Accounting Theory and

Practice
Lecture 3 – Conceptual Framework
Learning objectives
After you have studied this chapter in class and personal
study, you should be able to:
• Understand issues leading to the development of conceptual
frameworks in accounting.
• Explain the nature and purpose of the conceptual framework
in accounting.
• Understand the components of the conceptual framework
• Analyse the limitations of the conceptual framework.
• Discuss the benefits of the conceptual framework.
Introduction
• Accounting theory constitutes the frame of reference on which the
development of accounting techniques is based.
• This frame of reference, in turn, is based primarily on the
establishment of accounting concepts and principles.
• Interestingly, accounting practice has been based on acceptable
concepts, principles and standard for a long time.
• However, the ad hoc manner in which these concepts, principles and
standards were formulated caused inconsistencies between the
standards that led to many criticisms from academicians,
professionals and so on.
Towards a conceptual framework-
Evolution
• The main criticism levelled against the Accounting Standards
Committee was that it failed to establish objectives for financial
reports.
• The inconsistencies and criticisms created the need for a conceptual
foundation or framework that can lead to consistent financial
accounting standards for accounting practice.
Towards a Conceptual framework-
Evolution
• The ASB has aimed to remedy this defect by developing a clear
statement of Principles (not ad hoc rules) from which work on
individual standards will derive and providing a framework for the
standards themselves.
• A statement of the reasons or objectives that motivates the
establishment of the concepts and principles must be the first step.
• In 1970s a positive step towards the development of such a
framework began in the United States on the basis of earlier research
works by AICPA (American Institute of Certified Public Accountants)
and AAA (American Accounting Association).
Financial Accounting Standard Board (FASB) conceptual framework

The actual conceptual framework by FASB did not begin until 1974 where it
issued six statements called statements of financial accounting concepts.
In 1985, FASB issued a concept statement called ‘conceptual framework’ because
the framework lacks logical derivation.
The statements incorporated most of the generally accepted assumptions,
concepts and principles that have been practiced for a long period in accounting.
Among the traditional concepts are entity concept, money measurement
concept, going concern concept, time interval concept, accrual concept and alike.
Following the development in the United states, several other countries like the
UK, Canada and Australia too began to start work on their respective versions of
the framework.
The nature of the conceptual framework
The Trueblood Report specified twelve objectives and seven qualitative
characteristics of financial reporting.
Since its inception, the FASB realized that the whole problem of standard-setting
rests not only on the objectives, but also on an established body of concepts and
objectives.
There was a need for a structured or coherent system of interrelated objectives,
characteristics and concepts that lead to formulation of high-quality and
consistent reporting standards to prescribe the nature, function and limits of
financial accounting and reporting.
The nature of the conceptual framework
According to standard setters such as the FASB and IASB, a conceptual framework
is:
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.’
-The objectives identify the goals and the purposes of accounting.
-The fundamentals are the underlying concepts of accounting- concepts that guide
the selection of events to be accounted for; the measurement of those events and
the means of summarizing and communicating to interested parties.
The components of the conceptual framework
According to the Statement of Financial Accounting Concepts (SFAC), the five
main components of the conceptual framework relating to financial reporting for
business enterprises are:
SFAC No. 1- Objectives of financial reporting
SFAC No. 2- Qualitative characteristics of accounting information
SFAC No. 3- Elements of financial statements
SFAC No. 5- Recognitions in financial statements
SFAC No. 5- Measurements in financial statements
According to FASB, a conceptual framework is:
The objectives of financial reporting
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.’
Financial reporting should provide information about the financial position, performance
and the changes in the financial position of the enterprise to assist users in making
economic decision.
The objective of financial reporting is like those issued by other professional bodies. The
Australian Accounting Research Foundation in its statement of accounting concept 2 (SAC 2)
states that:
the general-purpose financial statements is meant to provide information to users, that is,
useful for making and evaluating decisions about the allocation of scarce resources.
So decision usefulness is the heart of the objectives of the conceptual framework .
The fundamental concepts
The fundamental concepts include both
qualitative characteristics of accounting
information and the definitions of the elements
of financial statements.
The qualitative characteristics of accounting information

• The fin statements need to have certain qualities or standard in order to make it useful
for decision making.
• Two primary qualities: Relevance and reliability (faithful representation)
• According to FASB, information is relevant when if it exerts influence on the designated
actions; that is, it influences the making of a decision in the allocation of scarce
resources.
• Relevance involves predictive value, confirmatory value and materiality.
• Faithful representation: The information must be complete, neutral and free from
error.
• Secondary qualities: Comparability, verifiability, timeliness and understandability.
The qualitative characteristics of accounting information

Cost benefit consideration- Before preparing and disseminating financial

information the benefits and cost of providing information must be compared.
The FASB recognizes cost benefit consideration as one pervasive constraint and emphasizes
the importance in standard development.
The basic elements of a financial statement
Elements Definition
Asset A resource controlled by an entity as a result of past events and from which
future economic benefits are expected to flow to the entity.

Liability A present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow of an entity resources.

Equity The residual interest in an entity’s assets after deducting all its liabilities.
Income Increases in economic benefits not resulting from contributions made by
equity holders.

Expenses Decreases in economic benefits not resulting from distributions to equity

holders.
Recognition and measurement

Recognition
An item should be recognized in the financial report if it is probable
that there will be an inflow or outflow of economic benefits associated
with the asset or liability and it can be measured reliably.
The recognition criteria include:
Definition: The item meets the definition of an element of financial statement.
Measurability: It has a relevant attribute measurable with sufficient reliability.
Relevance: The information about it is capable of making a difference in user
decisions.
Reliability: The information is representational, faithful, verifiable, and neutral.
Recognition and measurement

Measurement
With regard to measurement, the statement recognizes five different
attributes namely:
1. Historical cost;
2. Current replacement cost;
3. Current market value;
4. Net realizable value;
5. Present or discounted value of future cash flow.
MASB’s 2018 Revised Conceptual
Framework
Based on the revised IASB conceptual framework, there are now eight
chapters or key components namely:
1. The objective of the general-purpose financial reporting.
2. Qualitative Characteristics of Useful Financial information
3. Financial Statements and the Reporting Entity
4. The elements of Financial Statements
5. Recognition and Derecognition
6. Measurement
7. Presentation and Disclosure
8. Concept of Capital and Capital Maintenance
The purpose of conceptual framework

The conceptual framework is intended to act as a constitution for the

standard-setting process.
Its purpose is to guide in resolving disputes that arise during the
standard-setting process by narrowing the question to whether or not
specific standards conform to the conceptual framework.
Assist preparers to develop consistent accounting policies when no
standard applies to a particular transaction or other event, or when a
standard allows a choice of accounting policy.
The Benefits of Conceptual framework
The IASB identified the following as the specific benefits of the
conceptual framework:
Guide the IASB in establishing accounting standard
Provide a frame of reference for resolving accounting questions in
the absence of specific promulgated standard.
Determine the bounds of judgement in preparing financial
statements;
Enhance comparability by decreasing the number of alternative
accounting methods
The Limitations of conceptual framework
• There might be a conflict between the framework and the
long-established accounting assumptions.
• Possibility that framework might favor some groups of users
at the expense of other identified groups.
• The framework is expected to narrow down the alternatives
(such as depreciation calculation method).
• Conceptual framework project is time consuming and costly,
and there is no guarantee that the project will increase the
standards of financial reporting.
Learning outcomes
You should have now learnt:
• The issues leading to the development of conceptual frameworks in
accounting.
• The nature and purpose of the conceptual framework in accounting.
• The components of the conceptual framework
• The benefits of the conceptual framework.
• The limitations of the conceptual framework.