Financial Accounting Theory Craig Deegan Chapter 6

Financial Accounting Theory Craig Deegan Chapter 6 Normative theories of accountin accounting g—the case of conceptual framework projects Slides written by Craig Deegan and Michaela Rankin

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Learning objectives • In this chapter you will be introduced to  – the role that conceptual frameworks (CFs) can play in the practice of financial reporting  – the history of the development of the various existing conceptual framework projects  – the various building blocks that have been developed within various conceptual framework projects

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Learning objectives (cont.)  – perceived advantages and disadvantages that arise from the establishment and development of conceptual frameworks  – factors, including political factors, that might help or hinder the development of conceptual framework projects  – groups within society which are likely to benefit from the establishment and development of conceptual framework projects

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What is a conceptual framework? • ‘A coherent system of interrelated objectives and fundamentals that is expected to lead to consisten consistentt standards’ (Statement of Financial Accountin Accounting g Concepts No. 1: Objective Objectives s of Financial Reporting by Business Enterprises 1978) •  Attempts to provide provide a structured structured theory of accounting

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Conceptual frameworks as normative theories • Conceptual frameworks provide prescription so they are considered normative theories of accounting • ‘Prescribes the nature, function and limits of financial accounting and reporting’ (Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises, Enterprises , 1978)

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Rationale for conceptual frameworks • To develop the practice of financial reporting logically and consistently we need to address such issues as  – what we mean by financial reporting and what should be its scope  – which organisational characteristics indicate that an entity should produce financial reports  – the objective of financial reporting  – qualitative characteristics financial information should possess  – what are the elements of financial reporting  – what measurement rule should be employed

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Rationale for conceptual frameworks (cont.) • Proponents argue that without agreement on these issues accounting standards will be developed in an ad hoc  manner  manner • Limited consistency between accounting standards in the absence of a conceptual framework

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The ‘building blocks’ of the conceptual framework • The framework must be developed in a particular order  – some issues need to be resolved before moving on to subsequent ‘building blocks’

• Refer to Figure 6.1 (p. 179) in the text for an overview of the IASB Framework for the Preparation and Presentation of Financia Financiall Statements (which Statements  (which in 2005 replaced the Australian Conceptual Framework)

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History of the development of CFs • CFs were developed in a number of jurisdictions including  – US, UK, Canada, Australia, New Zealand, International  Accounting Standards Committee

• In recent years many countries have adopted the IASB Framework given that they have decided to adopt the accounting standards released by the IASB • No standard-setters had developed a complete CF; measurement issues typically unaddressed • Limited or no progress in recent years, although efforts underway to update IASB Framework

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Development of frameworks of accounting in the US • 1961 and 1962: Moonitz, and Moonitz and Sprouse prescribed that accounting practice should be based on current values • 1965: Grady developed theory based on description of existing practice  – led to the release of Accounting Principles Board (APB) Statement No. 4  – however, accounting profession under criticism for lack of any real framework

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Development of frameworks of accounting in the US (cont.) • Led to formation of Trueblood Committee in 1971 which produced Trueblood Report  – report outlined 12 objectives of accounting and seven qualitative characteristics which financial information should possess  – objective 1: focused on information needs of financial statement users  – objective 2: need to serve users with limited ability to demand financial information

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Development of frameworks of accounting in the US (cont.) • 1974: APB replaced by FASB which then embarked on its CF project • Six Statements of Financial Accounting Concepts (SFACs) released from 1978 to 1985 • Initial SFACs normative in nature, but SFAC No. 5 relating to recognition and measurement largely descriptive of current practice  – received much criticism  – since 2005 FASB and IASB have been jointly working towards the development of a revised conceptual framework that would be used by both boards —referred to as the ‘convergence project’ Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a F i n a n c i a l A c c o u n t i n g T h e o r y 2 e by Deegan

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Development of a CF in Australia • Degree of progression was slow • Only four Statements of Accounting Concepts (SACs) were released  – SAC 1: Definition of the Reporting Entity  – SAC 2: Objectives of General Purpose Financial Reporting  – SAC 3: Qualitative Characteristics of Financial Information  – SAC 4: Definition and Recognition of the Elements of Financial Statements

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Development of a CF in Australia (cont.) • Fifth SAC relating to measurement was never released • Had a number of similarities to the US CF project • 2005: Australia adopted the IASB Framework as a result of the decision by the Financial Reporting Council that Australia would adopt IAS/IFRS by 2005 • SAC 3 and SAC 4 were abandoned • SAC 1 and SAC 2 were retained until such time that a revised IASB Framework was developed

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Development of a CF in the UK • Early moves towards guidance relating to objectives and identification of users provided by The Corporate Report (1976)  – concerned with addressing the rights of the community in terms of their access to financial information (broader than notion of users adopted in other frameworks)  – ultimately contents generally not accepted by the accounting profession

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Development of a CF in the UK (cont.) • 1991: ASB adopted the IASC’s CF • IASC framework was generally consistent with the US and Australian frameworks— frameworks —subsequently became known as the IASB Framework

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Building blocks of the CF • Building blocks of the various CFs have addressed  – definition of the reporting entity  – objectives of general purpose financial reporting (GPFR)  – perceived users of GPFRs  – qualitative characteristics that GPFRs should possess  – elements of financial statements  – possible approaches to measuring the elements

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Definition of the reporting entity • The Conceptual Framework provides a definition of entities required to produce GPFRs  – known as reporting entities

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General purpose financial reports • GPFRs are defined as reports  – ‘… intended to meet the information needs common to users who are unable to command the preparation of reports tailored so as to satisfy, specifically, all of their information needs’ (SAC 1, para. 6)

• GPFRs are reports that comply with accounting standards and other generally accepted accounting practices (GAAPs)

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Special purpose financial reports • Special purpose reports are provided to meet the information demands of a particular user, or group of users

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Entities required to produce GPFRs • Not all entities are classed as reporting entities • SAC 1 states that GPFRs should be prepared when there are users  – ‘… whose information needs have common elements, and those users cannot command the preparation of information to satisfy their individual information needs’ (para. 8)

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Factors indicative of a reporting entity (SAC 1) • Separation of management from those with an economic interest in the entity • The economic or political importance/influence importance/influence of the entity to/on other parties • The financial characteristics of the entity

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Objectives of GPFR • Traditional objective was to enable outsiders to assess the stewardship of management • Recent commonly accepted goal of financial reporting is to assist report users’ economic decision making  – less emphasis placed on the stewardship function

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Objective embraced within CFs • Objective of GPFRs in SAC 2 is deemed to be  – to provide information to users that is useful for making and evaluating decisions about the allocation of scarce sc arce resources

• Objective of decision usefulness calls into question usefulness of historical cost information

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Other objectives of GPFRs •  Another objective objective is to enable enable reporting entities to to demonstrate accountability accountability between the entity and those parties to which the entity is deemed accountable •  Accountabi  Accountability lity is defined as as  – the duty to provide an account or reckoning of those actions for which one is held responsible

• accountability is not generally embraced by CFs

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Users of financial reports • SAC 2 identifies three primary user groups for GPFRs  – resource providers 

employees, lenders, creditors, suppliers, investors and contributors

 – recipients of goods and services 

customers and beneficiaries

 – parties performing review or oversight function 

parliaments, governments, regulatory agencies, analysts, labour unions, employer groups, media and special interest groups

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International perspectives on users of GPFRs of GPFRs • The IASB Framework  – identifies GPFRs users as investors, employees, lenders, suppliers, customers, govt. agencies and the public  – states that information designed to meet the needs of investors will usually meet the needs of the other groups

• US: SFAC 1  – main focus is present and potential investors and other users with either a direct financial interest or related to those with a direct financial interest

• UK: The Corporate Report  – all groups impacted by an organisation’s operations have rights to information about the reporting entity, not necessarily related to resource allocation decisions

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Level of expertise expected of financial report readers • Generally accepted that readers are expected to have some proficiency in financial accounting • IASB Framework (para. 25)  – ‘… users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence’

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Qualitative characteristics of financial reports • To ensure financial information is useful for economic decision making, we need to consider the attributes or qualities that financial information should have •  According to IASB IASB Framework  – primary qualitative characteristics are understandability, relevance, reliability and comparability  – related to relevance is materiality  – IASB Framework appears to give greater prominence to relevance and reliability  – there are issues associated with the ‘trade -off’ between relevance and reliability

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Reliability • Information is considered to be reliable if it ‘faithfully represents’ the entity’s transactions and events • Should be free from bias and undue error • Reliability Reliability is a function of representation representational al faithfulness,, verifiabil faithfulness verifiability ity and neutrality

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Reliability— Reliability—implications for traditional accounting • Traditionally, Traditionally, the doctrine of conservatism and the acceptance of ‘prudence’ has been adopted  – bias towards understating asset values and overstating liabilities

• This doctrine is not consistent with notions of reliability reliabili ty or freedom from bias

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Relevance • Something is relevant if it influences decisions on the allocation of scarce resources  – if it is capable of making a difference in a decision

• For information to be relevant it should have  – predictive value, and  – feedback value

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Materiality •  A limiting factor factor on the disclosure disclosure of relevant relevant and reliable material is the notion of materiality •  An item is material if (IASB (IASB Framework, para. para. 30)  – ‘... its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements …. Materiality provides a cut -off rather than being a primary qualitative characteristic which information must have if it is to be useful’

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Uniformity and consistency • Uniformity and consistency imply advantages in restricting the number of accounti accounting ng methods that can be used by reporting entities  – has been argued that firms adopt particular accounting methods because they best reflect their underlying performance  – restricting available methods imposes costs on reporting entities

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Costs vs benefits • Need to consider whether the cost of providing certain information exceeds the benefits to be derived from its provision  – costs include collection, storage, retrieval, presentation, analysis and interpretation  – benefits come from sound economic decision making by users

• Measuring potential costs and benefits involves professional judgement

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Can GPFRs provide unbiased accounts of performance? • The practice of accounting is heavily reliant on professional judgement • Prior to accounting standards being released, standard setters attempt to determine the economic consequences of following the standards  – if consider economic consequences then standards cannot be considered objective or neutral

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Can GPFRs provide unbiased accounts of performance? (cont.) • If we accept the notion that preparers will be driven by self-interest (from Positive Accounting Theory) notions of objectivity or neutrality are unrealistic • Political nature of standard setting process also affects neutrality and objectivity • In communicating reality accountants construct reality (Hines 1988)

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The elements of financial reporting • The next building block considers the definition and recognition criteria of the elements of financial reporting • Definition criteria— criteria—what attributes are required before an item can be considered as belonging to a particular class of element • Recognition Recognition criteria criteria— —employed to determine whether the item can be included in the financial reports

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Five elements of financial reporting in the IASB Framework •  Assets • Liabilities • Equity • Expenses • Income  – in the IASB Framework, income is further subdivided into revenues and gains  – ten elements identified in the US by FASB

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Definition of assets • ‘… a resource controlled by the entity as a result of past events and from fr om which future economic benefits are expected to flow to the entity’ (IASB Framework, para. 49(a)) • Three key characteristi characteristics cs  – must be an expected future economic benefit  – the reporting entity must control the future economic benefit  – the transaction or other past event giving rise to the reporting entity’s control must have occurred

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Definition of assets (cont.) • The definition refers to the benefit and not its source  – in the absence of future economic benefits, the object or right will not qualify as an asset

• The benefits can result from ongoing use, not necessarily a value in exchange

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The characteristic of control • Control relates to the capacity to benefit from the asset and to deny or regulate others’ access to the benefit • Legal enforceability is not a prerequisite for establishing the existence of control  – control (and not legal ownership) is required, although controlled assets are frequently owned

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Recognition of assets •  An asset— asset—and all the other elements of accounting— accounting —shall be recognised when  – it is probable that any future economic benefit associated with the item will flow to or from the entity, and  – the item has a cost or value that can be measured with reliability (IASB Framework, para. 83)

• Probable is generally considered to mean ‘more likely rather than less likely’

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Definition of liabilities • Liabilities are defined as  – ‘… 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’ (IASB Framework, para. 49(b))  – present obligations not only refers to legally enforceable obligations but also those imposed by notions of equity and fairness, or by custom or other business practices

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Recognition of liabilities • Recognition criteria consistent with those of assets and the other elements of accountin accounting g •  A liability liability shall be recognised recognised when  – it is probable that the sacrifice of economic benefits will be required, and  – the amount of the liability can be measured reliably

• Has implications for disclosure of various provisions

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Approaches to determining profit • Two common approaches to determining profits  – asset/liability approach links profit to changes in assets and liabilities  – revenue/expense approach relies on concepts such as the matching principle

• The definition of expenses and revenues in the CF based on asset/liability perspective

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Definition of expenses • ‘… 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 distributions to equity participants’ (IASB Framework, para. 70(b))

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Recognition of expenses •  An expense expense shall be recognised recognised when  – it is probable that the consumption or loss of future economic benefits resulting in a reduction in assets and/or an increase in liabilities has occurred, and  – the consumption or loss of economic benefits can be measured reliably

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Definition of income • ‘… 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 contribution contributions s from equity participants’ (SAC 4, para. 70(a))

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Definition of income (cont.) • Income can be recognised from normal trading relations, as well as from non-reciprocal transfers such as grants, donations, bequests or where liabilities are forgiven • IASB Framework further subdivides income into revenues and gains  – revenue arises in the course of the ordinary activities of an entity  – gains represent other items that meet the definition of income and may, or may not, arise in the ordinary activities of an enterprise  – not clear why there is a need to break income into two components

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Recognition of income •  As with the other other elements of accounting accounting,, income is recognised when  – it is probable that the inflow or other enhancement or saving in outflows of future economic benefits has occurred, and  – the inflow or other enhancement or saving in outflows of future economic benefits can be measured reliably

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Definition of equity • Equity is defined as ‘the residual interest in the t he assets of the entity after deducting all of its liabilities’ liabili ties’ (IASB Framework, para. 49(c)) •  As a residual residual interest it ranks ranks after liabilities liabilities in terms of claims against the assets • Definition is a direct function of the definitions of assets and liabilities

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Measurement principles • To date very little prescription in relation to measurement provided by CFs • FASB statement provides description of various approaches to measuring elements without providing prescription

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Benefits associated with conceptual frameworks •  Accounting  Accounting standards should should be more consistent consistent and logical • Increased international compatibility of accounting standards • Standard-setters should be more accountable for their decisions • Communication Communication between standard-setters and their constituents should be enhanced

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Benefits associated with CFs (cont.) • The development of accounting standards should be more economical • Where conceptual frameworks cover a particular issue, there might be a reduced need for additional standards • Emphasise the ‘decision usefulness’ role of financial reports rather than restricting concern to stewardship

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Disadvantages of conceptual frameworks • Smaller organisations may feel overburdened by reporting requirements • Typically economic in focus so ignore transactions that have not involved market transactions or exchange of property rights  – further reinforces the importance of economic performance relative to social performance

• Represent a codification of existing practice

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CFs as a means of legitimising standardsetting bodies • Some (e.g. Hines and Solomons) have suggested that CFs have been used as devices to help ensure the ongoing existence of the accounting profession • Increase the ability of the profession to selfregulate, thus counteracting government intervention

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