group. The production of accounting
information is influenced by their interests and needs. Although it
is not possible ro compile a complete list of users, the list would
include investors, financial analysts, bankers, creditors,
consumers, employees, suppliers and governmental agencies.
t The accounting profession constitutes the third group that may
affect the information to be included in financial statements.
Accountants act principally as 'auditors' in charge of verifying
that financial statements conform to generally accepted accounting
principles.
Following Cyert and Ijiri's analysis, the interaction between
these three groups may be
represented by a Venn diagram, as shown in Exhibit 5.1, where
circle U represents the interests of the users in the information
deemed useful for their economic decision making, circle C
represents the set of information that corporations publish and
disclose (whether or not it is within the boundaries of generally
accepted accounting principles) and circle P represents the set of
information that the accounting profession is capable of producing
and verifying. The area labelled I represents the set of
information that is acceptable to all three groups. In other words,
these data are disclosed by the firm, accountants are capable of
producing and verifying them and they are perceived as relevant by
users. Areas II-VII represent areas of conflicts of interest.
Given these conflicts, Cyert and Ijiri examine three possible
approaches to the formulation of accounting objectives. The first
approach considers the set of information that the firm is ready to
disclose and attempts to find the best means of measuring and
verifying it. (In other words, circle C is kept fixed and circles P
and U are moved toward it.) The second approach considers the
information that the profession is capable of measuring and
verifying and attempts to accommodate users and firms through
various accounting options. (In other words, circle P is kept fixed
and circles C and U are moved toward it.) The third
approach views the set of information deemed relevant by users
as central and encourages the profession and the firms to produce
and verify that information. (In other words, circle U is kept
fixed and circles P and C are moved toward it.)39
Stated simply, the first approach is firm-oriented, the second
approach is profession-oriented and the third approach is
user-oriented. Needless to say, given the dominance of the
political and legislative approaches to the formulation of an
accounting theory, as we saw in Chapter 3, the user-oriented
approach will prevail when future objectives of financial
statements are formulated. In fact, the user-oriented approach is
employed by the SACs in Australia, the FASB in the United States
and The Corporate Report in the United Kingdom.
The structure of the conceptual framework
Conceptual framework issues
In the process of developing a conceptual framework, the AARF
and its Boards have had to resolve and take an explicit position on
a number of fundamental conceptual issues that would determine the
nature and content of the SACs.' These issues are now
discussed.
Issue 1. Balance sheet versus profit and loss account
orientation
There are two distinct approaches to determining an entity's
income during a reporting period: t the asset/liability view; and t
the revenue/expense view.
The asset/liability view, also called the balance-sheet or
capital-maintenance view, maintains that revenues and expenses
result only from changes in the values of assets and liabilities.
Revenues represent increases in assets and decreases in
liabilities; expenses are decreases in assets and increases in
liabilities. Some increases and decreases in net assets are
excluded from the definition of income - namely, capital
contributions, capital withdrawals, corrections of income of prior
periods and, depending on the concept of capital maintenance
adopted, holding gains and losses. The asset/liability view should
not be interpreted as an abandonment of the matching principle. In
fact, matching revenues and expenses result from clear definitions
of assets and liabilities.
The revenue/expense view, also called the profit and loss
account or matching view, holds that revenues and expenses result
from the need for a proper matching. This view of income is
transaction based, as revenues are only recognised when realised
through a sales transaction. Income is merely the difference
between revenues in a period and the expenses incurred in earning
those revenues. Matching, the fundamental measurement process in
accounting, comprises two steps: 'Most of these issues had already
been given detailed consideration by the FASB in its Discussion
Memorandum 'Conceptual Framework for Financial Accountmg and
ReportlOg: Elements of Financial Statements and Their Measuremenf
(1976).
The FASB also specifically considered a third option - the
'non-articulated' view. For both the asseVliability view and the
revenue/expense view, the statement of earnlOgs 'articulates' with
the statement of financial position, in the sense that they are
both part at the same measurement process. The difference between
revenues and expenses is also equivalent to the increase in net
capital.
The non-articulated view is based on the beliet that
articulation leads to redundancy, 'since all events reported in the
profit and loss statement are also reported 10 the balance sheet,
although from a different perspective'. According to this view, the
definitions of assets and liabilities may be critical In the
presentation of flOancial position and the definitions of revenues
and expenses may dominate the measurement of earnings. The two
financial statements have independent existence and meanings;
therefore, different measurement schemes may be used for them. An
example of the non-articulated view would be the use of LIFO in the
Income statement and of FIFO in the balance sheet. The
non-articulated view has gained some ground recently. In facf, the
Amencan Accounting AssoCiation's Statement of Basic Accounting
Theory criticises articulation:
We find no logical reason why external finanCial reports should
be expected to 'balance' or articulate with each other. In fact, we
find that forced balancmg and articulation have frequently
restricted the presentatIon of relevant Information. The important
guide should be the disclosure of all relevant information with
measurement procedures that meet the other standards suggesfed in
ASOBAT [A statement of Basic Accounting Theory].1 revenue
recognition or timing through the realisation principle; 2 expense
recognition in three possible ways:
a associating cause and effect, such as for cost of goods sold;
b systematic and rational allocation, such as for depreciation;
c immediate recognition, such as for selling and administrative
costs.
Thus, contrary to the asset/liability view, the revenue/expense
view primarily emphasises measuring the income of the firm and not
the increase or decrease in the value of net assets. Assets and
liabilities, including deferred charges and credits, are considered
residuals that must be carried to future periods in order to ensure
proper matching and to avoid distortion of income.
Which view of profit should be adopted as the basis of a
conceptual framework for financial accounting and reporting) The
choice between these two views rests on which view constitutes the
fundamental measurement process. 401 measurement of the attributes
of assets and liabilities and changes in them; or 2 the matching
process.
If measurement of the attributes of assets and liabilities and
changes in them is deemed the fundamental measurement process (as
in the asset/liability view), then income is only the consequence
and the result of changes in the value of assets and liabilities.
On the other hand, if the matching process is deemed the
fundamental measurement process (as in the revenue/expense view),
then changes in assets and liabilities are merely the consequences
and results of revenues and expenses. A major criticism of the
revenue/expense orientation is that it has led to the recognition
in the statement of financial position of such items as 'deferred
charges', 'deferred credits' and 'reserves', which do not represent
economic resources and obligations but which are necessary to
ensure a proper matching of costs and revenues in the income
determination process. Furthermore, the revenue/expense view places
much emphasis on the importance of the historical cost and revenue
realisation principles. As we will see in Chapters 12-14, this
approach has been criticised for undermining the relevance of the
balance sheet to users.
The asset/liability view would exclude debit and credit items
(as result, for example, in intra-period tax allocation) because
they do not constitute economic benefits or resources available to
the entity. By rejecting these items in the balance sheet, the
asset/liability view faces a major criticism, which concerns its
unwillingness to recognise as revenues and expenses anything except
current changes in economic resources and obligations to transfer
resources, making it incapable of dealing with the complexities of
the modern business world.
A choice between these views would provide not only an
underlying basis for a conceptual framework for financial
accounting and reporting but also definitions of the elements of
financial statements.
Issue 2. Definition of assets. liabilities. equity. revenues and
expenses
Definitions of each element of financial statements may be
provided by both the asset/liability view and the revenue/expense
view.
According to the asset/liability view, assets are the economic
resources of a firm; they represent future benefits that are
expected to result directly or indirectly in a positive net cash
inflow. Alternatively, we may exclude from the definition of
'assets' economic resources that do not have the characteristics of
exchangeability or severability. In either case, based on
the asset/liability view, assets are restricted to
representations of economic resources of the firm. The economic
resources of the firm are:
1 productive resources of the enterprise
2 contractual rights to productive resources 3 products
4 money
5 claims to receive money
6 ownership interests in other enterprises. 41
According to the revenue/expense view, assets include not only
the assets defined from the asset/liability viewpoint, bur also all
items that do not represent economic resources bur are required for
proper matching and income determination.
A third view of assets arises from the perception of the balance
sheet not as a statement of financial position, bur as 'a statement
of the sources and composition of company capital'. According to
this view, assets constitute the 'present composition of invested
capital,42
If we exclude the problem of the element of 'deferred charges'
on the statement of financial position, the definitions of assets
presented in these three different views have the following
characteristics in common:
1 An asset represents potential cash flow to a firm. 2 Potential
benefits are obtainable by the firm.
3 The legal concept of property may affect the accounting
definition of assets.
4 The way an asset is acquired may be part of the definitions.
It may have been acquired in a past or current transaction or
event; the event includes either an exchange transaction, a
non-reciprocal transfer from owners or non-owners, or a windfall
and may exclude executory contracts.
5 Exchangeability may be an essential characteristic of
assets.
Which of these definitions or modifications of these definitions
should comprise the substance of a definition of 'assets' for a
conceptual framework for financial reporting) What is needed is a
definition that lends itself to the generality of application
required for a conceptual framework. Such a definition should take
into account the following characteristics:
1 An asset represents only economic resources and does not
include 'deferred charges'.
2 An asset represents potential cash flows to a firm.
3 Potential benefits are obtainable by the firm.
4 An asset represents the legal binding right to a particular
benefit, results from a past or current transaction and includes
all commitments, as in wholly executory contracts.
5 Exchangeability is not an essential characteristic of assets
except for 'deferred charges', in order to keep most intangibles as
assets and exclude 'deferred charges'.
The second element to be defined is liabilities. According to
the asset/liability view, liabilities are the obligations of the
firm to transfer economic resources to other entities in the
future. We may expand this definition to exclude items that do not
represent binding obligations to transfer economic resources to
other entities in the future.
According to the revenue/expense view, liabilities comprise not
only the liabilities defined from the asset/liability viewpoint bur
also certain deferred credits and reserves that do not represent
obligations to transfer economic resources bur that are required
for proper matching and income determination.
A third view of liabilities arises from the perception of the
balance sheet as 'a statement of the sources and composition of
company capital'. According to this view, liabilities con-
stitute sources of capital and include certain deferred credits
and reserves that do nor represent obligations to transfer economic
resources.
If we disregard the element of 'deferred credits', the
definitions of liabilities presented in these three different views
have the following characteristics in common:
1 A liability is a future sacrifice of economic resources.
2 A liability represents an obligation of a particular
enterprise. 3 A liability may be restricted to legal debt.
4 A liability results from past or current transactions or
events.
Which of these definitions or modifications of these definitions
should comprise the substance of a definition of , liabilities' for
a conceptual framework) As in the case of assets, what is needed is
a definition of liabilities that lends itself to the generality of
application required for a conceptual framework.
The third element to be defined is income. According to the
asset/liability view, income is the net assets of the firm except
for 'capital' changes. According to the revenue/expense view,
income results from the marching of revenues and expenses and,
perhaps, from the gains and losses. Gains and losses, therefore,
may be distinguished from the revenues and expenses, or they may be
considered part of them. Each possible component of income
(revenues, expenses, gains and losses) may be defined as
follows:
1 Revenues and expenses: according to the asset/liability view,
revenues, which encompass gains and losses, are defined as
increases in the assets or decreases in the liabilities that do nor
affect capital. Similarly, expenses, which encompass gains and
losses, are defined as decreases in the assets or increases in the
liabilities arising from the use of economic resources and services
during a given period.
According to the revenue/expense view, revenues, which encompass
gains and losses, result from the sale of goods and services and
include gains from the sale and exchange of assets other than
inventories, interests and dividends earned on investments and
other increases in owners' equity during a period ocher than
capital contributions and adjustments. Similarly, expenses comprise
all of the expired costs that correspond to the revenues of the
period. If gains and losses are defined as a separate element of
income, however, revenues are defined as measures of an entity's
outputs that result from the production or delivery of goods and
the rendering of services during a period. Similarly, expenses are
the expired costs corresponding to the revenues of the period.
Which of these definitions of income should comprise the
substance of 'revenues' and 'expenses' for a conceptual framework)
In other words, which definition lends itself to the generality of
application needed for a conceptual framework)
The definitions generated by the revenue/expense viewpoint rely
on a listing of all items that may be perceived as revenues or
expenses. First, such a list is nor necessarily exhaustive and
second, the items in the list may change. As a result, the
revenue/expense view of income and the ensuing definitions of
revenues and expenses may lack the generality of application needed
for a conceptual framework.
2 Gains and losses: according to the asset/liability view, gains
are defined as increases in net assets other than increases from
revenues or from changes in capital. Similarly, losses are defined
as decreases in net assets ocher than decreases from expenses or
from changes in capital. Thus, gains and losses constitute that
part of income nor explained by revenues and expensesAccording to
the revenue/expense view, gains are defined as the excess of
proceeds over the cost of assets sold, or as windfalls and other
benefits obtained at no cost or sacrifice. Similarly, losses are
defined as the excess over the related proceeds, if any, of all or
an appropriate portion of the costs of assets sold, abandoned, or
wholly or partially destroyed by casualty (or otherwise written
off), or as costs that expire without producing revenues. Thus,
according to the revenue/expense view, gains and losses are
independent from the definitions of other elements of financial
statements.
Which of these definitions of gains and losses contains the
generality of application required for a conceptual framework?
According to the revenue/expense view, the definitions are
independent of the definitions of the other elements and may, for
that reason, be viewed as lacking generality of application.
According to the asset/liability view, the definitions are derived
from the other definitions and emphasise the incidental nature of
gains and losses; they appear to contain the generality of
application required for a conceptual framework.
In any case, gains and losses may be either gains and losses
from exchanges, 'holding' gains and losses resulting from a change
in the value of assets and liabilities held by the firm, or gains
and losses from non-reciprocal transfers.
3 Relationships between income and the component of income:
three major relationships exist between income and the component of
income:
a Income = Revenues - Expenses + Gains - Losses b Income =
Revenues - Expenses
c Income = Revenues (including gains) - Expenses (including
losses)
In the first relationship, each component is separate and
essential to a definition of income. The different sources of
income are distinguished, thereby providing greater flexibility in
the classification and analysis of a firm's performance.
In the second relationship, gains and losses are not separate
and are not essential to the definition of income. All increases
and decreases are treated similarly as either revenues or expenses.
Such a definition does not fit all the gains and losses from
non-reciprocal transfers, windfalls, casualties and holding gains
and losses.
In the third relationship, although gains and losses are
separate concepts, they are part of revenues and expenses. Such a
definition has the same advantages as the first relationship and
avoids the disadvantages of the second relationship. The
definitions of revenues and expenses, however, must mix different
items and may require a complete identification and listing of the
items that comprise revenues, expenses, gains and losses.
The first relationship appears to present the least disadvantage
according to both the asset/liability view and the revenue/expense
view. It allows identification and disclosure of the three kinds of
gains and losses: gains and losses from exchanges, holding gains
and losses, and gains and losses from non-reciprocal transfers,
windfalls and casualties.
4 Accrual accounting: the elements of financial statements are
accounted for and included in financial statements through the use
of accrual accounting procedures. Accrual accounting measures the
effects of transactions (and other events) having cash consequences
for an entity as they are incurred, not simply as cash is received
or paid - they are recorded in accounting records and reported in
the financial statements of the reporting period to which they
relate. Naturally, the acquisition of resources used to provide
goods and services and the provision of goods and services by an
entity during a period usually do not coincide with the cash
receipts and payments of the period. Hence, accrual accounting
reflects credit and barter transactions and changes in the forms
of assets and liabilities resulting from relevant internal and
external events, in addition to an entity's cash transactions.
Accrual accounting provides information about all of an entity's
assets, liabilities (and consequently residual equity), revenues,
expenses and the changes in them that cannot be obtained by
accounting only for cash receipt and outlays or modified systems of
accrual accounting.
Accrual accounting tests on the concepts of accrual, deferral,
allocation, amortisation, realistrion and recognition.
The FASB opted for the following definitions of these
concepts:
Accrual is the accounting process of recognizing non-cash events
and circumstances as they occur; specifically, accrual entails
recognizing revenues and related increases in assets and expenses
and related increases in liabilities for amounts expected to be
received or paid, usually in cash, in the future ...
Deferral is the accounting process of recognizing a liability
for a current cash receipt or an asset for a current cash payment
(or current incurrence of a liability) with an expected future
impact on revenues and expenses ...
Allocation is the accounting process of assigning or
distributing an amount according to a plan or a formula. It is a
broader term than 'amortisation'; that is, amortisation is an
allocation process ...
Amortisation is the accounting process of systematically
reducing an amount by periodic payments, or write-downs ...
Realisation is the process of converting non-cash resources and
rights into money; it is most precisely used in accounting and
financial reporting to refer to sales of assets for cash or claims
of cash. The related terms, 'realised' and 'unrealised', therefore
identify revenues or gains and losses on assets sold and unsold,
respectively ....
Recognition is the process of formally recording or
incorporating an item in the accounts and financial statements of
an enterprise. Thus, an element may be recognized (recorded) or
unrecognised (unrecorded). 'Realisation' and 'recognition' are nor
used synonymously, as they sometimes are in the accounting and
financiallirerarure,43
Issue 3. Concepts of capital maintenance
The concept of capital maintenance allows us to make a
distinction between the return on capital, or income, and the
return of capital, or cost recovery. Income follows from recovery
or maintenance of capital. Two concepts of capital maintenance
exist: the financial capital concept and the physical capital
concept. Both concepts use measurements in terms of units of money
or units of the same general purchasing power, resulting in four
possible concepts of capital maintenance:
1 financial capital measured in units of money;
2 financial capital measured in units of the same general
purchasing power; 3 physical capital measured in units of money;
and
4 physical capital measured in units of the same general
purchasing power.
We will examine the conceptual and operational differences among
these concepts in Chapters 12-14. Note, however, that the
comprehensive income is a return on financial capital, as
distinguished from a return on physical capital. The essential
difference between the two concepts is that 'holding gains and
losses' are included in income under the financial capital concept,
bur are treated as 'capital maintenance adjustments' under the
physical capital concept.
Issue 4. Which measurement method should be adopted ?The issue
of measurement method concerns the determination of both the unit
of measure and the attribute to be measured. As far as the unit of
measure is concerned, the choice is between actual dollars and
general purchasing power adjusted dollars. As far as the particular
attribute to be measured is concerned, we basically have five
options:
1 historical cost method
2 current cost
3 current exit value
4 expected exit value
5 present value of ex peered cash flows.
These different measurement bases will be explored in depth in
Chapters 12-14.
Issue 5. Applicability of the conceptual framework to the public
sector
For financial reporting purposes, Australian standard-setters
have nor maintained a strong distinction between the private
sector, the public sector and not-for-profit entities in the
private sector. Indeed, Australia is one of the few countries in
the world that has made its conceptual framework equally applicable
to all entities, including public sector entities.~
Standard-setters have paid more than just lip service to this
policy stance. Accrual accounting principles and professional
accounting standards (AASs) are applicable to all nor-for-profit
entities in the private and public sectors. The relevance of
accrual accounting to nor-for-profit entities has also been
emphasised by some authoritative pronouncements in the United
States. For example, the Statement of Po sir ion 78-10 'Accounting
Principles and Reporting Practices for Certain Non-profit
Organisations states:
The accrual basis of accounting is widely accepted as providing
a more appropriate record of all an entity's transactions over a
given period of time than the cash basis of accounting. The cash
basis or any basis of accounting other than the accrual basis does
not result in the presentation of financial information in
conformity with generally accepted accounting principles (pagel0,
paragraph 11).
In the United States, Statement of Financial Accounting Concepts
No.4 'Objectives of Financial Reporting by Nonbusiness
Organisations', recommends adoption of accrual accounting
principles for non-business entities in the private sector.
However, the Governmental Accounting Standards Board, which
oversees the development of accounting standards and concepts
statements for government entities in the United States, only
recommends the use of modified accrual systems for the public
sector. In contrast to Australia, standard-setters in the United
States have tended to maintain greater distinctions between
profit-seeking and nor-for-profit entities (in both the private and
public sectors). For example, Anthony strcsses that resource
providers to not-for-profit entities (both in the private and
public sectors) do not expect to receive repayment or economic
benefits proportionate to resources provided, nor do they possess
rights to a residual interest in the net assets of the entity in
the event of liquidarion.44 As a result, resource providers are nor
assumed to be overly concerned with the financial status and
performance of the entity. Presumably these users are more
concerned that contributed funds have been used
in accordance with the objectives of the entity and within the
confines of any imposed resource restrictions.
Australia has adopted a different view. Comprehensive accrual
accounting has been progressively introduced into the public
sector. Recent accounting standards now requite the adoption of
comprehensive accrual accounting for all local government
authorities and government departments throughout Australia. For
example, AAS 29 'Financial Reporting by Government Departments'
requires all government departments in Australia to prepare an
annual balance sheet, operating statement and statement of cash
flows consistent with all relevant private sector accounting
standards. Furthermore, government departments are required to
disclose all assets, liabilities, revenues and expenses that meet
the definition and recognition criteria of SAC 4. AAS 29 asserts
that accrual accounting better reflects the performance, financing
and investing activities, financial position and compliance of
government departments than cash or modified accrual systems.
Implicit in AAS 29 requirements for accrual accounting is the
presumption that private and public sector entities have a number
of economic and operating characteristics in common. Many of these
arguments have been explicitly and implicitly stated in AAS 29.
According to AAS 29, government departments would have the
following similarities to private sector entities:
Similarities in the economic environment. Government departments
achieve their operating objectives by providing goods and services
to consumers and/or recipients. In so doing, these entities must
use scarce economic resources. Government departments must obtain
scarce resources from external resource providers and, therefore,
are accountable to providers of resources or their representatives
in how resources have been used consistent with the objectives of
the entity. These entities must also control assets and incur
liabilities in carrying out their operating objectives.
Furthermore, they must be financially viable by having sufficient
resources available to meet their operating objectives and must
meet their operating objectives under conditions of economic
uncertainty.
2 Similarities in user needs for information. The most
fundamental presumption of AAS 29 (paragraphs 18-23) is that
government departments constitute reporting entities - that is, it
can reasonably be expected that there exist external users
dependent on the general purpose financial reports of these
entities. AAS 29 identifies these users to include parliament,
regulators, other government departments, media and
special-interest groups, consumers, taxpayers and resource provers
(paragraph 21). These users are assumed to have common information
needs and to be interested in, inter alia, (a) how effectively and
efficiently resources have been used to meet operating objectives,
(b) the extent to which costs have been recovered from revenues,
(c) a government department's capacity to provide goods and
services into the future, and (d) its present and future funding
requirements.
3 Similarities in the objectives of the financial statements. In
a similar vein to private sector standards, AAS 29 states that the
primary objective of the financial statements of government
departments is to serve the information needs of a potentially wide
range of users (paragraph 18). With respect to economic decision
making, AAA 29 (paragraph 5) asserts that general purpose financial
reports will be particularly relevant to users for assessing (a)
performance, (b) financial position, (c) financing and Investing
activities, and (d) compliance of government departments.
5.4.2 Building blocks of the conceptual frameworkThe structure
of the Australian conceptual framework is shown by the tentative
building blocks displayed in Exhibit 5.2
As you can see, the conceptual framework can be divided into six
levels. At its highest level the conceptual framework defines the
scope of financial reporting. The scope of financial reporting
deals with the type of information that should be included in
general purpose financial reports (GPFRs). The next two levels of
the framework define the concept of the
reporting entity and the objectives of GPFRs. The reporting
entity concept was developed as a guide for determining the types
of entities that should be required to prepare GPFRs and comply
with Accounting Standards and associated Statements of Accounting
Concepts. Level 4 deals with the qualitative characteristics that
financial information should possess before inclusion in GPFRs. It
also covets the definition of basic elements of financial reports -
the assets, liabilities, equity, revenues and expenses of an
entity. Level 5 deals explicitly with how these elements are to be
recognised and measured. Lower levels of the framework deal with
the display (disclosure) of information, standard-setting policy
and policy enforcement procedures.
The following provides a more detailed description of the
different levels of the framework.
Part 1. Definition of financial reporting
This part of the conceptual framework deals with the type of
information that should be included within the scope of financial
reporting, and how the scope of company financial reporting is, or
should be, determined. The scope of company financial reports has
changed greatly over the years. In the nineteenth century, the
primary financial statement disclosed by companies was a balance
sheet. In the early decades of the twentieth century, it became
common for companies to disclose additional information in the form
of a profit and loss account45 By the 1940s and 1950s many
companies also disclosed funds statements. Today, the scope of
financial reporting has extended to cash flow statements, including
many other forms of information voluntarily disclosed by companies,
such as financial summaries, future-orientated information and
comparative figures.
A number of factors have affected the scope of financial
reporting over the years. One important factor is the incidence of
financial crises. Share market crashes and economic depressions
have usually resulted in more stringent disclosure regulations
imposed on companies by regulators such as the stock exchange, the
AARF and legislators. For example, the share market crash of 1987
was an important precursor of new regulations on the cash flow
statement46
Demands for information by investors and other users of company
financial reports have also influenced the scope of financial
reporting over the years."7 Investors need relevant information for
making economic decisions. Companies have been willing to provide
greater quantities of information to investors on a voluntary basis
because companies compete with each other for the capital resources
of investors.
Determining the scope of financial reporting
Determination of information to be included in the scope of
financial reporting will guide the jurisdiction of accounting
standards and standard setting, and associated SACs. However, this
part of the conceptual framework remains largely undeveloped. For
instance, there is no generally accepted definition of general
purpose financial reporting or its scope. However, SAC 2 'Objective
of General Purpose Financial Reporting' provides an indication that
the scope of financial reporting may extend beyond financial
information:
Financial reporting encompasses the provision of financial
statements and related financial and other information. (paragraph
10)
Paragraph 10 is more specific when it mentions that GPFRs
include:
be read with the financial statements ... However, other
information can best be provided, or can only be provided, outside
financial reports.
Other passages of paragraph 10 obscure the issue completely:
This Statement does not attempt to draw a clear distinction
between financial reports and financial reporting, nor does it
attempt to define the boundaries of general purpose financial
reporting.
Hence, the scope of financial reporting can be potentially very
broad. The absence of clear definitions is troublesome.
Determination of the scope of GPFR has important implications for
standard setting and other facets of the conceptual framework,
particularly in light of the growing incidence of various forms of
voluntary disclosure by companies over the years. These disclosures
include environmental disclosures, value-added statements,
financial summaries, trend data, future-oriented information and
non-financial performance indicators. It is important to know
whether these types of information should be included within the
scope of GPFR in Australia. If they do, they can potentially become
the subject of accounting standard setting and statements of
accounting concepts.
A critical issue evidently concerns what criteria should be used
to determine which information will or will not be included within
the scope of financial reporting. To some extent the scope of
financial reporting will be determined by reference to other
components of the conceptual framework, in particular SAC 2
'Objective of General Purpose Financial Reporting' and SAC 3
'Qualitative Characteristics of Financial Information'. SAC 2
specifies that the overall objective of GPFRs is to provide
relevant information for economic decision making by users. SAC 3
specifies the necessary characteristics that information should
possess before qualifying for inclusion in GPFRs. In particular,
the relevance and reliability of information are emphasised as the
primary characteristics. Following this approach, only information
that can reliably be determined and is demonstrably relevant for
economic decision making would be included in the scope of
financial reporting. For example, broad economy-related information
might be excluded from the scope of financial reporting because,
while this information could be relevant for economic decision
making, it cannot be measured reliably. On the other hand,
value-added statements might be included within the scope of
financial reporting because this information can be more reliably
measured.
In conclusion, it is unlikely that a definition of the scope of
financial reporting will be accomplished easily. Any definition
must take into consideration not only the present financial
reporting environment, bur the changing nature of its scope over
time.
This part of the conceptual framework deals with the types of
entities that should be preparing GPFRs and which entities should
be complying with Accounting Standards. Should a local council, a
tennis club, a church or a family business be required to prepare
financial reports and comply with Accounting Standards'
SAC 1 states that only reporting entities should be required to
prepare financial reports and comply with Accounting Standards. The
definition of the reporting entity is provided in SAC I 'Definition
of the Reporting Entity'. Reporting entities are defined as:
entities (including economic entities) in respect of which it is
reasonable to expect the existence of users dependent on GPFRs for
information which will be useful to them for making and evaluating
decisions about the allocation of scarce resources. (paragraph
40)
These users would include shareholders, investors, creditors,
suppliers, employees and other users who need financial reports as
a basis for assessing an entity's financial position, profitability
and performance. The definition implies that for those entities
where major external users are not expected to exist, then these
entities should not have to prepare GPFRs or comply with Accounting
Standards. For example, private companies, trusts, sole traders and
family businesses would nor qualify as reporting entities under SAC
1, because it would be reasonable to assume that there will be no
external users.
Because the definition of the reporting entity is linked to the
information needs of external users, the existence of a reporting
entity will not depend on:
1 the sector (whether public or private sector) within which the
entity operates;
2 the purpose for which the entity was created (whether business
or not-for-profit); or 3 the manner in which the entity is
constituted (whether legal or otherwise).
SAC 1 provides some general guidance in determining whether
dependent external users are likely to exist. For many entities it
will be readily apparent whether dependent users are likely to
exist (paragraph 19). For example, larger companies normally have
many creditors, investors, suppliers and employees of different
descriptions. However, SAC 1 acknowledges that it will not always
be clear whether dependent external users exist. The Statement
provides three general guidelines to assist in this determination.
These guidelines need to be considered together:
1 Separation of management from economic interests. SAC 1 argues
that the greater the spread of ownership/membership and the greater
the extent of the separation between management and owners/members
(or others with an economic interest in the entity) then the more
likely it is that there will be users who are dependent on
financial reports for economic decision making.
2 Economic or political importance/influence. SAC 1 further
argues that the greater the economic or political importance of an
entity, the more likely it is that there will be dependent external
users (paragraph 21). These types of entities are most likely to
have dominant positions in markets, and those that are concerned
with balancing the interests of significant groups, such as
employer/employee associations and public sector entities which
have regulatory powers.
3 Financial characteristics. SAC 1 argues that financial
characteristics are also important.
These include an entity's size (e.g. sales turnover) or
indebtedness. The larger the size or the greater the indebtedness
of an entity, the more likely it is that there will be external
users dependent on GPFRs for economic decision making (paragraph
22).
Some writers have argued that a major limitation of SAC 1 is
that it does not provide sufficient guidelines as to what
constitutes a reporting entity. In particular, guidelines for
identifying dependent users are expressed in qualitative rather
than quantitative terms. For example, what constitutes economic
political importance or what degree of size or indebtedness must
exist before it can safely be assumed that dependent users exist I
Because these guidelines are generic and are expressed in
qualitative terms, determination of whether a reporting entity
exists becomes a largely subjective exercise. A mote critical
assumption underlying SAC 1 concerns the existence of external
users. The reporting entity concept as enunciated in SAC 1 is
underpinned by assumptions about the information needs of users.
Some commentators have been concerned about the degree of 'use'
that needs to be established before it can be concluded that users
make economic decisions based on GPFRs.Would an entity still
qualify as a reporting entity if users only made very modest use of
the financial reports' Another potential weakness of SAC 1 is that
there has been no attempt co rank users, for the purposes of
defining a reporting entity, in some order of priority. For
example, if it is established that one entity has investors as a
major user, and another has employees as a major user, will the
entity with employees as the major user be more or less of a
reporting entity'
It is clear that the introduction of SAC 1, despite potential
limitations, will still have an impact on accounting practice. For
example, it will result in some partnerships, crusts, government
departments and statutory authorities currently not preparing GPFRs
co do so, because they would qualify as reporting entities under
SAC 1 (see paragraph 33).
This stage of the conceptual framework deals with the overall
objective of GPFRs, the users of these reports and their
information needs. Statement of Accounting Concepts o. 2 (SAC 2),
'Objective of General Purpose Financial Reporting' issued in August
1990, deals with this aspect of the framework. SAC 2 states:
General purpose financial reports focuses on providing
information co meet the common information needs of users who are
unable co command the preparation of reports tailored co their
particular information needs. These users must rely on the
information communicated co them by the reporting entity.
SAC 2 acknowledges that some users have specialised needs and
will possess the authority co obtain the information co meet those
needs. Examples are taxation authorities, central banks and grants
commissions. The information they seek is called special purpose
financial reports. Because these users are able co command the
preparation of this information, special purpose financial reports
are excluded from general purpose financial reporting, and hence
will not become the subject of standard setting.
The grand vision behind SAC 2 is the belief that the provision
of relevant financial information by companies co external users
will ultimately enhance the efficient allocation of scarce
resources throughout the entire economy, thus contributing co
national economic growth. Relevant financial information will
assist, for example, investors co make informed portfolio decisions
concerning the spread of risk and return, and creditors co make
informed lending decisions.
Because efficient resource allocation is the ideal, SAC 2 states
that the primary objective of GPFRs is co provide relevant
information co various external users so that they can make and
evaluate decisions about the allocation of scarce resources. SAC 2
outlines a secondary objective of GPFRs. This is co demonstrate the
discharge of accountability. SAC 2 states:
Managements and governing bodies are accountable to those who
provide resources co the entity for planning and controlling the
resources of the entity. In a broader sense, because of the
influence reporting entities exert on members of the community at
both the microeconomic and macroeconomic levels, they are
accountable co the public at large. General purpose financial
reporting provides a means by which this responsibility can be
discharged.
SAC 2 defines three classes of user: resource providers,
recipients of goods and services, and parties performing a review
or oversight function (paragraphs 17-19). It also defines the types
of information these user groups will need in order co make
informed and rational economic decisions. To this extent, SAC 2
stresses that user needs for information will overlap because all
users are fundamentally concerned with the ability of an entity co
generatefavorable cash flows. SAC 2 provides a discursive breakdown
of the information needed by users into four different headings:
performance, financial position, finance and investing, and
compliance.
1 Performance. Performance implies how effective an entity has
been in meeting its objectives, and how efficiently and
economically it has used resources in meeting those objectives.
Aspects of performance can be measured in both financial and
non-financial terms. Included in the financial information needed
to assess performance is information typically found in company
profit and loss accounts and balance sheets. Disclosure of revenues
and expenses, assets, liabilities and equity is envisaged by SAC 2
to be relevant to assessing performance. With this information,
users will be able to, inter alia, evaluate the changes in the
entity's control over resources by reference to the resources or
funds employed in achieving the change. Ostensibly, this
information is relevant to users in predicting both the capacity of
an entity to generate cash from its existing resource base and the
effectiveness by which it would employ additional resources.
2 Financial position. The financial position of an entity
involves disclosure of information about its wealth or control over
economic resources, financial structure, capacity for adaptation
and solvency. Most of the information needed to make these
assessments is contained in company balance sheers. Disclosure of
information about an entity's control over resources (its assets)
is ultimately useful in predicting the ability of an entity to
continue to meets its objectives, whether these relate to
generation of positive cash flows in the future or the continued
provision of goods and services. The financial structure of an
entity, at any point in time, is a specified relationship (both in
terms of value and amount) between its assets, liabilities and
equity. Disclosure of relevant information about the financial
structure of an entity relates to the sources, types and time
patterns of finance, whether debt or equity and the types of assets
used by the entity. This information is useful for predicting the
future distribution of cash flows among providers of resources and
the ability of an entity to attract resources in the future.
Capacity for adaptation refers to the ability of an entity to
change or modify its resource base, whether this is necessitated by
changes in economic conditions, new opportunities, or directives
from controlling bodies. SAC 2 states that information about the
location, realisable value and current state of repair of an
entity's assets would be relevant to users in assessing capacity
for adaptation.
Solvency concerns the ability of an entity to meet its debts as
they fall due. According to SAC 2, relevant information needed to
assess solvency would include the liquidity of company's assets and
the availability of cash from external sources. This information
will be useful for predicting the ability of the entity to meet its
obligations as they fall due and, therefore, in predicting the
ability of the company to provide goods and services into the
future.
3 Financing and investing. Financing and investing relates to an
entity's sources and application of funds during the period. This
information indicates the way in which an entity has financed its
operations and invested its resources during a period.
4 Compliance. SAC 2 states that information about non-compliance
with externally imposed regulations is relevant as an input into
user assessments about an entity's performance, financial position,
and financing and investing. Examples of externally imposed
requirements include: conditions imposed by borrowing agreements;
conditions imposed by licensing agreements and grant arrangements;
spending mandates and borrowing limits; occupational health and
safety legislation; and environmental legislation.
Part 4. Fundamentals
This part of the framework, Level 4 of Exhibit 5.2, comprises
two building blocks: qualitative characteristics of financial
information; and elements of financial statements.
Qualitative characteristics of financial information
SAC 3 'Qualitative Characteristics of Financial Information',
issued in August 1990, considers this aspect of the framework. The
specification of the qualitative characteristics of financial
information will provide criteria for choosing between: (a)
alternative accounting and reporting methods; and/or (b) disclosure
requirements. Basically, these criteria indicate which information
is better (more useful) for decision-making purposes. The
characteristics may be viewed as a hierarchy as indicated in
Exhibit 5.3.
Relevance and reliability are the two primary qualities, with
related ingredients.
Comparability and consistency are presented as secondary and
interactive qualities. Finally, the concepts of cost-benefit
considerations and materiality are recognised, respectively, as a
pervasive constraint and a threshold for recognition. Each of these
qualitative characteristics of accounting information will now be
examined.
Relevance. Relevance is defined in SAC 3 to mean that quality of
financial information that exists when information influences the
decisions of users about the allocation of scarce resources.
Influencing decisions could mean:
a helping users form predictions about the outcomes of past,
present or future events; and/or
b confirming or correcting their past evaluations, which enables
users to assess the rendering of accountability by preparers.
Hence, information must materially affect, or have the potential
to affect, the decisions of users. The importance of relevance as a
qualitative characteristic of financial information is central to
financial reporting and has been advocated widely in the accounting
litetature.18
I t is noted that SAC 3 emphasises that the predictive and
confirmatory roles of financial information ate not mutually
exclusive. For example, information about the current level and
structure of asset holdings will be relevant to users in assessing
(predicting) an entity's ability to take advantage of opportunities
in the marketplace. However, this same information can playa
confirmatory role in respect of past predictions. Furthermore, to
have predictive value information does nor have to be in the form
of an explicit forecast. Users are interested in forming
assessments (predictions) about the nature, timing and amounts of
future cash flows based on the information presented to them in
GPFRs.
Financial information can also be judged as relevant by
reference to its nature or magnitude. For example, an increase in
directors' emoluments or a related party contract may be critical
with respect to its nature even though the absolute amounts may be
insignificant compared to other costs.
Some authors have argued that a major weakness of the definition
of relevance provided in SAC 3 is that 'nature' and 'magnitude' are
not defined in operational or quantifiable terms, but in
qualitative terms only. This leaves the door open for professional
accountants to have legitimate disagreements over whether any
particular transaction is significant by virtue of either its
nature and/or magnitude to warrant disclosure in GPFRs.
Furthermore, it is possible that the predictive and confirmatory
roles of financial information emphasised by SAC 3 are too broadly
based to provide definite guidelines on different measurement and
disclosure alternatives in accounting. For example, many
researchers have disputed the relative merits of a current cost
accounting system versus a conventional historical cost accounting
for economic decision making by users. Because both systems would,
in differing degrees and under differing circumstances, play a
predictive or confirmatory role in user decision making, the
definition of relevance in SAC 3 might nor be sufficiently detailed
in testing or assessing whether one measurement system would be
more relevant to users than the other.
2 Reliability. Reliability is defined in SAC 3 as 'that quality
of financial information which exists when the information can be
depended upon to represent faithfully and without bias or undue
error, the transactions or events that it either purports to
represent or could reasonably be expected to represent'. It is
essential that financial information be reliable. i9 If information
is relevant, but not reliable, SAC 3 implies that it will not
qualify for inclusion in GPFRs. Unreliable information, while
relevant, can lead to poor or less than optimal decisions by users.
SAC 3 (paragraphs 25-26) is careful to point Out that reliability
should not be confused with the accounting convention of
conservatism or prudence. That is, accountants should not
deliberately understate net income on the basis or conservatism,
'thereby usurping the rights of users to make their own decisions'
(paragraph 21).
An important part of reliability is the avoidance of bias. For
information to avoid bias, or be presented neutrally, it should not
be designed to lead users to the conclusions that
serve particular needs, desires or preconceptions of preparers.
Bias can stem from deliberate misstatement or even 'misguided'
conservatism. This is not to imply that the preparers of
information do not have a purpose in mind when preparing the
reports; it only means that the purpose should not influence a
predetermined result. SAC 3 (paragraphl9) draws a distinction
between faithful representation of transactions and the effective
representation of those transactions. For example, measuring an
asset at historical cost may be reliable, but not effective in
terms of providing relevant information to users. In such
situations, SAC 3 does not rank relevance over reliability or vice
versa. Both characteristics are seen as primary. In practice,
however, there