DeeganFAT3e PPT Ch06-Ed

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6-1Copyright 2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e 6-1Copyright 2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e

Financial Accounting TheoryCraig Deegan

Chapter 6

Normative theories of accountingthe case

of conceptual framework projects

Slides written by Craig Deegan


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Learning objectives

In this chapter you will be introduced to: the role that conceptual frameworks (CFs) can play in the

practice of financial reporting

the history of the development of the various existing

conceptual framework projects

the various building blocks that have been developedwithin various conceptual framework projects


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Learning objectives (cont.)

perceived advantages and disadvantages that arise fromthe establishment and development of conceptual

frameworks

recent initiatives being undertaken by the IASB and the

FASB to develop an improved conceptual framework

factors, including political factors, that might help orhinder the development of conceptual framework projects

groups within society which are likely to benefit from the

establishment and development of conceptual framework

projects


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What is a conceptual framework?

'A coherent system of interrelated objectives andfundamentals that is expected to lead to consistent

standards' (Statement of Financial Accounting

Concepts No. 1: Objectives of Financial Reporting

by Business Enterprises 1978)

Attempts to provide a structured theory of

accounting


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Conceptual frameworks as normativetheories

Conceptual frameworks provide prescription sothey are considered normative theories of

accounting

'Prescribes the nature, function and limits offinancial accounting and reporting' (Statement of

Financial Accounting Concepts No. 1: Objectives

of Financial Reporting by Business Enterprises,

1978)


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A revised conceptual framework

In recent years the FASB and IASB have beenjointly working towards the development of an

improved conceptual framework

In 2008 they released a document entitled:

Exposure Draft of an improved Conceptual

Framework for Financial Reporting

This phase of the project specifically addressed

the objective of financial reporting and the

qualitative characteristics and constraints of

decision-useful financial reporting information.


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Rationale for conceptual frameworks

To develop the practice of financial reportinglogically and consistently we need to address such

issues as:

what we mean by 'financial reporting' and what should be

its scope;

which organisational characteristics indicate that an entityshould produce financial reports;

the 'objective' of financial reporting;

qualitative characteristics financial information should

possess;

what are the elements of financial reporting; and

what measurement rule should be employed.


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Rationale for conceptual frameworks(cont.)

Proponents argue that without agreement on theseissues accounting standards will be developed in

an ad hocmanner

Limited consistency between accounting standardsin the absence of a conceptual framework


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The 'building blocks' of theconceptual framework

The framework must be developed in a particularorder some issues (or assumptions) need to be resolved or

made before moving on to subsequent 'building blocks'

One obvious issue that needs early agreement would bewhat is meant by 'financial reporting'.

Other issues that would also need agreement early in theprocess would be:

Definition of a reporting entity

Definition of the users of financial statements

The objective of financial reporting


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The 'building blocks' of theconceptual framework (cont.)

Because the rest of the framework flows fromassumptions about the 'objective', if we reject theassumption, then we personally might be preparedto reject the prescriptions provided by theframework

Refer to Figure 6.1 (p.213) in the text for anoverview of the IASB Framework for thePreparation and Presentation of FinancialStatements(which in 2005 replaced the AustralianConceptual Framework)

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History of the development of CFs

CFs were developed in a number of jurisdictionsincluding US, UK, Canada, Australia, New Zealand, International

Accounting Standards Committee

In recent years many countries have adopted the

IASB Framework given that they have decided toadopt the accounting standards released by theIASB

No standard-setters had developed a completeCF; measurement issues typically unaddressed

Limited or no progress in recent years, althoughthere is now a joint IASB/FASB project to developa new and improved conceptual framework


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Development of frameworks ofaccounting in the US

1961 and 1962: Moonitz, and Moonitz andSprouse prescribed that accounting practice

should be based on current values

1965: Grady developed theory based ondescription of existing practice

led to the release of Accounting Principles Board (APB)

Statement No. 4

however, accounting profession under criticism for lack of

any real framework


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Development of frameworks ofaccounting in the US (cont.)

Led to formation of Trueblood Committee in 1971which produced Trueblood Report

report outlined 12 objectives of accounting and seven

qualitative characteristics which financial information

should possess

objective 1: focused on information needs of financialstatement users

objective 2: need to serve users with limited ability to

demand financial information


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Development of frameworks ofaccounting in the US (cont.)

1974: APB replaced by FASB which thenembarked on its CF project

Six Statements of Financial Accounting Concepts

(SFACs) released from 1978 to 1985

Initial SFACs normative in nature, but SFAC No. 5relating to recognition and measurement largely

descriptive of current practice

received much criticism

since 2005 FASB and IASB have been jointly working

towards the development of a revised conceptualframework that would be used by both boardsreferred

to as the 'convergence project'


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Development of a CF in the UK

Early moves towards guidance relating toobjectives and identification of users provided by

The Corporate Report (1976)

concerned with addressing the rights of the community in

terms of their access to financial information (broader

than notion of users adopted in other frameworks) ultimately contents generally not accepted by the

accounting profession


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Development of a CF in the UK (cont.)

1991: ASB adopted the IASC's CF

IASC framework was generally consistent with the

US and Australian frameworkssubsequently

became known as the IASB Framework


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Development of a CF in Australia

Degree of progression was slow Only four Statements of Accounting Concepts

(SACs) were released

SAC 1: Definition of the Reporting Entity

SAC 2: Objectives of General Purpose Financial

Reporting

SAC 3: Qualitative Characteristics of Financial

Information

SAC 4: Definition and Recognition of the Elements of

Financial Statements


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Development of a CF in Australia(cont.)

Fifth SAC relating to measurement was neverreleased

Had a number of similarities to the US CF project

2005: Australia adopted the IASB Framework as a

result of the decision by the Financial ReportingCouncil that Australia would adopt IAS/IFRS by

2005

SAC 3 and SAC 4 were abandoned

SAC 1 and SAC 2 were retained until such timethat a revised IASB Framework was developed


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Current efforts of the IASB and theFASB

From 2005 the IASB and the FASB have beenjointly working towards the development of arevised conceptual framework that will be used byboth parties

The need for this revised framework has arisenbecause of the 'convergence project' in which theIASB and the FASB are working together toconverge their two sets of accounting standards

Will take several years to complete


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Current efforts of the IASB and theFASB (cont.)

The IASB and FASB are undertaking the work onthe conceptual framework in eight phases, thesebeing: objectives and qualitative characteristics

definitions of elements

recognition and de-recognition

measurement reporting entity concept

boundaries of financial reporting, and presentation anddisclosure

purpose and status of the framework

application of the framework to not-for-profit entities remaining issues, if any

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Building blocks of the CF

The following discussion is based on the IASB

Framework currently in place Where appropriate, reference will also be made to

current work being done by IASB and FASB given

that this gives an indication of what might come in

the future Building blocks of the various CFs have addressed

definition of the reporting entity

objectives of general purpose financial reporting (GPFR)

perceived users of GPFRs qualitative characteristics that GPFRs should possess

elements of financial statements

possible approaches to measuring the elements


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Definition of the reporting entity

The Conceptual Framework provides a definitionof entities required to produce GPFRs

known as reporting entities


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General purpose financial reports

GPFRs are defined as reports ' intended to meet the information needs common tousers who are unable to command the preparation of

reports tailored so as to satisfy, specifically, all of their

information needs' (SAC 1, para.6)

GPFRs are reports that comply with accounting

standards and other generally accepted

accounting practices (GAAPs)


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Special purpose financial reports

By contrast, special purpose reports are providedto meet the information demands of a particular

user, or group of users


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Entities required to produce GPFRs

Not all entities are classed as reporting entities

SAC 1 states that GPFRs should be prepared

when there are users:

' whose information needs have common elements,and those users cannot command the preparation of

information to satisfy their individual information needs'

(para.8)

F t i di ti f ti


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Factors indicative of a reportingentity (SAC 1)

Separation of management from those with aneconomic interest in the entity

The economic or political importance/influence of

the entity to/on other parties

The financial characteristics of the entity


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Objective embraced within CFs

Objective of GPFRs in SAC 2 is deemed to be to provide information to users that is useful for makingand evaluating decisions about the allocation of scarce

resources

Objective of decision usefulness calls into questionusefulness of historical cost information


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Other objectives of GPFRs

Another objective is to enable reporting entities todemonstrate 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

C t thi ki f th IASB d


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Current thinking of the IASB andFASB

In the 2008 conceptual framework exposure draft itis stated: The objective of general purpose financial reporting is to

provide financial information about the reporting entitythat is useful to present and potential equity investors,lenders and other creditors in making decisions in their

capacity as capital providers. Information that is decision-useful to capital providers may also be useful to otherusers of financial reporting who are not capital providers.

C t thi ki f th IASB d


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Current thinking of the IASB andFASB (cont.)

As we know from previous lectures, before we areprepared to accept the prescriptions provided by anormative theory we must be satisfied with theunderlying assumptions made

Hence, if we reject the assumptions about theobjective of general purpose financial reportingthen we would be inclined to reject theprescriptions made despite how logical theframework may appear

Is this objective (above) too restrictive?




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Users of financial reports

SAC 2 identifies three primary user groups forGPFRs

resource providers

employees, lenders, creditors, suppliers, investors and

contributors

recipients of goods and services customers and beneficiaries

parties performing review or oversight function

parliaments, governments, regulatory agencies, analysts,

labour unions, employer groups, media and special interest

groups


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InternationalperspectivesonusersofGPFRs

The IASB Framework identifies GPFRs users as investors,employees,lenders,

suppliers, customers,govt.agencies and the public

states that information designed to meet the needs ofinvestors will usually meet the needs of the other groups

US: SFAC 1 main focus is present and potential investors and other

users with either a direct financial interest or related tothose with a direct financial interest

UK: The Corporate Report

all groups impacted by an organisation's operations haverights to information about the reporting entity, notnecessarily related to resource allocation decisions

Level of expertise expected of


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Level of expertise expected offinancial report readers

Generally accepted that readers are expected tohave some proficiency in financial accounting

IASB Framework (para.25)

users are assumed to have a reasonable knowledge ofbusiness and economic activities and accounting and a

willingness to study the information with reasonable

diligence

Current thinking of the IASB and the


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Current thinking of the IASB and theFASB in relation to 'users'

The 2008 exposure draft stated: The primary user group includes both present andpotential equity investors, lenders and other creditors,

regardless of how they obtained, or will obtain, their

interests. Other users who have specialised needs,

such as suppliers, customers and employees (when not

acting as capital providers), as well as governments and

their agencies and members of the public, may also find

useful the information that meets the needs of capital

providers; however, financial reporting is not primarily

directed to these other groups because capital providers

have more direct and immediate needs

Is this perspective of 'users' too restrictive?

Qualitative characteristics of


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Qualitative characteristics offinancial reports

To ensure financial information is useful foreconomic decision making, we need to consider

the attributes or qualities that financial information

should have

According to IASB Framework

primary qualitative characteristics are understandability,

relevance, reliability and comparability

related to relevance is materiality

IASB Framework appears to give greater prominence to

relevance and reliability there are issues associated with the 'trade-off' between

relevance and reliability


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Reliability

Information is considered to be reliable if it'faithfully represents' the entity's transactions and

events

Should be free from bias and undue error

Reliability is a function of representational

faithfulness, verifiability and neutrality


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Relevance

Something is relevant if it influences decisions on

the allocation of scarce resources

if it is capable of making a difference in a decision

For information to be relevant it should have: predictive value, and

feedback value


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Materiality

A limiting factor on the disclosure of relevant and

reliable material is the notion of materiality

An item is material if (IASB Framework, para. 30)

... its omission or misstatement could influence the

economic decisions of users taken on the basis of the

financial statements . Materiality provides a cut-off

rather than being a primary qualitative characteristic

which information must have if it is to be useful


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Uniformity and consistency

Uniformity and consistency imply advantages in

restricting the number of accounting methods that

can be used by reporting entities

has been argued that firms adopt particular accounting

methods because they best reflect their underlying

performance restricting available methods imposes costs on reporting

entities


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Costs vs. benefits

Need to consider whether the cost of providing

certain information exceeds the benefits to be

derived from its provision

costs include collection, storage, retrieval, presentation,

analysis and interpretation

benefits come from sound economic decision making byusers

Measuring potential costs and benefits involves

professional judgement

Latest thinking of the IASB and the FASB


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Latest thinking of the IASB and the FASBregarding qualitative characteristics

In the 2008 exposure draft released as part of the

conceptual framework project it is stated:

For financial information to be useful, it must possess two

fundamental qualitative characteristicsrelevance and

faithfulrepresentation.

The draft conceptual framework has reduced the

four 'primary qualitative characteristics' to two

'fundamental qualitative characteristics'

Latest thinking of the IASB and the FASB


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Latest thinking of the IASB and the FASBregarding qualitative characteristics (cont.)

The qualitative characteristic of reliability wasreplaced by 'faithfully representation'

The other two primary qualitative characteristicsidentified in the IASB Framework, these beingunderstandability and comparability, have been

renamed as 'enhancing qualitative characteristics'in the draft document released by the IASB

Two additional 'enhancing qualitativecharacteristics' have also been included (therebygiving a total of four enhancing qualitative

characteristics), these being verifiability andtimeliness

Can GPFRs provide unbiased


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Can GPFRs provide unbiasedaccounts of performance?

The practice of accounting is heavily reliant on

professional judgement

Prior to accounting standards being released,

standard-setters attempt to determine the

economic consequences of following the

standards

if they consider economic consequences then standards

cannot be considered objective or neutral

Can GPFRs provide unbiased


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Can GPFRs provide unbiasedaccounts of performance? (cont.)

If we accept the notion that preparers will be drivenby self-interest (from Positive Accounting Theory)notions of objectivity or neutrality are unrealistic

Political nature of standard setting process alsoaffects neutrality and objectivity

In communicating reality accountants constructreality (Hines 1988) That is, if accountants identify something and start to

place a monetary value on it then it gains importanceitbecomes visible (and 'real')

Conversely, if accountants ignore itsuch as manyexternalities caused by business entitiesthen for manypeople the 'issue' does not exist


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The elements of financial reporting

The next building block considers the definition

and recognition criteria of the elements of financial

reporting

Definition criteriawhat attributes are required

before an item can be considered as belonging to

a particular class of element

Recognition criteriaemployed to determine

whether the item can be included in the financial

statements


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Definition of assets (cont.)

The definition refers to the benefit and not its

source

in the absence of future economic benefits, the object or

right will not qualify as an asset

The benefits can result from ongoing use, not

necessarily a value in exchange


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The characteristic of control

Control relates to the capacity to benefit from the

asset and to deny or regulate others' access to the

benefit

Legal enforceability is not a prerequisite for

establishing the existence of control

control (and not legal ownership) is required, although

controlled assets are frequently owned


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Recognition of assets

An assetand all the other elements of

accountingshall be recognised when

it is probable that any future economic benefit associated

with the item will flow to or from the entity, and

the item has a cost or value that can be measured with

reliability (IASB Framework, para.83)

Probable is generally considered to mean 'more

likely rather than less likely'

'Current thinking' of the IASB and


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Current thinking of the IASB andFASB in relation to assets

Within the 2008 exposure draft the IASB and FASB thought

there were shortcomings with the existing asset definition.They stated: Some users misinterpret the terms 'expected' (IASB definition)

and 'probable' (FASB definition) to mean that there must be ahigh likelihood of future economic benefits for the definition tobe met; this excludes asset items with a low likelihood of futureeconomic benefits.

The definitions place too much emphasis on identifying thefuture flow of economic benefits, instead of focusing on the itemthat presently exists, an economic resource.

Some users misinterpret the term 'control' and use it in thesame sense as that used for purposes of consolidationaccounting. The term should focus on whether the entity hassome rights or privileged access to the economic resource.

The definitions place undue emphasis on identifying the pasttransactions or events that gave rise to the asset, instead offocusing on whether the entity had access to the economicresource at the balance sheet date.


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Recognition of liabilities

Recognition criteria consistent with those of assets

and the other elements of accounting

A liability shall be recognised when:

it is probable that the sacrifice of economic benefits will

be required, and

the amount of the liability can be measured reliably

Has implications for disclosure of various

provisions


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Present thinking of the IASB and


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ese t t g o t e S a dFASB in relation to liabilities (cont.)

The IASB and FASB proposed the following draft

definition of a liability: A liability of an entity is a present economic obligation

that is enforceable against the entity.

As with the proposed definition of assets, thesuggested change in the liability definition couldpotentially have significant implications for financialreporting. For example: The above definition could act to exclude constructive or

equitable obligations that are not enforceable against theentity. This would be a major departure from existing

practice Would this be a good change?


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Approaches to determining profit

Two common approaches to determining profits

asset/liability approach links profit to changes in assets

and liabilities

revenue/expense approach relies on concepts such as

the matching principle

The definition of expenses and revenues in the CF

based on asset/liability perspective


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Definition of expenses

' decreases in economic benefits during the

accounting period in the form of outflows or

depletions of assets or incurrences of liabilities that

result in decreases in equity, other than those

relating to distributions to equity participants' (IASB

Framework, para.70(b))


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Recognition of expenses

An expense shall be recognised when

it is probable that the consumption or loss of future

economic benefits resulting in a reduction in assets

and/or an increase in liabilities has occurred, and

the consumption or loss of economic benefits can be

measured reliably


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Definition of income (cont.)

Income can be recognised from normal trading

relations, as well as from non-reciprocal transferssuch as grants, donations, bequests or whereliabilities are forgiven

IASB Framework further subdivides income into

revenues and gains revenue arises in the course of the ordinary activities ofan entity

gains represent other items that meet the definition ofincome and may, or may not, arise in the ordinaryactivities of an enterprise

not clear why there is a need to break income into twocomponents


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Definition of equity

Equity is defined as 'the residual interest in the

assets of the entity after deducting all of its

liabilities' (IASB Framework, para.49(c))

As a residual interest it ranks after liabilities in

terms of claims against the assets

Definition is a direct function of the definitions of

assets and liabilities


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Measurement principles

To date there is very little prescription in relation to

measurement provided by CFs

FASB statement provides description of various

approaches to measuring elements without

providing prescription


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Current IASB and FASB work on


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measurement issues (cont.)

Phase C of the joint IASB and FASB Conceptual

Framework Project is to address measurementissues. In this work the IASB and FASB haveidentified nine potential measurement bases, thesebeing:past entry price,past exit price, modifiedpast amount, current entry price, current exit price,current equilibrium price, value in use, future entryprice, and future exit price

It is expected that it will be a number of yearsbefore any conclusion is reached about the most

appropriate measurement basis for assets andliabilities

Benefits associated with conceptual


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frameworks

Accounting standards should be more consistent

and logical

Increased international compatibility of accountingstandards

Standard-setters should be more accountable fortheir decisions

Communication between standard-setters andtheir constituents should be enhanced


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Benefits associated with CFs (cont.)

The development of accounting standards should

be more economical

Where conceptual frameworks cover a particular

issue, there might be a reduced need for additional

standards

Emphasise the 'decision usefulness' role of

financial reports rather than restricting concern to

stewardship


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CFs as a means of legitimisingd d i b di


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standard-setting bodies

Some (e.g. Hines and Solomons) have suggested

that CFs have been used as devices to help

ensure the ongoing existence of the accounting

profession

Increase the ability of the profession to self-

regulate, thus counteracting government

intervention

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