DEPARTMENT OF ACCOUNTING

UNIVERSITY OF JAFFNA- SRILANKA

Programme Title: First in Business Administration- 2020/2021

Course Unit : BBAA 11033 Financial Accounting 1
Handout : 01- Conceptual Framework
Prepared by : Mrs.P.Muraleetharan,
Issued on : 15th June 2022

Learning Outcomes:
After completing this lesson you should be able to:
Describe the usefulness of a conceptual framework
Understand the objective of financial reporting
Identify the qualitative characteristics of accounting information
Define the basic elements of financial statements
Describe the basic assumptions of accounting
Explain the application of the basic principles of accounting

1. INTRODUCTION
For many of us, accounting appears to be methodical and procedural in nature. The visible
portion of accounting – record keeping and preparation of financial statements too often
suggests the application of a low level skill in an occupation devoted to mundane objectives
and devoid of challenge and imagination. In accounting, a large body of theory (conceptual
framework) does exist, however. 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
justify accounting as a truly professional discipline. Thus, accountants philosophize,
theorize, judge, create, and deliberate as a significant part of their professional activity.
The principles of accounting are unlike the principles of the natural sciences and
mathematics. Because

1. they can’t be derived from or proved by the laws of nature

2. They are not viewed as fundamental truths or axioms

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2. NATURE OF A CONCEPTUAL FRAMEWORK
A conceptual framework is like a constitution. A conceptual framework for financial
accounting is “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.”

In a broad sense a conceptual framework can be seen as an attempt to define the nature and
purpose of accounting. A conceptual framework must consider the theoretical and conceptual
issues surrounding financial reporting and form a coherent and consistent foundation that will
underpin the development of accounting standards.

Conceptual frameworks can apply to many disciplines, but when specific ally related to
financial reporting, a conceptual framework can be seen as a statement of generally accepted
accounting principles (GAAP) that form a frame of reference for the evaluation of existing
practices and the development of new ones. As the purpose of financial reporting is to
provide useful information as a basis for economic decision making, a conceptual framework
will form a theoretical basis for determining how transactions should be measured (historical
value or current value) and reported – ie how they are presented or communicated to users.

Why is a Conceptual Framework Necessary?

First, to be useful, standard setting should build on and relate to an established body of
concepts and objectives. A soundly developed conceptual framework should enable the
development and issuance of a coherent set of standards and practices built upon the same
foundation.

Second, a conceptual framework should increase financial statement users’ understanding of

and confidence in financial reporting.

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Third, such a framework should enhance comparability among the financial statements
of different companies. Similar events should be similarly accounted for and reported;
dissimilar events should not be.

Fourth, new and emerging practical problems should be solved more quickly by referring to
an existing framework of basic theory

3. DEVELOPMENT OF A CONCEPTUAL FRAMEWORK

One of the initial projects of the financial Accounting standards Board (FASB) was a study
designed to identify the “broad qualitative standards for financial reporting” After extensive
work on the project, the FASB decided to expand the scope of the project to include the entire
conceptual framework of financial accounting and reporting, including objectives, qualitative
characteristics, and the needs of users of accounting information. The purpose of the
conceptual framework project was to provide a sound and consist basis for the development
of financial accounting standards.

The expanded conceptual framework project undertaken by the FASB has resulted in the
publication of the following relating to financial reporting for business enterprises:
Statement of Financial Accounting concepts No.1 (SFAC No.1), “objectives of Financial
Reporting by business Enterprises” Presents the goals and Purposes of Accounting.

SFAC No.2, “Qualitative characteristics of Accounting Information” Examines the

Characteristics that make accounting information useful.

SFAC No. 3, “Elements of Financial Statements of Business Enterprises” Provides

definitions of items that financial statements comprise, such as assets, liabilities, revenues
and expenses.

SFAC No. 5, “Recognition and measurement in financial Statements of Business enterprises”

Sets forth fundamental recognition and measurement criteria and guidance on
what information should be formally incorporate into financial statements and
when.

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SFAC No. 6, Elements of Financial Statements” Replaces SFAC No.3 and expands its scope
to include not –for-profit organizations.

These issues are discussed in three levels of conceptual framework.

First level: Objectives: SFAC No. 1
Second level: - Qualitative characteristics: SFAC No. 2
Elements of financial statements SFAC No. 6
Third level: Recognition and measurement concepts. SFAC No. 5

4. FIRST LEVEL: OBJECTIVES OF FINANCIAL REPORTING AND

FINANCIAL STATEMENTS
In general, when providing information to users of financial statements, the accounting
profession has relied on general-purpose financial statements. The intent of these is to
provide useful information to various user groups at reasonable cost. Underlying these
objectives is the presumption that users have a fairly sophisticated understanding of matters
related to business and financial accounting. This point is important because it means that
when preparing financial statements, accountants may assume that users have a reasonable

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level of competence; this has an impact on the way and the extent to which information is
reported.

4.1The objectives established by the FASB were as follows:

1. 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. The information should be comprehensible to those who have a
reasonable understanding of business and economic activities and are willing to study
the information with reasonable diligence.
2. Financial reporting should provide information to help present and potential investors
and creditors and other users in assessing the amounts, timing, and uncertainty of
prospective cash receipts from dividends or interest and the proceeds from the sale,
redemption, or maturity of securities or loans.
3. Financial reporting should provide information about the economic resources of an
enterprise, the claims to those resources, and the effects of transactions, events, and
circumstances that change resources and claims to those resources.
4. Financial reporting should provide information about an enterprise’s financial
performance during a period.
5. The primary focus of financial reporting is information about an enterprise’s
performance provided by measures of earnings and its components.
6. Financial reporting should provide information about how enterprise obtains and
spends cash, about its borrowing and repayment of borrowing, about its capital
transactions, including cash dividends and other distributions of enterprise resources
to owners, and about other factors that may affect an enterprise liquidity or solvency.
7. Financial reporting should provide information about how management of an
enterprise has discharged its stewardship responsibility to owners (stockholders) for
the use of enterprise resources interested to it.
8. Financial reporting should provide information that is useful to managers and
directors in making decisions.
Summarizing, the FASB identified eight objectives of financial reporting, all of which
focused on providing information needed by current and prospective investors and creditors
of a business enterprise in their decision making. The primary emphasis was placed on
information regarding the enterprise’s earnings.

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5. SECOND LEVEL: FUNDAMENTAL CONCEPTS
The objectives (first level) are concerned with the goals and purposes of accounting. The
qualitative characteristics of accounting information and define the elements that financial
statements comprise. These conceptual building blocks form bridge between the why (the
objectives) and the how (recognition and measurement) of accounting.

5.1 Qualitative Characteristics of Accounting Information

Choosing an acceptable accounting method, the amount and type of information to be
disclosed, and the format in which information should be presented involves determining
which of several possible alternatives provide the best (i.e. most useful) information for
decision – making purposes.

5.1.1. Decision Makers (Users) and Understandability

Decision makers vary widely in the types of decisions they make, the methods of decision
making they employ, the information they already possess or can obtain from other sources,
and their ability to process the information. Consequently, for information to be useful there
must be a connection (linkage) between it and the users and the decisions they make. This
linkage is the understandability of the information. Understability of financial statements,
however, depends not only on the accounting’s skills and abilities to comprehend that
information. In this regard, a user’s ability could vary from being simplistic to expert.

5.1.2 Primary Qualities

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)
A. Relevance
Relevance is the capacity of accounting information to make a difference to the external
decision makers who use financial reports. If certain information is disregarded because it is
perceived to have no bearing on a decision, it is irrelevant to that decision.
Relevance can be evaluated according to three qualitative criteria,
1. Timeliness – means available to decision makers before it loses its capacity to
influence their decisions. Accounting information should be timely if it is to

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 influence decisions, like the news of the world, state financial information has less
impact than fresh information.
2. Predictive value – Accounting information should be helpful to external decision
makers by increasing their ability to make predictions about the outcome of future
events. Decision makers working from accounting information that has little or no
predictive value are merely speculating. For example, information about the current
level and structure of asset holdings help users to assess the entity’s ability to exploit
opportunities and react to adverse situations
3. Feedback value: Accounting information should be helpful to external decision
makers who are confirming past predictions or making updates, adjustments, or
corrections to predictions.

B. Reliability
Reliability means that users can depend on accounting information to represent the
underlying economic conditions or events that it purports to represent. Reliability of
information is a necessity for individuals who have neither the time nor the expertise to
evaluate the factual content of financial statements. It is especially important to the
independent audit process. Like relevance, reliability must meet three qualitative criteria.

1. Representational faithfulness – Accounting information should represent what it

purports to represent and should ensure that the selected method of measurement has
been used without error or bias. This attribute is sometimes called Validity: -
Information must give a faithful picture of the facts and circumstances involved.
Accounting information must report the economic substance of transactions, not just
their form and surface appearance.
2. Verifiability:-Verifiability pertains to maintenance of audit trials to information
source documents that can be checked for accuracy. It also pertains to the existence
of alternative information sources as backing. Verification implies a consensus and
implies that independent measures using the same measurement methods would reach
substantially the same conclusions.
3. Neutrality: - Accounting information must be free from bias regarding a particular
view point, predetermined result, or particular party. Preparers of financial reports
must not attempt to induce a predetermined outcome or a particular mode of behavior

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 (such as to purchase a company’s stock). Accounting information cannot be selected
to favor one set of interested parties over another. It should be factual and truthful.

5.1.3 Secondary Qualities

The potential use of different acceptable methods by one enterprise in different years, or by
different companies in a given year, would make comparison of financial results difficult
consequently, in order to enhance the usefulness of accounting reports, the qualities of
comparability and consistency are components of the conceptual framework. They are
considered to be secondary in our hierarchy to the qualities of relevance and reliability. If
information is to be useful, it must first be relevant and reliable, but achieving these primary
qualities may require foregoing the secondary qualities. Ideally, financial accounting
information would satisfy both qualitative levels

A. Comparability: - Information that has been measured and reported in a similar manner for
different enterprise in a given year, or for the same enterprise in different years, is considered
comparable. Thus, comparability is a characteristic of the relationship between two pieces of
information rather than of a particular piece of information in itself. Comparability enables
to identify the real similarities and differences in economic phenomena because these
differences and similarities have not been obscured by the use of noncomparable methods of
accounting.

B. Consistency: - This characteristic is achieved by an enterprise when it uses the same

selected accounting policies from period to period; that is, these methods are consistently
applied. Consistency results in enhancing the comparability of financial statements of an
enterprise from year to year.

Consistency doesn’t mean that a company can never switch from one method of accounting
to another. Companies can change methods, but the changes are restricted to situations in
which it can be demonstrated that the newly adopted method is preferable to the old. Then
the nature and effect of the accounting change, as well as the justification for it, must be fully
disclosed in the financial statements for the period in which the change is made.

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6. Elements of Financial Statements
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. One such
term is asset. It seems necessary, therefore, to develop a basic definitional framework for the
elements of accounting.

6.1 Assets.
Assets are probable future economic benefits obtained or controlled by a particular entity as a
result of past transactions or events. They 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
c. The transaction or event-giving rise to the entity’s right to, or control of, the benefit
has already occurred (result of past transactions).

6.2 Liabilities
Liabilities are probable future sacrifices of economic benefits arising from present obligations
of a particular entity to transfer assets or provide services to other entities in the future as
result of past transactions or events. They 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.
c. The transaction or event obligating the entity has already occurred.

6.3 Equity
Equity is the residual (ownership) interest in the assets of an entity that remains after
deducting its liabilities. While equity in total is a residual, it includes specific categories of
items, for example, types of share capital, contributed surplus and retained earnings

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 Investments by Owners
Are increases in net assets of a particular enterprise resulting from transfers to it from other
entities of something of value to obtain or increase ownership interests (or equity) in
it. Investments by owners are characterized as
a. Cash or other assets exchanged for stock
b. Service performance (sometimes called sweat equity) exchanged for stock
c. Conversion of liabilities to equity ownership
Distributions to Owners
Are decreases in net assets of a particular enterprise resulting from transferring assets,
rendering services, or incurring liabilities by the enterprise to owners? They are
characterized as
a. Cash dividend payments or declarations
b. Transfer of assets to owners
c. Liquidating distributions (asset sale proceeds)
d. Conversion of equity ownership to liabilities
6.4 Revenues
Revenues are inflows or other enhancements of assets of an entity or settlement of its
liabilities (or combination of both) during a period from delivering or producing goods,
rendering services, or other activities that constitute the entity’s ongoing major or central
operations. The two essential characteristics of a revenue transaction are
a. It arises from the company’s primary earning activity (main stream business lines)
and not from incidental or investment transactions (assuming that the entity is a non
investment company).
b. It is recurring

6.5 Expenses
Expenses are outflows or other using up of assets or incurrence of liabilities (or combination
of both) during a period from delivering or producing goods, rendering services, carrying out
other activities that constitute the entities ongoing major or central operations.
The essential characteristic of an expense is that it must be incurred in conjunction with the
company’s revenue-generating process. Expenditures that do not qualify as expenses must be
treated as assets (future economic benefit to be derived), as losses (no economic benefit), or
as distributions to owners.

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6.6. Gains
Gains are increases in equity (net assets) from peripheral or incidental transactions of an
entity and from all other transactions and other events and circumstances affecting the entity
during a period except those that result from revenues or investments by owners.
6.7 Losses
Losses are decreases in equity (net assets) from peripheral or incidental transactions of an
entity and from all other transactions and other events and circumstances affecting the entity
during a period except those that result from expenses or distributions to owners.
6.8 Comprehensive Income
Is change in equity (net assets) of an entity during a period from transactions and other events
and circumstances from non owner sources, i.e., change in equity other than resulting from
investment by owners and distribution to owners. The FASB’s new comprehensive income
incorporates certain gains and losses in its computation that are not currently included in net
income capital transactions are still excluded.

7. THIRD LEVEL: RECOGNITIONANDMEASUREMENT CONCEPTS.

SFAC No 5 published in 1984, provides a set of companion directives to those in SFAC No
2. The statements are similar in that both are aimed at promoting consistency (in how
accounting information is communicated to interested parties). SFAC No 5 addresses six
specific topic areas: Recognition criteria, measurement criteria, environmental assumptions,
implementation principles, and implementation constraints and general purpose financial
statements.
Recognition Criteria:- recognition pertains to the point in time when business transactions
are recorded in the accounting system. The term recognition is broadly defined as the process
of recording and reporting an item as an asset, liability, revenue, expense, gain, loss or
change in owners’ equity. Recognition of an item is required when all four of the following
criteria are met:
i. Definition: the item in question must meet the definition of an element of financial
statements.

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 ii. Measurability: The item must have a relevant quality or attribute that is reliably
measurable (historical cost, current cost, market value, present value or net realizable
value).
iii. Reliability:- The accounting information generated by the item must be
representational faithful, verifiable (Subject to audit confirmation or second – Source
collaboration) and neutral (bias – free).
iv. Relevance – The accounting information generated by the item must be significant,
that is, capable of making a difference to external users in making decision.

Measurement Criteria – SFAC No 5 reflects that all monetary measurements will be based
on nominal units of money. However, a change in the level of inflation, which leads to
significant distortions, could lead another, more stable measurement scale.

7.1 Basic Assumptions.

Four basic environmental assumptions that significantly affect the recording, measuring, and
reporting of accounting information. They are:
1. Business entity Assumption – Accounting deals with specific, identifiable business
entities, each considered an accounting unit separate and apart from its owners and
from other entities. A corporation and its stockholders are separate entities for
accounting purposes. Also partnership and sole proprietorships are treated as separate
from their owners, although this separation does not hold true in a legal sense.
Under the business entity assumption, all accounting records and reports are
developed from the viewpoint of a single entity, whether it is a proprietorship, a
partnership, or a corporation. The assumption is that an individual’s transactions are
distinguishable from those of the business he or she might own.

2. Going – Concern Assumption –under this assumption the business entity in question
is expected not to liquidate but to continue operations for the foreseeable future. That
is, it will stay in business for a period of time sufficient to carry out contemplated
operations, contracts and commitments. This non liquidation assumption provides a
conceptual basis for many of the classifications used in account. Assets and
liabilities, for example, are classified as either current or long term on the basis of this
assumption. If continuity is not assumed, the distinction between current and long –

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 term loses its significance, all assets and liabilities become current. Continuity
supports the measurement and recording of assets and liabilities at historical cost.

3. Unit - of – measure Assumption – It states that the results of a business’s economic

activities are reported in terms of a standard monetary unit throughout the financial
statements. Money amounts are the language of accounting – the common unit of
measure (yardstick) enables dissimilar items, such as the cost of a ton of coal and an
account payable, to be aggregated into a single total. Example, the unit of measure in
the United States is the dollar; in Japan it is the yen, in Ethiopia it is the birr.
Unfortunately, the use of a standard monetary unit for measurement purposes poses a
dilemma unlike a yardstick, which is always the same length, a currency experiences
change in value. During periods of inflation (deflation) dollars of different values are
accounted for without regard to the fact that some have greater purchasing power than
others.
4. Time – period Assumption. The operating results of any business enterprise can’t be
known with certainty until the company has completed its life span and ceased doing
business. In the meantime, external decision makers require timely accounting
information to satisfy their analytical needs. To meet their needs, the time period
assumption requires that changes in a business’s financial position be reported over a
series of shorter time periods.
The time – period assumption recognizes both that decision makers’ need timely
financial information and that recognition of accruals and deferrals is necessary for
reporting accurate information. If a demand for periodic reports didn’t exist during
the life span of a business, accruals and deferrals would not be necessary.

7.2. Basic Principles:

Accounting principles assist in the recognition of revenue, expense, gain, and loss items for
financial statement reporting purposes. Income is defined as revenues plus gains minus
expenses and losses. The cost principle, the revenue principle, and the matching concept are
employed in practice in the process of determining income. The four principles are
1. The cost principle: Normally applied in conjunction with asset acquisitions, the cost
principle specifies that the actual acquisition cost be used for initial accounting recognition

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purposes. The cash – equivalent cost of an asset is used if the asset is acquired via some
means other than cash.
The cost principle assumes that assets are acquired in business transactions conducted at
arm’s length, that is, transactions between a buyer and a seller at the fair value prevailing at
the time of the transaction. For non – cash transactions conducted at arm’s length the cost
principle assumes that the market value of the resources given up in a transaction provides
reliable evidence for the valuation of the item acquired.
When an asset is acquired as a gift, in exchange for stock, or in an exchange of assets,
determining a realistic cost basis can be difficult. In these situations the cost principle
requires that the cost basis be based on the market value of the assets given up or the market
value of the asset received, which ever value is more reliably determined at the time of the
exchange.
When an asset is acquired with debt, such as with a note payable given in settlement for the
purchase, the cost basis is equal to the present value of the debt to be paid in the future.

2. The revenue realization principle: This principle requires the recognition and reporting
of revenues in accordance with accrual basis accounting principles. Applying the revenue
principle requires that all four of the recognition criteria – definition, measurability, reliability
and relevance must be met. More generally, revenue is measured as the market value of the
resources received or the product or service given, whichever is the more reliably
determinable.
The revenue principle pertains to accrual basis accounting, not to cash basis accounting.
Therefore, completed transactions for the sale of goods or services on credit usually are
recognized as revenue for the period in which the cash is eventually collected. Furthermore,
related expenses are matched with these revenues.

3. The matching Principle.

Like the revenue principle, the matching principle is predicated on accrual basis accounting,
but matching refers to the recognition of expenses. The principle implies that all expenses
incurred in earning the revenue recognized for a period should be recognized during the same
period. If the revenue is carried over (deferred) for recognition to a future period, the related
expenses should also be carried over or deferred since they are incurred in earning that
revenue.

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Application of the matching principle requires carrying on the books as asset outlays that
under cash basis accounting would be expensed at the time cash is disbursed. These
expenditure are for fixed assets, materials, purchased services and the like that are used to
earn future revenue. Only later, when the revenue is recognized, would the asset accounts be
expensed. In this way revenues and related expenses would be matched across accounting
period.

4. FULL – Disclosure Principle.

This principle stipulates that the financial statements report all relevant information bearing
on the economic affairs of a business enterprise. Many items, such as executory contracts,
fail to meet the recognition criteria but must still be disclosed for relevance and complete
reporting.
Additionally, the full – disclosure principle stipulates that the primary objective is to report
the economic substance of a transaction rather than merely its form. This means that
substance should not be blurred by the way the transaction is presented. The aim of full
disclosure is to provide external users with the accounting information they need to make
informed investment and credit decisions. Full disclosure requires that the accounting
policies followed be explained in the notes to the financial statements. Accounting
information may be reported in the body of the financial statements, in disclosure notes to
these statements, or in supplementary schedules and other presentation formats for events that
fail to meet the recognition criteria.

7.3 Constraints
Consistency in the application of accounting principles and uniformity of accounting practice
within the profession may not be achievable in all cases. Exceptions to GAAP are allowed in
special Situations categorized according to four constraints:
1. Cost –Benefit Constraint
Underlying the cost – benefit constrain is the expectation that the benefits derived by external
users of financial statements should outweigh the costs incurred by the preparers of the
information. Although it is admittedly difficult to quantify these benefits and costs, the
FASB often attempts to obtain information from preparers on the costs of implementing a
new reporting requirement. It does not, however, try to estimate indirect costs, such as the

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cost of any altered allocation of resources in the economy. The cost – benefit determination
is essentially a judgment call.
2. Materiality Constraint.
Materiality is defined as “ the magnitude of an omission or misstatement of accounting that,
in the light of surrounding circumstances, makes it probable that the judgment of a reasonable
person relying on the information would have been changed or influenced by the omission or
misstatement”
The materiality constraint is also called a threshold for recognition. The assumption is that
the omission or inclusion of immaterial facts is not likely to change or influence the decision
of a rational external user. However, the materiality threshold does not mean that small items
and amounts do not have to be accounted for or reported. For example, Fraud is an important
event regardless of the size of the amount.
Materiality judgments are situation specific. An amount considered immaterial in one
situation might be material in another. The decision depends on the nature of the item, its
birr amount ,and the relationship of the amount to the total amount of income, expenses,
assets, or liabilities, as the case may be.
3. Industry peculiarities.
One of the overriding concerns of accounting is that the information in financial statements
be useful. The problem is that certain types of accounting information might be critical for
decision making in one industry setting but not in another.
Basically, every industry has its own way of doing things, its own business practices. Under
the industry peculiarities constraint, selective exceptions to GAAP are permitted, provided
there is a clear precedent in the industry., Precedent is based on the uniqueness of the
situation, the usefulness of the information involved, preference of substance over form, and
any possible compromise of representational faith-fullness.
4. Conservatism
The conservatism constraint holds that when two alternative accounting methods are
acceptable and both equally satisfy the conceptual and implementation principles set out by
the FASB, alternatives having the less favorable effect on net income or total assets is
preferable. The reasoning is that investors prefer information that does not unnecessary raise
expectations.
Conservatism assumes that when uncertainty exists, the users of financial statements are
better served by under –statement of net income and assets. Prime examples include valuing

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inventories at the lower of cost or current market and minimizing the estimated service life
and residual value of depreciable assets.

8.SUMMARY
In this chapter we have discussed the development of a conceptual framework for financial
accounting and reporting by the FASB which is composed of basic objectives, fundamental
concepts, and operational guidelines.
A conceptual Framework is a coherent system of interrelated objects and fundamentals that
can lead to consistent standards and that prescribes the nature, function, and limits of
financial accounting and financial statements.

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