Conceptual Framework

Week 5 Fauziah Md. Taib

Conceptual Framework

Is a constitution, 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.

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 summarising and communicating to interested parties.

Difficulties of Formulating Objectives of Accounting

Have to resolve the conflicts of interest that exist in the information market. Interactions from 3 main groups;

Firms main party engaged in the acctg process Users production of acctg information is influenced by their interests and needs Accounting Profession third party that may affect the information to be included in the F/S

Conflict of Interests on Accounting Information

VI IV III I VII V Users

Accounting Profession

II

Corporations Source: Cyert and Ijiri (1974)

Cyert and Ijiris Analysis

2-7 represents areas of conflict of interests Firms Oriented

Sets of information that the firm is ready to disclose and attempts to find the best means of measuring and verifying it. The information that the profession is capable of measuring and verifying it and attempts to accommodate users and firms through various accounting options The set of information deemed relevant by users as central and encourages the profession and firms to produce and verify the information

Profession Oriented

Users Oriented

Financial Statement Objectives

Extremely important

Debates about alternative standards and reporting techniques must be resolved logically and with reasons rather than ad hoc and piece meal approach. Accounting profession in the US, UK and Canada took steps to form the financial statements objectives.

F/S Objectives - Cont

US reports by the Study Group about objectives of F/S and the formulation of C/F by FASB UK The Corporate Report ICAEW Canada Corporate Reporting

Important Committee Reports that Give Rise to Objectives and Standards

Objectives of F/S

In response to criticisms of corporate financial reporting, AICPA formed 2 study groups in 1971.

Wheat Committee to improve the standard setting process Trueblood Committee to develop the objectives of financial statements that is to determine: Who needs financial statements? What information they need? How much of the needed information can be provided through accounting? What framework is required to provide the needed information?

Trueblood Committee

Specified 12 objectives and 7 qualitative characteristics of financial reporting.

Why Conceptual Framework?

Criticisms of financial reporting:

2 or more methods of accounting are acceptable Less conservative methods are being used Reserves are used to artificially smooth earnings F/S fail to warn of impending liquidity crunches Deferrals are followed by big bath write offs Unjustified optimism exists in estimates of recoverability Off balance sheet financing An unwarranted assertion of immateriality has been used to justify non-disclosure of unfavourable information or departures from standards Form is elevated over substance

FASB Scope of Conceptual Framework

Objectives
Objectives
SFAC # 1 & 4

Fundamental
SFAC # 3 & 6
Elements

Qualitative Characteristics

SFAC # 2

Operational
SFAC # 5

Recognition Criteria

Fin. Statemt Vs Fin.Reporting

Measurement

Display

Reporting Earnings

Reporting Funds Flow & Liquidity

Reporting Financial Position

SFAC # 6

Developing a Conceptual Framework

In response to corporate collapes in 2001-02 in the US, FASB has been directed to take an objectives-oriented approach to standard setting. Principles-Based

A CF is considered important in providing underlying principles to be used in objectives based standards. Use of appropriate principles could lead to clearer communication and more precision w/o the need for detailed rules currently included in the stds.

Principles based Standards

Characteristics:

Based on an improved and consistently applied CF. Clearly state the objective of the std Provide sufficient detail and structure that the stand be operationalised and applied on a consistent basis. Minimise the use of exceptions to the standard Avoid use of % that allow financial engineers to achieve technical compliance wiwth the stands while evading the intent of the standards.

Principles based

Require skill and judgement In some cases, 2 different experts could interpret the requirements of accounting standard differently. SEC has in the past requested rules from FASB to ensure compliance.

Rule based Standards

Contains too many detailed requirements in relation to treatments which must be followed to comply with the accounting standards. DISADVANTAGES

Allows for technical compliance only but not the objective(s). Forms over substance culture Highly specific and too prescriptive

Rule based

ADVANTAGES

Detailed rules protect auditors from litigation. Rules assist reporting entities to apply the requirements of the std in the same way (comparability)