GODFREY

HODGSON
HOLMES
TARCA

CHAPTER 4
A CONCEPTUAL FRAMEWORK
Kuliah Sesi 4 – Dr. Zaroni
 CONCEPTUAL FRAMEWORK

Conceptual Framework establishes the concepts that

underlie financial reporting.
Need for a Conceptual Framework
► Rule-making should build on and relate to an established
body of concepts.
► Enables IASB to issue more useful and consistent
pronouncements over time.

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 Development of a Conceptual Framework

Presently, the Conceptual Framework is comprising of the following.

• Chapter 1: The Objective of General-Purpose Financial Reporting
• Chapter 2: The Reporting Entity (not yet issued)
• Chapter 3: Qualitative Characteristics of Useful Financial Information
• Chapter 4: The Framework, comprised of the following:
1. Underlying assumption—the going concern assumption;
2. The elements of financial statements;
3. Recognition of the elements of financial statements;
4. Measurement of the elements of financial statements; and
5. Concepts of capital and capital maintenance.

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Overview of the Conceptual Framework

Three levels:
 First Level = Objectives of Financial Reporting
 Second Level = Qualitative Characteristics and
Elements of Financial Statements
 Third Level = Recognition, Measurement, and
Disclosure Concepts.

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 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
Third level
3. Monetary unit 3. Expense recognition
The "how"—
4. Periodicity 4. Full disclosure implementation
5. Accrual

QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets
qualities 2. Liabilities Second level
2. Enhancing 3. Equity Bridge between
qualities 4. Income
levels 1 and 3
5. Expenses
ILLUSTRATION
Conceptual Framework
for Financial Reporting OBJECTIVE
Provide information
about the reporting
entity that is useful
to present and potential
equity investors,
First level
lenders, and other The "why"—purpose
creditors in their of accounting
capacity as capital
providers.
 FIRST LEVEL: BASIC OBJECTIVE

OBJECTIVE
“To provide financial information about the reporting entity
that is useful to present and potential equity investors,
lenders, and other creditors in making decisions about
providing resources to the entity.

 Provided by issuing general-purpose financial statements.

 Assumption is that users need reasonable knowledge of business
and financial accounting matters to understand the information.

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SECOND LEVEL: FUNDAMENTAL CONCEPTS

Qualitative Characteristics of Accounting

Information

IASB identified the Qualitative Characteristics of

accounting information that distinguish better (more useful)
information from inferior (less useful) information for
decision-making purposes.

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SECOND LEVEL: FUNDAMENTAL CONCEPTS

Hierarchy of Accounting
Qualities

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SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

To be relevant, accounting information must be capable of making

a difference in a decision.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

Financial information has predictive value if it has value as an input

to predictive processes used by investors to form their own
expectations about the future.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

Relevant information also helps users confirm or correct prior

expectations.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Relevance

Information is material if omitting it or misstating it could influence

decisions that users make on the basis of the reported financial
information.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions

match what really existed or happened.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

Completeness means that all the information that is necessary for

faithful representation is provided.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

Neutrality means that a company cannot select information to favor

one set of interested parties over another.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Fundamental Quality—Faithful Representation

An information item that is free from error will be a more accurate

(faithful) representation of a financial item.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Information that is measured and reported in a similar manner for

different companies is considered comparable.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Verifiability occurs when independent measurers, using the same

methods, obtain similar results.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Timeliness means having information available to decision-makers

before it loses its capacity to influence decisions.
SECOND LEVEL: FUNDAMENTAL CONCEPTS

Enhancing Qualities

Understandability is the quality of information that lets reasonably

informed users see its significance.

LO 4
SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset A resource controlled by the entity as a

result of past events and from which
future economic benefits are expected to
Liability flow to the entity.

Equity

Income

Expenses
SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

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

Income

Expenses
SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset

Liability

Equity The residual interest in the assets of the

entity after deducting all its liabilities.

Income

Expenses
SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset

Liability

Equity Increases in economic benefits during the

accounting period in the form of inflows or
enhancements of assets or decreases of
Income
liabilities that result in increases in equity,
other than those relating to contributions
Expenses from equity participants.
SECOND LEVEL: BASIC ELEMENTS
Elements of Financial Statements

Asset

Liability

Equity Decreases in economic benefits during the

accounting period in the form of outflows
Income or depletions of assets or incurrences of
liabilities that result in decreases in equity,
other than those relating to distributions to
Expenses
equity participants.
THIRD LEVEL: RECOGNITION, MEASUREMENT,
AND DISCLOSURE CONCEPTS

These concepts explain how companies should recognize,

measure, and report financial elements and events.

Recognition, Measurement, and Disclosure Concepts

ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
3. Monetary unit 3. Expense recognition
4. Periodicity 4. Full disclosure
5. Accrual

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 THIRD LEVEL: ASSUMPTIONS

Basic Assumptions
Economic Entity – company keeps its activity separate from its
owners and other business unit.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic activities into

time periods.

Accrual Basis of Accounting – transactions are recorded in the

periods in which the events occur.
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 THIRD LEVEL: ASSUMPTIONS

BE2-8: Identify which basic assumption of accounting is best

described in each item below.
(a) The economic activities of FedEx Corporation
(USA) are divided into 12-month periods for the Periodicity
purpose of issuing annual reports.
(b) Total S.A. (FRA) does not adjust amounts in its Monetary
financial statements for the effects of inflation. Unit
(c) Barclays (GBR) reports current and non-current
classifications in its statement of financial Going Concern
position.
(d) The economic activities of Tokai Rubber
Industries (JPN) and its subsidiaries are Economic
merged for accounting and reporting purposes. Entity
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 THIRD LEVEL: BASIC PRINCIPLES

Measurement Principles
 Historical Cost is generally thought to be a faithful
representation of the amount paid for a given item.

 Fair value is defined as “the price that would be received to

sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement
date.”

 IASB has given companies the option to use fair value as the
basis for measurement of financial assets and financial
liabilities.
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 THIRD LEVEL: BASIC PRINCIPLES

Measurement Principles
IASB established a fair value hierarchy that provides insight into
the priority of valuation techniques to use to determine fair value.
ILLUSTRATION 2-4

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 THIRD LEVEL: BASIC PRINCIPLES

Revenue Recognition
When a company agrees to perform a service or sell a product to
a customer, it has a performance obligation.

Requires that companies recognize revenue in the accounting

period in which the performance obligation is satisfied.

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 THIRD LEVEL: BASIC PRINCIPLES

Expense Recognition - Outflows or “using up” of assets

or incurring of liabilities during a period as a result of delivering
or producing goods and/or rendering services.

“Let the expense follow the revenues.”

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THIRD LEVEL: BASIC PRINCIPLES

Full Disclosure
Providing information that is of sufficient importance to
influence the judgment and decisions of an informed user.
Provided through:
 Financial Statements
 Notes to the Financial Statements
 Supplementary information
THIRD LEVEL: BASIC PRINCIPLES

BE2-9: Identify which basic principle of accounting is best

described in each item below.
(a) Parmalat (ITA) reports revenue in its income Revenue
statement when it delivered goods instead of when Recognition
the cash is collected.
(b) Google (USA) recognizes depreciation expense for Expense
a machine over the 2-year period during which that
Recognition
machine helps the company earn revenue.
(c) KC Corp. (USA) reports information about pending
Full
lawsuits in the notes to its financial statements.
Disclosure
(d) Fuji Film (JPN) reports land on its statement of
financial position at the amount paid to acquire it,
even though the estimated fair market value is Measurement
greater. 34
THIRD LEVEL: COST CONSTRAINT

Cost Constraint
Companies must weigh the costs of providing the information
against the benefits that can be derived from using it.

 Rule-making bodies and governmental agencies use cost-

benefit analysis before making final their informational
requirements.
 In order to justify requiring a particular measurement or
disclosure, the benefits perceived to be derived from it
must exceed the costs perceived to be associated with it.
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THIRD LEVEL: COST CONSTRAINT

BE2-11: Determine whether you would classify these

transactions as material.

(a) In the current year, Blair Co. reduces its bad

debt expense to ensure another positive Material
earnings year. The impact of this adjustment is
equal to 3% of net income.
(b) Damon Co. expenses all capital equipment
Likely not
under €2,500 on the basis that it is immaterial.
material
The company has followed this practice for a
number of years.

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Summary of
the Structure

ILLUSTRATION 2-7
Conceptual Framework
for Financial Reporting

LO 8
 The role of a conceptual framework
• A structured theory of accounting
• States the scope and objective of financial reporting
• Identifies and defines qualitative characteristics of financial
information and the basic elements of accounting
• Deals with principles and rules of recognition and
measurement, and report disclosures

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The role of a conceptual framework

… 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.
FASB

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The role of a conceptual framework
Issues:
– Do we need a general theory of accounting?
– Is current accounting too permissive?
– Are current accounting practices too inconsistent?
– Is there too much political interference in the neutrality of accounting
reports?

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The role of a conceptual framework
Benefits:
– consistent, logical reporting requirements
– greater compliance
– enhanced accountability
– fewer specific standards
– enhanced understanding of reporting requirements
– more economical standard setting

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Objectives of conceptual frameworks

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.
FASB

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Objectives of conceptual frameworks
• Information should be
– useful in making economic decisions
– useful in assessing cash flow prospects
– about enterprise resources, claims to those resources and changes in
them

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Objectives of conceptual frameworks

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Developing a conceptual framework
• The development of conceptual frameworks is influenced by
two key issues:
– principles versus rules-based approaches to standard setting
– information for decision making and the decision-theory approach

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Principles-based and rule-based standard setting

• IASB mostly produces consistent, coherent principles-based

standards
• Rule-based standards may increase comparability and
verifiability and may reduce earnings management

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Principles-based and rule-based standard setting

• The standards of the FASB have traditionally been rule-based

• Emphasis now being given to principles
• Timely given the IASB/FASB convergence program

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Information for decision making and the decision-
theory approach
• Accounting data are required for decision making or
accountability purposes
– stewardship
– decision making
• users

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Information for decision making and the decision-
theory approach
• The decision-theory approach maps the process by which the
outputs of the accounting system provide inputs to the
decision model of a user

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Information for decision making and the decision-
theory approach
Decision-theory process
Overall
Overalltheory
theory
of
ofaccounting
accounting

Individual
Individual Prediction
Prediction Decision
Decision
accounting
accounting model
modelofof model
modelofof
system
system user
user user
user

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International developments: the IASB and FASB
Conceptual Framework
• In 2004 the FASB and IASB agree to undertake a joint project
to:
– develop an improved, common conceptual framework
– goal of developing standards that are principles-based, internally
consistent and internationally converged
– an Exposure Draft was produced - June 2009
– deferred consideration of not-for-profit sector issues

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International developments: the IASB and FASB
Conceptual Framework
• ED has several contentious areas:
– entity vs proprietorship perspective
– primary user group
– decision usefulness and stewardship
– qualitative characteristics

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International developments: the IASB and FASB
Conceptual Framework
• Australia follows an approach whereby issues for both the not-
for-profit and for-profit sectors are considered together
• Standards are intended to apply to both sectors
• IFAC’s International Public Sector Accounting Standards Board
has begun a project to develop a public sector CF

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A critique of conceptual framework projects
• Approaches to developing a CF:
– scientific
• recourse to logic and empiricism or both
– professional
• prescribes the best course of action by recourse to professional values

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A critique of conceptual framework projects
Scientific criticisms:
• prescriptive
• unspecified rules and conventions
• do not resolve contemporary disclosure issues
• vague definitions
• do not address measurement issues
• risk of mechanical decision making
• framework may become an end in itself
• overreliance on definitions

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Ontological and epistemological assumptions
• Freedom from bias (neutrality)
– an information quality that avoids leading users to conclusions that secure the
particular needs, desires or preconceptions of the preparers
• Solomons: freedom from bias as ‘financial mapmaking’
• Feyerabend: scientific truth is not absolute
• Hines claims mainstream accounting is ‘taken-for-granted’

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Circularity of reasoning
• Objective of a conceptual framework: guide the everyday practice of
accountants
• A superficial view
– deducing principles from generalised theory

• Existing frameworks typified by internal circularity:

– e.g. FASB Statement No. 2
– qualitative characteristics are often stated in terms of other qualities which are
non-operationalised

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An unscientific discipline
• Is accounting a science?
– prescriptive by nature and value laden
• Stamp
Until we are sure in our minds about the nature of accounting, it is
fruitless for the profession to invest large resources in developing a
conceptual framework to support accounting standards.

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Positive research
• Conceptual framework projects ignore the empirical findings of positive
accounting research
– in conflict with each other
• Mounting evidence that capital markets are not efficient
• If the conceptual framework could ensure users receive useful
information this would serve a useful purpose

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The conceptual framework as a policy document
– As a generalised body of knowledge, conceptual frameworks fail a
number of ‘scientific’ tests
– The distinction between theories and policies is important
– CFs not produced in a political vacuum
– CFs may just be a reflection of the dominant group’s will

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Professional values and self-preservation
• ‘Self-preservation’
– implies the pursuit of self-interest
• ‘Professional values’
– suggests idealism and altruism
• Gerboth
– sense of personal responsibility
• Hines
– professional legitimacy

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Conceptual framework for auditing standards

• Auditing is a discipline based in logic

• The traditional verification role has evolved into business risk
auditing

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Summary
• The conceptual framework is intended to provide a coherent and
prescriptive guide to accounting practice
• If effective it should result in the communication of more useful financial
information to users
• Developing a conceptual framework has been a long and complicated
process
• Criticisms of conceptual framework projects exist
• Others debate the importance of these criticisms
• In auditing there has been a shift away from substantive testing toward
the role of client business risk
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 Quiz Session #4
1. Some people argue that there is no need for a general theory of accounting, as
established in a conceptual framework. They say there is no overall theory of
physics, biology, botany or psychology, so there is no need for an overall theory of
accounting. Furthermore, attempts to develop such a theory are futile and
unnecessary, since accounting has not needed a conceptual framework so far.
Debate this view!
2. Explain the advantages and disadvantages of principles-based and rule-based
standards!
3. What type of information do you think is useful for shareholders, lenders, and
creditors? Is this type of information that is currently provided?

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Key terms and concepts

• Conceptual frameworks for accounting and auditing

• Statement of accounting concepts
• FASB and IASB
• Principles-based and rule-based standards
• Decision making and decision-theory
• Professional values and self-preservation
• Business risk auditing

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