Conceptual Framework for Financial Accounting and Reporting

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

An accounting theory is not something that is discovered rather, it is created, developed, or decreed on the basis of environmental factors, intuition, authority, and acceptability because the theoretical framework accounting is difficult to substantiate objectively or by experimentation, arguments concerning it can degenerate into quasi – religious dogmatism. As a result, the credibility of accounting rests upon its general recognition and acceptance by preparers, auditors, and users of financial statements.  Given this, the purpose of this chapter is to examine the nature and usefulness of a conceptual framework for financial accounting, and discuss its components. 

 

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.”

Why is a Conceptual Framework Necessary?

Firs, 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.

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

 

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.

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

 

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

The 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.

 

The objectives (first level) are concerned with the goals and purposes of accounting.  Later, we will discuss the ways these goals and purposes are implemented (third level).  Between these two levels it is necessary to provide certain conceptual building blocks that explain 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.

 

   2.5.1. 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.  Financial reporting is concerned, in varying degrees, with decision making by financial statement users.  As a consequence, the overriding criterion by which accounting choices can be judged is that of decision usefulness, that is, providing information that is most useful for decision-making.  To help distinguish superior (more useful) form inferior (less useful) information, the qualitative characteristics, which make information useful, should be considered.
 

      2.5.1.1. 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.
 

      2.5.1.2   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 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 faithfullness – 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 some times 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 (such as to purchase a company’s stock). Accounting information can not be selected to favor one set of interested parties over another.  It should be factual and truthful.
    

       2.5.1.3 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 affect 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..

 

   2.5.2 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.  Is it something we own? If the answer is yes, can we assume that any asset leased would never be shown on the balance sheet?  Is it any thing of value used (or for which there is a right to use) by the enterprise? If the answer is yes, then why should the management of the enterprise not be reported as an asset?  It seems necessary, therefore, to develop a basic definitional framework for the elements of accounting.  Such definitions provide guidance for identifying what to include and what to exclude from the financial statements.

SFAC No.6 defines 10 elements of financial statements as follows:

  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:

1. 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.
2. The entity can control access to the benefit

3. The transaction or event-giving rise to the entity’s right to, or control of, the benefit has already occurred (result of past transactions).

  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.

1. 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.
2. The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it.
3. The transaction or event obligating the entity has already occurred.

  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

  Investments by Owners

Are increases in net assets of a particular enterprise resulting from transfers to it from other entities of some thing of value to obtain or increase ownership interests (or equity) in it. 

Investments by owners are characterized as

1. Cash or other assets exchanged for stock
2. Service performance (sometimes called sweat equity) exchanged for stock
3. 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

1. Cash dividend payments or declarations
2. Transfer of assets to owners
3. Liquidating distributions (asset sale proceeds)
4. Conversion of equity ownership to liabilities

  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

1. 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).
2. It is recurring

  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.

  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.

  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.

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.

 

SFAC N^o 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 N^o 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:

1. Definition: the item in question must meet the definition of an element of financial statements.
2. 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).
3. 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).
4. 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 N^o 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.

 

   2.6.1 Basic Assumptions.

Statements of financial Accounting concepts No5 addresses 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 (continuity) 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 – term loses its significance, all assets and liabilities be come 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.

 

  2.6.2. 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 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. 

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.
 

  2.6.3 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 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.  Because materiality matters tend to be case – by – case judgments, the FASB has not specified general materiality guidelines.

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

 

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.  Knowledge of the specific meaning of certain basic elements is essential for an understanding of financial accounting and in the practice of financial accounting, certain basic assumptions are important to an understanding of the manner in which data are presented.

Therefore, the conceptual framework is critical for a thorough understanding of the financial accounting process.