2-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig DeeganSlides prepared by Craig Deegan

Chapter 2

The Conceptual Framework of Accounting

and its relevance to financial reporting

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Objectives• 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• Understand the desirable qualitative characteristics of

financial information• Be able to critically evaluate the conceptual framework

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Conceptual Framework (CF) – an introduction• Initially we had an Australian Framework developed by AASB • Adoption of IFRSs required us to adopt the conceptual framework

developed by IASB• Generally accepted, however, that the Australian Conceptual

Framework was more robust than IASB Framework – although work is currently being undertaken to further develop IASB Framework

• CF prescribes the nature, function and limits of financial accounting and reporting

• Central goal in establishing CF is general consensus on– scope and objectives of financial reporting

– qualitative characteristics that financial information should possess

– elements of financial reporting

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Benefits of a Conceptual Framework

• Accounting standards more consistent• Increased international comparability• Should result in the Boards (eg IASB, AASB) being

more accountable for their decisions• Enhanced process of communication between the

Boards and constituents• More economical accounting standard development

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Structure of the Conceptual Framework

Until 2004, four Statement of Accounting Concepts (SACs) 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

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Structure of the CF (cont.)

SAC1 and SAC2 to be temporarily retained but their requirements expected to be incorporated in later document

• It would appear that the Framework must be adhered to by preparers of GPFRs. As paragraph 11 of AASB 8 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.

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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

Components of CF

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What are GPFRs and reporting entities?

SAC1—Definition of the Reporting Entity• Defines general-purpose financial reports (GPFRs)

– reports intended to meet the information needs common to users who are unable to command the preparation of reports tailored to their specific needs

– GPFRs 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 GPFRs—and not necessarily be required to comply with all accounting standards

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Reporting entity (cont.)Factors that may indicate a reporting entity• 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

• Small proprietary companies are frequently not considered to be reporting entities—it 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 entity

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Objectives of GPFRs

SAC2—Objective of GPFRs• 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

• Defines users of GPFRs

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Qualitative characteristics of financial reporting (cont.)

• Previously covered by SAC3 – now addressed in The 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 identified in AASB Framework:1. understandability

2. relevance

3. reliability

4. comparability

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Qualitative characteristics (cont.)

• Understandable – to whom? What is the expectation about accounting proficiency?

• Relevance– if information influences decisions about the allocation of

scarce resources– consider relationship to concept of ‘materiality’ (consider

materiality thresholds shortly)

• Reliability– faithfully represents the entity’s transactions and events– free from bias– free from undue error

• Comparabilityacross time and across organisations

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Qualitative characteristics (cont.)

• Relevant and reliable information is also subject to the test of materiality– omission, misstatement or non-disclosure can affect decision

making (AASB Framework, par. 30)– definition of materiality consistent with AASB 1031 ‘Materiality’– tests for materiality provided in AASB 1031 (par. 13)– guidelines for materiality:

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 not considered material

Between 5 and 10%—grey area where professional judgment required

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Relevance versus reliability

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

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Elements of accounting

• Five elements of accounting are defined in the AASB• Framework

– assets– liabilities– equity– expenses– income

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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 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

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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.

• ‘Probable’ not defined in AASB Framework but SAC4 (par. 40) defines it as ‘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)

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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 characteristics1. 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

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Elements (cont.)

Definition and recognition of liabilities (cont.)• Recognition in financial statements consistent with

those of assets—AASB 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

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Elements (cont)• What is a contingent liability and how is it different to a

liability?• How would we disclose contingent liabilities?

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Elements (cont.)

Definition and recognition of expenses• The definition is dependent upon the definition 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

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Elements (cont.)

Definition and recognition of expenses (cont.)• Expenses are recognised in the income statement

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

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Elements (cont.)

Definition and recognition of income• Again, the definition is dependent on those of ‘asset’

and ‘liability’• 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

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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

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Elements (cont.)

Definition and recognition of income (cont.)• ‘Revenues’ and ‘gains’ distinguished 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

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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

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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

enterprise’—a narrower definition than that of ‘reporting entity’

• The Framework is currently in a period of redevelopment so more changes to be expected

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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 the perceptions of accountability

• In determining whether or not an entity is a reporting entity, is the need for information to enable informed ‘resource allocation decisions’ the only or dominant consideration?

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Critical review of conceptual frameworks (cont.)• Economic focus of GPFRs 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 performance

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Critical review of conceptual frameworks (cont.)• Financial press also generally use financial indicators

as a guide to a firm’s success

It has been argued that• Conceptual frameworks simply codify existing practice• Conceptual frameworks have been used as devices to

legitimise the existence of the accounting profession