CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL …



SCHOOL OF BUSINESS

DEPARTMENT OF FINANCE AND ACCOUNTING

BY H O ONDIGO

HAND OUT ON CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING

Introduction:

Accounting is often mistaken, to involve the application of a low-level skill devoid of any challenge or imagination. This is far from the truth. In accounting a conceptual framework exists. It consists of philosophical objectives, normative theories, interrelated concepts, precise definitions and underlying assumptions, principles and constraints. This theoretical foundation may be unknown to many people but serves to justifying that accounting is truly a professional discipline.

Definition:

A conceptual framework has been defined as “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 accounting statements”.

A conceptual framework underlying financial accounting cannot be viewed as the description of fundamental truths and axioms as found in theories regarding the natural sciences which are derived from and proven by the laws of nature, rather, it is created, developed or decreed on the basis of environmental factors, intuition, authority and acceptability.

The credibility of the conceptual framework rests upon its general recognition and acceptance by preparers, auditors and users of financial statements.

Usefulness of a conceptual framework.

▪ It enables the development and issuance of a coherent set of standards and practices built upon the same foundation.

▪ It increases financial statement users’ understanding of and confidence in financial reporting.

▪ It enhances comparability among financial statements of different companies. It provides a basis upon which similar transactions and events are similarly accounted for and reported.

▪ It assists in the resolution of new and emerging practical problems by providing a frame of reference for resolving accounting issues.

▪ It defines the bounds of judgement in the preparation of financial statements.

DIAGRAM: OVERVIEW OF A CONCEPTUAL FRAMEWORK FOR FINANCIAL ACCOUNTING.

First level

Objectives THE ‘WHY’-GOALS

AND PURPOSES

OF ACCOUNTING

Qualitative

Characteristics Second level

Of Elements BRIDGE

Accounting BETWEEN

Information LEVELS

1 AND 3.

Recognition and Measurement

Guidelines Third level

THE ‘HOW’

Assumptions Principles Constraints

At the first level, the objectives identify the goals and purposes of accounting and are the cornerstones for the conceptual framework.

At the second level are the qualitative characteristics of accounting information and definition of elements of financial statements. The qualitative characteristics are the characteristics that make accounting information useful while elements are definitions of financial statements components. Together these two categories provide the foundation for developing recognition and measurement guidelines to be used in practice.

At the final level are the recognition and measurement guidelines that accountants use in establishing and applying accounting standards. The recognition and measurement guidelines encompass assumptions, principles and constraints that describe the present reporting environment.

FIRST LEVEL: OBJECTIVES.

The objective of financial reporting is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

Financial statements prepared for this purpose meet the common needs of most users.

General purpose financial statements, however, do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not necessarily provide non-financial information.

Financial statements also provide information about how management of an enterprise discharged its stewardship responsibility to owners for the use of resources entrusted to it.

SECOND LEVEL:

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION.

Qualitative characteristics are the characteristics that make the information provided in the financial statements useful to users for assessing the financial position, performance and financial adaptability of an enterprise.

Some, qualitative characteristics relate to the content of the information contained in financial statements others relate to how that information is presented.

The primary qualitative characteristics relating to content are relevance and reliability.

The primary qualitative characteristics relating to presentation are comparability and understandability.

The relationship between these characteristics is shown in the following diagram:

The qualitative characteristics of financial information

What makes financial information useful?

Threshold Materiality Information that is not material

quality cannot be useful

More of one may

Content Relevance mean less of other Reliability

What makes What makes

information relevant? information reliable?

Information that influences decision Information that is free from error or bias

Predictive value and Timeliness Faithful Neutrality Completeness

Feedback value representation

Prudence

Substance

What qualities make the presentation of

Presentation financial information useful?

Comparability Understandability

Consistency Disclosures (eg. Aggregation and Users’ abilities

Accounting policies and classification

Corresponding figures)

What limits the application of the

Qualitative characteristics?

Balance between

Constraints characteristics Timeliness Benefit and cost

Primary qualities relating to content.

It is generally agreed that relevance and reliability are two primary qualities that make accounting information useful for decision making. Each of these qualities is achieved to the extent that information incorporates specific capabilities (ingredients) as discussed below.

Relevance.

Information is relevant when it can influence the decisions of users (i.e. it is capable of making a difference in a decision). If certain information is disregarded because it is perceived to have no bearing on a decision, it is irrelevant to that decision. Information is relevant when it helps users make predictions about the outcome of past, present, and future events (predictive value), or confirms or corrects prior expectations (feedback value). For example, when a company issues an interim report, this information is considered relevant because it provides a basis for forecasting annual earnings, and provides feedback on past performance. It follows that for information to be relevant, it must also be available to decision-makers before it loses its capacity to influence their decision (timeliness). For example, if a company did not report its interim results until six months after the end of the period, the information would be much less useful for decision-making purposes. Thus, for information to be relevant, it should have the ingredients of predictive value, feedback value, and timeliness.

Reliability.

To be useful, information must also be reliable, information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under legal action are disputed, it may be inappropriate for the enterprise to recognise the full amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim.

Secondary Qualities of Reliability.

Faithful Representation.

To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Thus, for example, a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the enterprise at the reporting date which meet the recognition criteria.

Most financial information is subject to some risk of being less than a faithful representation of what it purports to portray. This is not due to bias, but rather to inherent difficulties either in identifying the measurement and presentation techniques that convey messages that correspond with those transactions and events. In certain cases, the measurement of the financial effects of items could be so uncertain that enterprises generally would not recognise them in the financial statements; for example, although most enterprises generate goodwill internally over time, it is usually difficult to identify or measure that goodwill reliably. In other cases, however, it may be relevant to recognize items and to disclose the risk of error surrounding their recognition and measurement.

Substance Over Form

If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, an enterprise may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the enterprise continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction).

Neutrality

To be reliable, the information contained in financial statements must be neutral, that is, free from bias. Financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgement in order to achieve a predetermined result or outcome.

Prudence

overstatement of liabilities or expenses, because the financial statements would not be neutral and, therefore, not have the quality of reliability.

Completeness

To be reliable, the information in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance.

Primary Qualities relating to Presentation.

Understandability

An essential quality of the information provided in financial statements is that it is readily understandable by users. For this purpose, users are assumed to have a reasonable knowledge of business and economic activities and accounting and willingness to study the information with reasonable diligence. However, information about complex matters that should be included in the financial statements because of its relevance to the economic decision-making needs of users should not be excluded merely on the grounds that it may be too difficult for certain users to understand.

Comparability

Users must be able to compare the financial statements of an enterprise through time in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises in order to evaluate their relative financial position, performance and changes in financial position. Hence, the measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout an enterprise and over time for that enterprise and in a consistent way for different enterprises.

An important implication of the qualitative characteristics of comparability is that users be informed of the accounting policies employed in the preparation of the financial statements, any changes in those policies and the effects of such changes. Users need to be able to identify differences between the accounting policies for like transactions and other events used by the same enterprise from period to period and by different enterprises. Compliance with accounting standards, including the disclosure of the accounting policies used by the enterprise, helps to achieve comparability.

The need for comparability should not be confused with mere uniformity and should not be allowed to become an impediment to the introduction of improved accounting standards. It is not appropriate for an enterprise to continue accounting in the same manner for a transaction or other event if the policy adopted is not in keeping with the qualitative characteristics of relevance and reliability. It is also inappropriate for an enterprise to leave its accounting policies unchanged when more relevant and reliable alternatives exist.

Because users wish to compare the financial position, performance and changes in financial position of an enterprise over time, it is important that the financial statements show corresponding information for the preceeding periods.

The purpose of establishing qualitative characteristics of accounting information is to provide a framework for accountants when making choices regarding measurements and disclosure in financial reports. Using such a framework does not provide obvious solutions to accounting problems; rather it simply identifies and defines aspects that should be considered when reaching a solution. Indeed, many accounting choices require trade-off between the qualitative characteristics. For example, some believe that financial reports based on current costs could provide more relevant information than reports based on historical costs, which are reliable. There is not, however, any clear-cut consensus on the relative weighting (importance) of relevance and reliability (or other characteristics) that assist in deciding such issues. Consequently, while awareness of the qualitative characteristics may help in choosing between alternatives, the actual decisions, in most cases, require the exercise of professional judgement.

Basic Elements.

An important aspect of the theoretical structure is the establishment and definition of the basic categories of items to be included in financial statements. At present, accounting uses many terms that have peculiar and specific meaning in the language of business. It seems necessary, therefore, to develop a basic definition framework for the elements of accounting. Such definitions provide guidance for identifying what to include and what to exclude from the financial statements.

ELEMENTS OF FINANCIAL STATEMENTS.

Assets

Assets are economic resources controlled by an entity as a result of past transactions or events from which future economic benefits may be obtained.

Assets have three essential characteristics:

a) they embody a future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash flows;

b) the entity can control access to the benefit; and

c) the transaction or event giving rise to the entity’s right to, or control of, the benefit has already occurred.

It is not essential for control of access to the benefit to be legally enforceable for a resource to be an asset, provided the entity can control its use by other means.

Liabilities

Liabilities are obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future.

Liabilities have three essential characteristics:

a) they embody a duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services or other yielding of economic benefits, at a specified or determinable date, on occurrence of a specified event, or on demand;

b) the duty or responsibility obligates the entity, leaving it little or no discretion to avoid it; and

c) the transaction or event obligating the entity has already occurred.

Equity

Equity is the ownership interest in the assets after deducting its liabilities. While equity in total is residual, it includes specific categories of items, for example, types of share capital, share premium, revaluation reserves, capital redemption reserve fund, retained earnings and proposed dividends.

Revenues

Revenues are increases in economic resources, either by way of inflows or enhancements of assets or reductions of liabilities, resulting from the ordinary activities of an entity, normally from the sale of goods, the rendering of services, or the use by others of entity resources yielding rent, interest, royalties or dividends.

Expenses

Expenses are decreases in economic resources, either by way of outflows or reductions of assets or incurrences of liabilities, resulting from the ordinary revenue-earning activities of any entity.

Gains

Gains are increases in equity from peripheral or incidental transactions and events affecting an entity, and from all other transactions, events and circumstances affecting the entity except those that result from revenues or equity contributions.

Losses

Losses are decreases in equity from peripheral or incidental transactions and events affecting an entity and from all other transactions, events and circumstances affecting the entity except those that result from expenses or distributions of equity.

Net income

Net income is the residual amount after expenses and losses are deducted from revenue and gains. Net income generally includes all transactions and events increasing or decreasing the equity of the entity except those that result from equity contributions and distributions.

It is useful to think of the elements as two distinct groups. The first group of three elements-assets, liabilities, and equity-describe amounts of resources and claims to resources at a moment in time and appear in a balance sheet. The other five elements (net income and its components-revenues, expenses, gains and losses) describe transactions, events and circumstances that affect an enterprise during a period of time and are presented in an income statement. The first group is changed by elements of the second group, and at any time is the cumulative result of all changes. This interaction is referred to as articulation, and results in financial statements that are fundamentally interrelated. Thus, a statement, for example the balance sheet, that reports elements of the first group depends on the statement, the income statement, that reports elements in the second group, and vice versa.

Recognition of the Elements of Financial Statements

Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element. It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheet or income statement totals.

Items that satisfy the recognition criteria should be recognized in the balance sheet or income statement. An item that meets the definition of an element should be recognized if:

a. it is probable that any future economic benefit associated with the item will flow to or from the enterprise; and

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

The interrelationship between the elements means that an item that meets the definition and recognition criteria for a particular element, for example an asset, automatically requires the recognition of another element, for example, income or liability.

The Probability of Future Economic Benefit

The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the enterprise. The concept is in keeping with the uncertainty that characterizes the environment in which an enterprise operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared. For example, when it is probable that a receivable owed by an enterprise will be paid, it is then justifiable, in the absence of any evidence to the contrary, to recognize the receivable as an asset. For a large population of receivables, however, some degree of non-payment is normally considered probable; hence an expense representing the expected reduction in economic benefits is recognized.

Reliability of measurement

The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with reliability. In many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When, however a reasonable estimate cannot be made the item is not recognized in the balance sheet or income statement. If it is not possible for the item to be measured reliably, it should be disclosed in the notes, explanatory material or supplementary schedules.

Recognition of assets

An asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably.

Recognition of liabilities

A liability is recognized in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.

Recognition of income

Income is recognized in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.

Recognition of expenses

Expenses are recognized in the income statement when a decrease in an asset or an increase in liability has arisen that can be measured reliably.

Measurement of the elements of financial statements.

Measurement is the process of determining the monetary amount at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.

A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following:

a. Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amount of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

b. Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash and cash equivalents that would be required to settle the obligation currently.

c. Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalent that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

d. Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

The measurement basis most commonly adopted by the enterprise in preparing their financial statements is historical cost.

Absence of a universally agreed Conceptual Framework

It should be noted that no single framework is universally accepted or totally relied upon in practice. This is due to a number of factors, which include:

▪ The variety of users that financial statements serve is so wide that no one framework is likely to meet all their needs.

▪ The time and resources needed to develop a universally agreed conceptual framework perhaps makes it impossible for professional bodies to continue with their programs.

▪ Accounting conventions that underlie financial reporting cannot be proved to be correct; they depend on consensus. Without consensus there cannot be an agreed conceptual framework and it may not be possible to achieve consensus on wide issues.

▪ The development of an accounting standard may be influenced by factors other than a conceptual framework, for example existing practice and political pressure.

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