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CHAPTER 1 THEORETICAL BACKGROUND

1.1 THE ROLE OF A CONCEPTUAL FRAMEWORK


A conceptual framework of accounting aims to provide a structured theory of accounting.
At its highest theoretical levels, it states the scope and objective of financial reporting. At
the next fundamental conceptual level, it identifies and defines the qualitative
characteristics of financial instruments (such as relevance, reliability, comparability,
timeliness and understandability. At the lower operational levels, the conceptual
framework deals with principles and rules of recognition and measurement of the basic
elements, and report disclosures.

The FASB has defined the conceptual framework as:


a coherent system of interrelated objectives and fundamentals that is expected to lead
to consistent standards and that prescribes the nature, function and limits of financial
accounting and reporting. Such words as coherent system and consistent indicate that
the FASB advocates a theoretical and non-arbitrary framework, and the word prescribes
supports a normative approach.

Some accountants ask whether a conceptual framework is necessary. They argue that
formulating a general theory of accounting through a conceptual framework is not
necessary. Some people hold the view that accounting practices is overly permissive
because it permits alternatives accounting practices to be applied to similar
circumstances. The inconsistency of practices has also been seen as a problem. There are
many sources of authority in accounting that regulate, such as the inventory calculation,
differently. Business managers and executives sometimes persuade accountants to devise
acceptable accounting schemes for the purpose of minimizing their tax expense or
increasing their reported profit. There is an argument that the conceptual framework as a
defence against political interference in the neutrality of accounting reports.

The benefits of a conceptual framework have been summarized by Australian standard


setters as follows:
a) Reporting requirements will 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 that establish 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-out, thus minimizing
the risk over-regulation.
e) Preparers and auditors will be able to better understand the financial reporting
requirements they face.
f) More economical standard setting because issues should not need to be re-debated
from differing viewpoints.

1.2 OBJECTIVES OF CONCEPTUAL FRAMEWORK


The FASB statement of Financial Accounting Concepts (SFAC) No 1 (paragraph 34)
stated the basic objectives of external financial reporting for business entities:
Financial reporting should provide information that is useful to present and potential
investors and creditors and other users in making rational investment, credit and similar
decisions.

Both the IASB and FASB frameworks consider the main objective of financial reporting
is to communicate financial information to users. This objectives is seen to be achieved
by reporting information that is:
Useful in making economic decisions
Useful in assessing cash flow prospects
About enterprise resources, claims to those resources and changes in them

SFAC No 2 and IASB framework explain the qualitative characteristics.


Understandability refers to the ability of information to be understood by users, Users are
assumed to have reasonable knowledge of business and economic activities and
accounting, and a willingness to study the information with reasonable diligence.
Information has the quality of relevance when it influences the economic decisions of
users by helping them evaluate past, present or future or confirming or correcting their
past evaluations. To be reliable, financial information should faithfully represent
transactions and events without material bias or error (IASB Framework, paragraph 24-
42).
The FASB issued seven concept statements covering the following topics:

Objectives of financial reporting by business enterprises and non-profit


organizations
Qualitative characteristics of useful accounting information
Elements of financial statements
Criteria for recognizing and measuring the elements
Use of cash flow and present value information in accounting measurements

The IASB has just one concept statements, the Framework for the Preparation and
Presentation of Financial Statements, which:

Defines the objectives of financial statements


Identifies qualitative characteristics that make information in financial statements
useful
Defines the basic elements of financial statements and the concept for recognizing
and measuring them in financial statements.

1.3 DEVELOPING A CONCEPTUAL FRAMEWORK


The development of conceptual frameworks is influenced by two key issues:
principles versus rules-based approaches to standard setting
information for decision making and the decision-theory approach

Principles-based and rule-based standard setting

The IASB aims to produce principle-based standards and thus it looks to the conceptual
framework for guidance. It represents the basic ideas which underpin the development of
the standard and assist users in their interpretation of the standards. While the IASB aims
to be principle-based standard setter, standards such as IAS 39 have been criticized as
being overly rule-based. Nobes suggests that the reasons standards become rules-based is
that they are inconsistent with the conceptual frameworks of standard setters. He argues
that the need for rules results from lack of principles or use of an inappropriate principle.

However, rule-based standards have some advantages which explain their popularity.
These include increased comparability and increased verifiability for auditors and
regulators. Rule-based standards may reduce the opportunities for earnings management;
however they allow for the specific structuring of transactions to work around the rules.

The study recommended that accounting standards be developed using a principles-based


approach and that standard should have the following characteristics.

Be based on an improved and consistently applied conceptual framework.


Clearly state the objective of the standard.
Provide sufficient detail and structure that the standard can be operationalized and
applied on a consistent basis.
Minimize the use of exceptions from the standards.
Avoid use of percentage tests that allow financial engineers to achieve technical
compliance with the standards while evading the intent of the standard.

The greater emphasis on the conceptual framework, principles and objectives arises from
events of the corporate collapses at Enron and WorldCom. The Sarbanes-Oxley act 2002
introduced many changes to improve the quality of financial reporting and auditing.
Establishing a principle-based approach as a FASB objective is timely in terms of the
IASB/FASB convergence program. A lack of the same underlying approach would make
converging standards and producing standards for use in both jurisdictions more difficult.

Information for decision making and decision-theory approach

Accounting data are for decision making or evaluative purposes in relation to a specific
entity. Accounting information for decision making begins with the stewardship
functions. The information on how managers have discharged their stewardship
responsibility is used by the equityholders to evaluate the performances of the managers
and the firm.

Information for decision making, however, is not seen to replace information relating to
stewardship or accountability. Information for decision making implies more than
information on stewardship. First, the users of financial information are greatly expanded
to include all resources providers, recipients of goods and services and parties performing
a review or oversight function. Second, accounting information is seen as input data for
the prediction models of users

The decision-theory approach to accounting is helpful to test whether accounting achieves


its purposes. The theory should serve as a standard by which accounting practices are
judged. The model is presented in figure below. The arrows indicate the output of the
theory, system or model.

The model maps the process by which the outputs of the accounting system provide
inputs to the decision model of a user. Financial information may have a wider range of
users, includes investors, employees, lenders, suppliers and trade creditors, customers,
governments and their agencies, and the public as potential users.

International developments: the IASB and FASB Conceptual Framework

In October 2004, the FASB and IASB added a joint project to their agendas to develop an
improved, common conceptual framework. The revised framework will build on the
existing IASBs and FASBs frameworks and consider developments subsequent to the
issuance of those frameworks. The FASB states that the project will do the following:

1. Focus on changes in the environment since the original frameworks were issued, as
well as the omissions in the original frameworks, in order to efficiently and
effectively improve, complete, and converge the existing frameworks.
2. Give priority to addressing and deliberating those issues within each phase that are
likely to yield benefits to the Boards in the short term; that is, cross-cutting issues that
affect a number of their projects for new or revised standards.
3. Initially consider concepts applicable to private sector business entities.

Controversial matters include the perspective underlying financial reporting (entity vs


proprietorship), the primary user group and the objective of financial reporting, and the
qualitative characteristics of financial reporting.

1.3 A CRITIQUE OF CONCEPTUAL FRAMEWORK PROJECTS


The development of conceptual frameworks met with criticisms. An analysis of the
criticisms will help explain reasons for the previous slow development of the frameworks
and highlight issues relevant to achieving progress in the current IASB/FASB project.
There are two approaches use in the analysis:
Scientific, which recourse to logic and empiricism or both
Professional, which prescribes the best course of action by recourse to
professional values

Scientific criticisms for the conceptual framework project includes,

prescriptive
unspecified rules and conventions
do not resolve contemporary disclosure issues
vague definitions
do not address measurement issues
risk of mechanical decision making
framework may become an end in itself
overreliance on definitions

Further criticisms focus on the ontological and epistemological assumptions. Accounting


can never be neutral and unbiased. Accounting as a social science is two-way and does
not have an objective and separate existence from accountants. In measuring and
communicating reality, accountants play a critical role in creating that reality. Particular
methods and methodological assumptions also dominate accounting, which leads to
generalized and large-scale empirical research. This type of research ignores the micro
level of practicing accountants who may require a situation-specific problem-solving
approach.

There are also arguments that view the conceptual framework as policy documents based
on professional values and self-interest. Therefore they are seen to be a reflection of the
political will of the dominant group, which is dominated by professional values. One
motivation is to increase economic power through monopoly-seeking behavior. The
conceptual frameworks, as a response, testify to the presumed existence of a coherent
theoretical core which underlies practice, thus alleviating criticism. There is some
evidence, however, that the existence of the conceptual framework project has increased
the level of conceptual debate in the standard setting lobbying process. Furthermore, it
provides guidance for dealing with issues that are not yet the subject of an accounting
standards.

1.5 CONCEPTUAL FRAMEWORK FOR AUDITING STANDARD


Early auditing theory emphasized the role of logic and key concepts such as auditor
independence and evidence gathering. By the 1990s the formalized auditing processes
and structures were under pressure from clients for lower audit fees and greater value.
There was a swift away from substantive testing towards a greater emphasis on
consideration of audit risk, in particular the role of client business risk. Business risk
auditing emphasized the impact of threats to the clients business model from external
factors and the resulting risk of fraud and error in the financial statements. Critics
believed that business risk auditing was an attempt to justify less audit work and greater
consulting. Legislative changes since the early 2000s have restricted the opportunity for
consulting to audit clients but also increased the focus on auditing clients internal
controls.

CHAPTER II CASE STUDY


Case Study 4.3

Revisiting the conceptual framework

Questions

1. Explain why principles-based standards require a conceptual framework.


2. Why is it important that the IASB and FASB share a common conceptual framework?
3. It is suggested that several parties can benefit from a conceptual framework. Do you
consider that a conceptual framework is more important for some parties than others?
Explain your reasoning.
4. What is meant by a 'cross-cutting' issue? Suggest some possible examples of
crosscutting issues

Answers

1. Principle-based standards require a conceptual framework because of following


reasons:
a. A conceptual framework makes the standards to be deep rooted in
fundamental concepts rather than just being a collection of conventions
b. Conceptual framework helps FASB and IASB to achieve coherent accounting
and reporting
c. Conceptual framework ensures that there is consistent between standards and
between the past and future decisions. This prevents reaching different
conclusions on similar events.
d. Conceptual framework ensures that standards are not based on the individual
concepts of the standard-setting board members.
e. Conceptual framework brings consistence between financial statement
preparation, financial reporting and interpretation of the information contained
in the financial statements.
f. A conceptual framework acts a written constitution for financial accounting
and reporting and all references are made from it.

2. It is important to share a common conceptual framework in order to enable the


refinement, updating, completion and convergence between the current IASB
framework, and FASB concept statements. This is because these frameworks were
developed in the 70s and 80s and therefore refining and updating them is necessary.
3. There are arguments (including a securities regulator and many accounting firms)
agreed that the primary user of the Conceptual Framework should be the IASB.
They cited the following reason:
a) Because the IASB has developed more comprehensive guidance since the
original Framework, there are fewer instances when parties other than the
IASB will use the Conceptual Framework to interpret Standards.
b) It reinforces the position that the Conceptual Framework is not a Standard and
does not override Standards.
c) It will ensure that the IASB focuses on conceptual issues when developing the
Conceptual Framework and does not merely codify current practice.
Others cited reasons why the Conceptual Framework is important to parties other than
the IASB:
a) The Conceptual Framework facilitates a common understanding of basic
principles or concepts of financial reporting among all those who use the
Standards.
b) Focusing on the IASB as the primary user of the Conceptual Framework is
likely to reduce the prominence or importance of this document to other
parties. For example:
a. auditors and regulators consider the Conceptual Framework when
assessing the judgements made by preparers; and
b. the IFRS Interpretations Committee uses the Conceptual Framework
when developing Interpretations.
c) A Conceptual Framework should contain high-level principles that
stakeholders can understand to fulfil the IFRS Foundations objective of
promoting and facilitating the adoption of IFRS.
d) The Conceptual Framework is a behavioral code that all parties should
follow.

Based on all those reasons, we concluded that everyone might use the conceptual
framework as point of references in the accounting application. The IASB might be
use the conceptual framework the most, but that doesnt mean that other parties are
not important enough to use these.

4. OECD (2014) reviewed that cross cutting issues are defined as that immensely effects
the operations of a given field due to their nature, therefore, special attention is
provided to such issues. Some of the examples of cross cutting issues in the
contemporary business include sustainability of the environment, gender equality and
health related issues. Hollander, Kim, Braun, Simeon, and Zohar (2009) added that
issues such as environment and gender equality are crucial from all the perspectives
of development, most of the societies and business consider environment and the
development to be a similar thing. Since, the business as well as societal development
is affected adversely if the rivers are contaminated, subtle changes in the weather, and
due to depletion in the soil. In the same manner, Narrow, Clarke, Kuramoto, Kraemer,
Kupfer, Greiner, Regier (2013) stated that people cannot take care of the environment
if they are financially unstable. Thus gender equality has also emerged out as a goal in
its self. However, according to Hk, Moldan, and Dahl (2012), countries cannot reach
their potential without utilising 50% of their labour force and talent. Moser and
Ekstrom (2010) stated that if women are provided with the similar resources financial
services and technological equipments as men, the production of agriculture across
the world will increase which will eventually decrease the hungry people by 100
million. Therefore, Narrow, Clarke, Kuramoto, Kraemer, Kupfer, Greiner, Regier
(2013) stated that the mainstream cross cutting issue suggest that the developmental
initiatives shall have a positive effect on the consideration that are termed as
mainstream cross cutting issues.

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