The Conceptual Framework of Accounting and Its Relevance To Financial Reporting

Chapter 2
The Conceptual
Framework of Accounting
and its relevance to
financial reporting
.
Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e
2-1
Objectives of this lecture

Understand the role of a conceptual framework of
accounting
Be able to define the elements of financial reporting
Be able to explain the recognition criteria of the
elements of accounting
Be able to explain the meaning of reporting entity
Understand the objectives of general purpose
financial reporting
Understand the desirable qualitative characteristics
that financial information should possess
Be able to critically evaluate the existing conceptual
framework
.

2-2
Conceptual Framework (CF)an

introduction
Initially we had an Australian Framework developed
by the AASB
Adoption of IFRSs required us to also adopt the
conceptual framework developed by the IASB
It was generally accepted, however, that the
Australian Conceptual Framework was more robust
than the IASB Frameworkalthough work is
currently being undertaken to further develop the
IASB Framework

2-3
Conceptual Framework (CF)an

introduction (cont.)
CFs prescribe the nature, function and limits of
financial accounting and reporting
Central goal in establishing a CF is general
consensus on:
scope and objectives of financial reporting
qualitative characteristics that financial information should
possess
elements of financial reporting

2-4
Benefits of a Conceptual Framework

Accounting standards would be more consistent
and logical because they are developed from a
clearly developed set of concepts
Increased international comparability of financial
information
Should result in the Boards (e.g. IASB, AASB)
being more accountable for their standard-setting
decisions
Enhanced process of communication between the
Boards and constituents
More economical accounting standard development
.

2-5
Current initiatives to develop a

revised conceptual framework
In Australia we are using the IASB Framework

In the United States they have their own conceptual framework
(they have not adopted either IFRSs or the IASB Framework)
Both the IASB and the US Conceptual Frameworks are
considered to have shortcomings
As a result, the IASB and FASB are jointly developing a
revised conceptual framework
A revised conceptual framework is also necessary because of
the joint efforts of the IASB and FASB to converge their
accounting standardswith uniform accounting standards
there is also a need to have a uniform conceptual framework
The discussion that follows will relate to the existing IASB
Framework, but it needs to be appreciated that this framework
will be replaced in the near future (as will many accounting
standards!)
2-6
Structure of the Conceptual

Framework
Until 2004, four Statements of Accounting Concepts
(SACs) were issued
From 2005 we no longer used the entire conceptual
framework that was developed in Australia
SAC3 and SAC4 were replaced by the Framework for the
Preparation and Presentation of Financial Statements
(released July 2004)in Australia known as the AASB
Framework
SAC1 and SAC2 to be temporarily retained but their
requirements expected to be incorporated in a later
document

2-7
Structure of the CF (cont.)

It would appear that the Framework must be adhered to by
preparers of GPFSs. As paragraph 11 of AASB 108 states:
In making the judgement described in paragraph 10,
management shall refer to, and consider the applicability of, the
following sources in descending order:
(a) the requirements and guidance in Australian Accounting
Standards dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement
concepts for assets, liabilities, income and expenses in
the Framework.
The development of a conceptual framework is based upon a
number of building blocks which need to be developed in
sequencesee the next slide

2-8
Components of CF
1. Definition of financial reporting
2. Definition of the reporting entity
3. Definition of users of accounts

and their information needs
4. Objectives of financial statements
5. Underlying assumptions
6. Qualitative charateristics of
financial statements
7. Elements of financial
statements
8. Recognition criteria
9. Measurement basis and

techniques

2-9
Consideration of the building blocks

of a CF
The first matter to be addressed is the definition of financial

reporting. Unless there is some agreement on this it would be
difficult to construct a framework for financial reporting
Having determined what financial reporting means, we then
turn our attention to the subject of financial reporting
specifically which entities are required to produce generalpurpose financial statements, and the likely characteristics of
the users of these statements
Then we look at the objective of financial reporting
Once we have determined the objective of financial reporting,
the next step is to determine the basic underlying assumptions
and qualitative characteristics of financial information
necessary to achieve the stated objective
We can then define the elements of financial reporting, their
respective recognition criteria, and the basis of measurement
2-10
What are general-purpose financial

statements and reporting entities?
SAC1Definition of the Reporting Entity
Defines general-purpose financial statements
(GPFSs)
Financial statements intended to meet the information
needs common to users who are unable to command the
preparation of reports tailored to their specific needs

2-11
What are general-purpose financial

statements and reporting entities? (cont.)
SAC1Definition of the Reporting Entity (cont.)
GPFSs to be produced by entities who have users
who cannot command the preparation of specific
information
Such entities are deemed to be reporting entities
If an entity is not deemed to be a reporting entity it will
not be required to produce GPFRsand not
necessarily be required to comply with all accounting
standards

2-12
Reporting entities
Factors that may indicate that an entity is a reporting
entity include:
separation of management from those with an economic
interest in the entity
economic or political importance/influence
Financial characteristics of an entity
amount of sales
value of assets
extent of indebtedness
number of customers
number of employees

2-13
Reporting entities (cont.)

Small proprietary companies are frequently not
considered to be reporting entitiesit is assumed
that most people who require financial information
about the entity will be in a position to specifically
demand it
We must understand the implications of being
deemed to be a reporting entityif an entity is
deemed to be a reporting entity then it is expected to
provide financial statements in accordance with
accounting standards

2-14
Objectives of GPFSs
SAC2Objective of GPFSs
To provide relevant and reliable information to assist
users to make and evaluate decisions about the
allocation of scarce resources and to allow
management and governing bodies to discharge
their accountability
The rest of the framework is developed around this
objective.
Do we believe this is a good objective? If we dismiss
this objective then we might be inclined to dismiss
the balance of the framework
The objective above refers to users but who are
perceived to be the users of GPFSs?
.

2-15
The users of financial statements
If conceptual frameworks are designed to meet the

information needs of a wide range of users, they need to
identify potential users and their main information needs
The definition of users provided in the AASB Framework
encompasses investors, employees, lenders, suppliers,
customers, government agencies and the public (although the
AASB Framework does embrace the assumption that
information designed to meet the needs of investors will
usually meet the needs of other groups)
The AASB Framework has also embraced the assumption
that users are assumed to have a reasonable knowledge of
business and economic activities and accounting and a
willingness to study the information with reasonable diligence.
What do we think are some of the implications of the above
definition of users and the assumptions about their accounting
expertise?

2-16
Qualitative characteristics of financial

information
The AASB Framework identifies the characteristics

of financial information necessary to allow users to
make and evaluate decisions about the allocation
of scarce resources
Four principal characteristics of financial reporting
are identified in AASB Framework:
1.
2.
3.
4.
understandability
relevance
reliability
comparability

2-17
Qualitative characteristics (cont.)
Understandability
To whom? What is the expectation about accounting
proficiency? (as already indicated the assumption is that
users have a reasonable level of business and accounting
knowledge)
Relevance
Something is deemed relevant if the information influences
decisions about the allocation of scarce resources
Consider relationship to concept of materiality (materiality
thresholds considered shortly). Materiality is a threshold
concept in that if something is potentially relevant, but is
deemed to be immaterial, then disclosure is not necessary

2-18
Reliability
Faithfully represents the entitys transactions and events
Free from bias
Free from undue error
Comparability
Ideally, information should be comparable across time and
across organisations

2-19

As noted, relevant and reliable information is also
subject to the test of materiality
Something is material if its omission, misstatement or nondisclosure can affect economic decision making (AASB
Framework, par. 30)
Above definition of materiality is consistent with AASB 1031
Materiality
Tests for materiality provided in AASB 1031 (par. 13)

2-20

Relevant and reliable information also subject to materiality test
(cont.)
Guidelines for materialityin determining whether an item, or an
aggregate of items, is material then:
An amount equal to or greater than 10% of the
appropriate base amount is considered material
An item that is equal to or less than 5% of the
appropriate base amount is not considered material
Between 5 and 10%grey area where professional
judgment required

2-21
Relevance versus reliability

Is one more important than the other?
Is there a trade-off between the two?

2-22
Elements of accounting
Five elements of accounting are defined in the
AASB Framework
assets
liabilities
equity
expenses
income

2-23
Elements (cont.)
Definition and recognition of assets
Assets are defined as (AASB Framework, par. 49):
a resource controlled by the entity as a result of past
events and from which future economic benefits are
expected to flow to the entity
Three key characteristics of the definition:

1. There must be future economic benefits
2. The reporting entity must control the future economic
benefits
3. The transaction or other event giving rise to the control
must have occurred

2-24
Elements (cont.)
Definition and recognition of assets (cont.)
An asset is to be recognised in the financial
statements if (AASB Framework. par. 83):
it is probable that any future economic benefit
associated with the asset will flow to or from the
entity; and
the item has a cost or value that can be
measured with reliability

2-25
Elements (cont.)
Definition and recognition of assets (cont.)
Probable is not defined in AASB Framework but
probable is generally considered to mean more
likely rather than less likely
If an asset or other element fails to meet the
recognition criteria in one period but satisfies them
in another period, the asset can be reinstated
(subject to requirements in particular accounting
standards)AASB Framework (par. 87)

2-26
Elements (cont.)
Definition and recognition of liabilities
Liabilities defined as (AASB Framework, par. 49):
a present obligation of the entity arising from past events,
the settlement of which is expected to result in an outflow
from the entity of resources embodying economic benefits
There are three main characteristics

1. There must be a future disposition or sacrifice of economic
benefits to other entities
2. It must be a present obligation
3. A past transaction or other event must have created the
obligation

2-27
Elements (cont.)
Definition and recognition of liabilities (cont.)
Recognition in financial statements consistent with
those of assetsAASB Framework (par. 91)
a liability is recognised 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
Where a liability cannot be reliably measured but is

potentially material, the liability should be disclosed
within the notes to the financial statements

2-28
Liabilities do not necessarily need to be

legally enforceable
An essential characteristic of a liability is that the entity has a

present obligation. Obligations can be legally enforceable
However, obligations also arise from normal business practice,
custom and a desire to maintain good business relations or act
in an equitable manner
Hence the liabilities that appear within an entitys statement of
financial position might include obligations that are legally
enforceable as well obligations that are deemed to be
equitable or constructive
An equitable obligation is governed by social or moral
sanctions or custom rather than legal sanctions. A constructive
obligation is created, inferred or construed from the facts in a
particular situation rather than contracted by agreement with
another entity or imposed by government
So dont assume that all liabilities shown in a statement of
financial position (balance sheet) are legally enforceable

2-29
Liabilities do not necessarily need to be

legally enforceable (cont.)
Whilst legal enforceability is not a prerequisite for
liability recognition under the AASB Framework it is
interesting to note that as part of the work being
done on a revised conceptual framework, the IASB
and FASB in 2008 suggested a revised definition of
liabilities, this being a present economic obligation
that is enforceable against the entity.
While the above definition might not ultimately be
adopted if it is then it might have significant
implications for reported liabilities in the future.

2-30
Contingent liabilities
What is a contingent liability and how is it different
from a liability?
How would we disclose contingent liabilities?

2-31
Elements of accounting (cont.)

Definition and recognition of expenses
The definition is dependent upon the definitions of
assets and liabilities
Expenses are defined as (AASB Framework, par.
70):
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 equity participants
Usual tests of probability and measurability apply

2-32
Elements (cont.)
Definition and recognition of expenses (cont.)
Expenses are recognised in the statement of
comprehensive income when (AASB Framework,
par. 94):
a decrease in future economic benefits related to a
decrease in an asset or an increase in a liability has arisen
that can be measured reliably
If a resource is used up or damaged by an entity but

that entity does not control the resource (not an
asset of the entity), to the extent that no liabilities or
fines are imposed, no expenses will be recorded by
the entity
.

2-33
Elements (cont.)
Definition and recognition of income
Again, the definition is dependent on those of
assets and liabilities
Income defined as (AASB Framework, par. 70):
increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity,
other than those relating to contributions from equity
participants

2-34
Elements (cont.)
Definition and recognition of income (cont.)
Income can be recognised in the financial
statements when:
it is probable that the inflow or other enhancement or
saving in outflows has occurred; and
the inflow or other enhancement or saving in outflows of
economic benefits can be measured reliably

2-35
Elements (cont.)
Definition and recognition of income (cont.)
Revenues and gains distinguished between in
AASB Framework
Revenue arises in the course of the ordinary activities of an
entity and includes: sales, fees, interest, dividends,
royalties, and rent
Gains represent other items that meet the definition of
income and might or might not arise in the ordinary
activities of an entity, e.g. disposal of non-current assets
Some professional judgment is required to determine
whether a component of income should be classified as
revenue or a gain

2-36
Elements (cont.)
Definition of equity (AASB Framework, par. 49):
residual interest in the assets of the entity after deducting
all of its liabilities
Directly a function of the definitions given to assets

and liabilities
No need for separate recognition criteria for equity

2-37
Measurement principles
Conceptual frameworks have provided little
guidance in relation to measurement issues
We currently have a multitude of measurement
bases for assets and liabilities
Do we think it is conceptually valid to have different
measurement bases for different classes of assets
and liabilities?

2-38
Implications of convergence with IFRSs

for our Conceptual Framework
Standards issued by IASB are developed to be
consistent with the IASB Framework
As we are embracing IASB standards, we must adopt
the IASB Framework
IASB Framework has no equivalent for SAC1 or SAC2
AASB retained (for the time being), SAC1 and SAC2
IASB Framework adopts definition of reporting
enterprisea narrower definition than that of
reporting entity
The Framework is currently in a period of
redevelopment so more changes to be expected

2-39
Critical review of conceptual

frameworks
Objective of GPFRs in SAC2 implies that reports
should be primarily economic in focus
Should social issues be ignored in the annual report?
An individual's view of business responsibilities

directly impacts on perceptions of accountability
In determining whether or not an entity is a reporting
entity, should the need for information to enable
informed resource allocation decisions be the only
or dominant consideration?

2-40

frameworks (cont.)
Economic focus of GPFSs ignores transactions or
events not resulting from market transactions or an
exchange of property rights
Ignores environmental externalities caused by
business
Financial statements included within reports reflect
only financial performance and do not provide a
means of assessing social or environmental
performance

2-41

frameworks (cont.)
Financial press also generally use financial
indicators as a guide to a firms success
It has also been argued that:
Conceptual frameworks simply codify existing
practice and therefore provide little hope for
improving financial reporting
Conceptual frameworks have been used as devices
to legitimise the existence of the accounting
profession

2-42

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Chapter 2

Copyright 2010 McGraw-Hill Australia Pty Ltd

Objectives of this lecture

Copyright 2010 McGraw-Hill Australia Pty Ltd

Conceptual Framework (CF)an

Copyright 2010 McGraw-Hill Australia Pty Ltd

Conceptual Framework (CF)an

Copyright 2010 McGraw-Hill Australia Pty Ltd

Benefits of a Conceptual Framework

Copyright 2010 McGraw-Hill Australia Pty Ltd

Current initiatives to develop a

In Australia we are using the IASB Framework

Structure of the Conceptual

Copyright 2010 McGraw-Hill Australia Pty Ltd

Structure of the CF (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

2. Definition of the reporting entity

3. Definition of users of accounts

4. Objectives of financial statements

9. Measurement basis and

Copyright 2010 McGraw-Hill Australia Pty Ltd

Consideration of the building blocks

The first matter to be addressed is the definition of financial

What are general-purpose financial

Copyright 2010 McGraw-Hill Australia Pty Ltd

What are general-purpose financial

Copyright 2010 McGraw-Hill Australia Pty Ltd

Financial characteristics of an entity

Copyright 2010 McGraw-Hill Australia Pty Ltd

Reporting entities (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

The users of financial statements

If conceptual frameworks are designed to meet the

Copyright 2010 McGraw-Hill Australia Pty Ltd

Qualitative characteristics of financial

The AASB Framework identifies the characteristics

Copyright 2010 McGraw-Hill Australia Pty Ltd

Qualitative characteristics (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Qualitative characteristics (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Qualitative characteristics (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Qualitative characteristics (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Relevance versus reliability

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Three key characteristics of the definition:

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

There are three main characteristics

Copyright 2010 McGraw-Hill Australia Pty Ltd

Where a liability cannot be reliably measured but is

Copyright 2010 McGraw-Hill Australia Pty Ltd

Liabilities do not necessarily need to be

An essential characteristic of a liability is that the entity has a