CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING.

Lecture Outline Introduction Objectives Definition Need for a conceptual framework Overview of a conceptual framework for financial accounting Objectives of financial accounting Qualitative characteristics of accounting information Primary qualities relating to content Primary qualities relating to presentation Elements of financial statements Recognition and measurement guidelines Recognition of elements of the financial statements Measurement of elements of financial statement Absence of a universally accepted conceptual framework for financial accounting Summary References 1.1 Introduction

Accounting, as you are already aware, has been defined as both a science as well as an art. To a large extent the training in financial accounting has focused more on the art of accounting (i.e the how of accounting) as opposed to the science (the why) of accounting. Accounting is a science because it is backed by a body of knowledge; a conceptual framework. In this lecture, you shall be exposed to the theoretical foundation of accounting. This theoretical framework may be unknown to many people but serves to justify that accounting is truly a professional discipline. The lecture shall cover the definition of the conceptual framework, the need for a conceptual framework, the makeup of the conceptual framework and the reasons for the absence of a universally accepted conceptual framework underlying financial accounting. 1.2 Objectives

At the end of this lecture you should be able to: 1. 2. 3. Explain the need for a conceptual framework for financial accounting. Identify and explain the elements of the conceptual framework for financial accounting. Explain the reasons for the absence of a universally accepted conceptual framework for financial accounting.

1.3 Definition A conceptual framework has been defined as 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 accounting statements. A conceptual framework underlying financial accounting cannot be viewed as the description of fundamental truths and axioms as found in theories regarding the natural sciences which are derived from and proven by the laws of nature. A conceptual framework, rather, is created, developed or decreed on the basis of environmental factors, intuition, authority and acceptability. The credibility of the conceptual framework rests upon its general recognition and acceptance by preparers, auditors and users of financial statements. Take note A conceptual framework cannot be viewed as the description of fundamental truths. Its credibility rests upon its general recognition and acceptance.

1.4

Need for a conceptual framework. Intext question The question that has often been asked is, Is there a need for a conceptual framework to underlie financial accounting when accounting is a highly practical discipline?

The usefulness of a conceptual framework for financial accounting is evident in that: (i) it enables the development and issuance of a coherent set of accounting standards and practices built upon the same foundation; (ii) it increases financial statement users understanding of and confidence in financial reporting; (iii) it enhances comparability among financial statements of different companies. This is because it provides a basis upon which similar transactions and events are similarly accounted for and reported; (iv) it assists in the resolution of new and emerging practical problems by providing a frame of reference for resolving accounting issues; and (v) it defines the bounds of judgment in the preparation of financial statements.

1.5

Diagram 1.1: Overview of a Conceptual Framework for Financial Accounting

First level Objectives THE WHY-GOALS AND PURPOSES OF ACCOUNTING

Qualitative Characteristics Of Accounting Information

Elements

Second level BRIDGE BETWEEN LEVELS 1 AND 3. Third level THE HOW

Recognition and Measurement Guidelines Assumptions Principles Constraints

At the first level, the objectives identify the goals and purposes of accounting and are the cornerstones for the conceptual framework. At the second level are the qualitative characteristics of accounting information and definition of elements of financial statements. The qualitative characteristics are the characteristics that make accounting information useful while elements are definitions of financial statements components. Together these two categories provide the foundation for developing recognition and measurement guidelines to be used in practice. At the final level are the recognition and measurement guidelines that accountants use in establishing and applying accounting standards. The recognition and measurement guidelines encompass assumptions, principles and constraints that describe the present reporting environment. 1.5.1 Objectives of Financial Accounting

The objective of financial reporting is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of

users in making economic decisions. Financial statements prepared for this purpose meet the common needs of most users. General purpose financial statements, however, do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not necessarily provide non-financial information. Activity 1.1 Differentiate between general purpose financial statements and specific purpose financial statements.

1.5.2

Qualitative Characteristics of accounting information Intext question What are the qualities that accounting information should possess for it to be useful?

Qualitative characteristics are the characteristics that make the information provided in financial statements useful to users for assessing the financial position, performance and financial adaptability of an enterprise. Some qualitative characteristics relate to the content of information while others relate to how that information is presented in the financial statements. The primary qualitative characteristics relating to content are relevance and reliability. The primary qualitative characteristics relating to presentation are comparability and understandability.

Diagram 1.2:

The relationship between the qualitative characteristics of good accounting information.

What makes financial information useful?

Threshold quality

Materiality More of one may

Information that is not material cannot be useful

Content

Relevance What makes information relevant?

mean less of other

Reliability What makes information reliable?

Information that influences decision Predictive value and Feedback value Timeliness

Information that is free from error or bias Faithful representation Substance Neutrality Prudence Completeness

Presentation

What qualities make the presentation of financial information useful?

Comparability Consistency Disclosures (eg. Accounting policies and Corresponding figures)

Understandability Aggregation and classification Users abilities

What limits the application of the Qualitative characteristics? Balance between characteristics

Constraints

Timeliness

Benefit and cost

Take note The primary qualitative characteristics relating to content are relevance and reliability. The primary qualitative characteristics relating to presentation are comparability and understandability.

1.5.2.1 Primary qualities relating to content.

It is generally agreed that relevance and reliability are the 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) as discussed below. Relevance. Information is relevant when it has the ability of influencing the decisions of users (i.e. it is capable of making a difference in a decision). If certain information is disregarded because it is perceived to have no bearing on a decision, it is irrelevant to that decision. Information is said to be relevant when it has: Predictive value-helps users make predictions about the outcome of past, present, and future events, and or Feedback value- confirms or corrects prior expectations For example, when a company issues an interim report, this information is considered relevant because it provides a basis for forecasting annual earnings, and provides feedback on past performance. It follows that for information to be relevant, it must also be timely - available to decisionmakers before it loses its capacity to influence their decision. For example, if a company did not report its interim results until six months after the end of the period, the information would be much less useful for decision-making purposes. Take note For information to be relevant, it should have the ingredients of predictive value, feedback value, and timeliness.

Reliability. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. The secondary qualities that give rise to the quality of reliability include: (i) Faithful Representation. To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Accountants are required to

use accurate figures as far as possible and reasonable estimates otherwise when accounting for transactions and events. Most financial information is subject to some risk of being less than a faithful representation of what it purports to portray. This is not due to bias, but rather to inherent difficulties either in identifying the measurement and presentation techniques that convey messages that correspond with those transactions and events. Take note In certain cases, the measurement of the financial effects of items could be so uncertain that enterprises generally would not recognise them in the financial statements; for example, although most enterprises generate goodwill internally over time, it is usually difficult to identify or measure that goodwill reliably (ii) Substance Over Form As stated earlier, for information to be reliable, it must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their financial substance and economic reality and not merely their legal form (legal interpretation). The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, accountants present assets that are the subject of hire-purchase transactions on the balance sheet of the purchaser even though legally title may not have yet passed from the vendor to the vendee. Another example is where a sale is not reported in the case of a sale lease back transaction where the lease qualifies as a finance lease. (iii) Neutrality To be reliable, the information contained in financial statements must be neutral, that is, free from bias. Financial statements are not neutral if by the selection or presentation of information, they influence the making of a decision or judgment in order to achieve a predetermined result or outcome. (iv) Prudence The preparers of financial statements do, however, have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collect ability of doubtful receivables, the probable useful life of plant and equipment and the number of warranty claims that may occur. Such uncertainties are recognised by the disclosure of their nature and extent by the exercise of prudence in the preparation of the financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or income are not

overstated and liabilities or expenses are not understated. The exercise of prudence, however, does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because the financial statements would not be neutral and, therefore, not have the quality of reliability. (v) Completeness To be reliable, information contained in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance. Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under legal action are disputed, it may be inappropriate for the enterprise to recognise the full amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim. 1.5.2.2 Primary qualities relating to presentation. Understandability An essential quality of the information provided in financial statements is that it is readily understandable by users. For this purpose, users are assumed to have a reasonable knowledge of business and economic activities and accounting and willingness to study the information with reasonable diligence. Information about complex matters that should be included in the financial statements because of its relevance to the economic decision-making needs of users, however, should not be excluded merely on the grounds that it may be too difficult for certain users to understand. Comparability Users must be able to compare the financial statements of an enterprise over time in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises in order to evaluate their relative financial position, performance and changes in financial position. Hence, the measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout an enterprise and over time for that enterprise and in a consistent way for different enterprises. An important implication of the qualitative characteristics of comparability is that users be informed of the accounting policies employed in the preparation of the financial statements, any changes in those policies and the effects of such changes. Users need to be able to identify differences between the accounting policies for like transactions and other events used by the same enterprise from period to period and by different enterprises. Compliance with accounting standards, including the disclosure of the accounting policies used by the enterprise, helps to achieve comparability.

The need for comparability should not be confused with mere uniformity and should not be allowed to become an impediment to the introduction of improved accounting standards. It is not appropriate for an enterprise to continue accounting in the same manner for a transaction or other event if the policy adopted is not in keeping with the qualitative characteristics of relevance and reliability. It is also inappropriate for an enterprise to leave its accounting policies unchanged when more relevant and reliable alternatives exist. Because users wish to compare the financial position, performance and changes in financial position of an enterprise over time, it is important that the financial statements show corresponding information for the preceding periods. Take note The purpose of establishing qualitative characteristics of accounting information is to provide a framework for accountants when making choices regarding measurements and disclosure in financial reports. Using such a framework does not provide obvious solutions to accounting problems; rather it simply identifies and defines aspects that should be considered when reaching a solution. Many accounting choices require trade-off between the qualitative characteristics. For example, some believe that financial reports based on current costs could provide more relevant information than reports based on historical costs, which are reliable. There is no clear-cut consensus on the relative weighting (importance) of relevance and reliability (or other characteristics) that assist in deciding such issues. While awareness of the qualitative characteristics may help in choosing between alternatives, the actual decisions, in most cases, require the exercise of professional judgment.

1.5.3

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. It seems necessary, therefore, to develop a basic definition framework for the elements of accounting. Such definitions provide guidance for identifying what to include and what to exclude from the financial statements.

Assets Assets are economic resources controlled by an entity as a result of past transactions or events from which future economic benefits may be obtained. Assets have three essential characteristics: a) 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; b) the entity can control access to the benefit; and c) the transaction or event giving rise to the entitys right to, or control of, the benefit has already occurred. It is not essential for control of access to the benefit to be legally enforceable for a resource to be an asset, provided the entity can control its use by other means. Liabilities Liabilities are obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future. Liabilities, like assets, have three essential characteristics: a) 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; b) the duty or responsibility obligates the entity, leaving it little or no discretion to avoid it; and c) the transaction or event obligating the entity has already occurred. Equity Equity is the ownership interest in the assets after deducting its liabilities. Take note

EQUITY= ASSETS - LIABILITIES

Revenues Revenues are increases in economic resources, either by way of inflows or enhancements of assets or reductions of liabilities, resulting from the ordinary activities of an entity, normally from the sale of goods, the rendering of services, or the use by others of entity resources yielding rent, interest, royalties or dividends. Expenses Expenses are decreases in economic resources, either by way of outflows or reductions of assets or incurrence of liabilities, resulting from the ordinary revenue-earning activities of any entity.

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Gains Gains are increases in equity from peripheral or incidental transactions and events affecting an entity, and from all other transactions, events and circumstances affecting the entity except those that result from revenues or equity contributions. Losses Losses are decreases in equity from peripheral or incidental transactions and events affecting an entity and from all other transactions, events and circumstances affecting the entity except those that result from expenses or distributions of equity. Take note Revenues and expenses arise from the ordinary activities of an enterprise while gains and losses arise from peripheral or incidental events and circumstances.

It is useful to think of the elements as two distinct groups. (i)

(ii)

The first group of three elements-assets, liabilities, and equity-describe amounts of resources and claims to resources at a moment in time and appear in a balance sheet. The second group of elements-revenues, expenses, gains and losses describe transactions, events and circumstances that affect an enterprise during a period of time and are presented in an income statement.

The first group is changed by elements of the second group, and at any time is the cumulative result of all changes. This interaction is referred to as articulation, and results in financial statements that are fundamentally interrelated. Thus, a statement, for example the balance sheet, that reports elements of the first group depends on the statement, the income statement, that reports elements in the second group, and vice versa.

1.5.4

RECOGNITION AND MEASUREMENT GUIDELINES

1.5.4.1 Recognition of the elements of financial statements

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Intext question What is recognition?

Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element. It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheet or income statement totals. Items that satisfy the recognition criteria should be recognized in the balance sheet or income statement. An item that meets the definition of an element should be recognized if: a. it is probable that any future economic benefit associated with the item will flow to or from the enterprise; and b. the item has a cost or value that can be measured with reliability. In many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When, however a reasonable estimate cannot be made the item is not recognized in the balance sheet or income statement. If it is not possible for the item to be measured reliably, it should be disclosed in the notes, explanatory material or supplementary schedules. Take note The interrelationship between the elements means that an item that meets the definition and recognition criteria for a particular element, for example an asset, automatically requires the recognition of another element, for example, income or liability.

The Probability of Future Economic Benefit The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the enterprise. The concept is in keeping with the uncertainty that characterizes the environment in which an enterprise operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared. For example, when it is probable that a receivable owed by an enterprise will be paid, it is then justifiable, in the absence of any evidence to the contrary, to recognize the receivable as an asset. For a large population of receivables, however, some degree of nonpayment is normally considered probable; hence an expense representing the expected reduction in economic benefits is recognized.

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Reliability of measurement The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with reliability. In many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When, however a reasonable estimate cannot be made the item is not recognized in the balance sheet or income statement. If it is not possible for the item to be measured reliably, it should be disclosed in the notes, explanatory material or supplementary schedules. Recognition of assets An asset is recognized in the statement of financial position when it is probable that the future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably. Recognition of liabilities A liability is recognized in the statement of financial position 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. Recognition of income Income is recognized in the statement of comprehensive income when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. Recognition of expenses Expenses are recognized in the statement of comprehensive income when a decrease in an asset or an increase in liability has arisen that can be measured reliably. 1.5.4.2 Measurement of the elements of financial statements. Intext question What is measurement?

Measurement is the process of determining the monetary amount at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement. This involves the selection of a particular basis of measurement. A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following:

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a.

Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amount of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash and cash equivalents that would be required to settle the obligation currently. Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalent that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

b.

c.

d.

The measurement basis most commonly adopted by the enterprise in preparing their financial statements is historical cost. Take note The recognition and measurement guidelines encompass assumptions, principles and constraints that describe the present reporting environment.

Activity 1.3 Refer to your materials for DAC 101 : Foundations of accounting for a detailed review of the fundamental accounting assumptions, generally accepted accounting principles and constraints

1.6

Absence of a universally accepted conceptual framework

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It should be noted that no single framework is universally accepted or totally relied upon in practice. This is due to a number of factors, which include: The variety of users that financial statements serve is so wide that no one framework is likely to meet all their needs. (ii) The time and resources needed to develop a universally agreed conceptual framework perhaps makes it impossible for professional bodies to continue with their programs. (iii) Accounting conventions that underlie financial reporting cannot be proved to be correct; they depend on consensus. Without consensus, there cannot be an agreed conceptual framework and it may not be possible to achieve consensus on wide issues. (iv)The development of an accounting standard may be influenced by factors other than a conceptual framework, for example existing practice and political pressure.
(i)

Summary A conceptual framework for financial accounting enables the development and issuance of a coherent set of accounting standards and practices, increases financial statement users understanding of and confidence in financial reporting, enhances comparability and assists in the resolution of new and emerging practical problems. Objectives of accounting identify the goals and purposes of accounting and are the cornerstones for the conceptual framework. The qualitative characteristics are the characteristics that make accounting information useful while elements are definitions of financial statements components. Together these two categories provide the foundation for developing recognition and measurement guidelines to be used in accounting practice. Despite the desire for a universal conceptual framework for accounting, the same has not been achieved. The variety of users of financial statements and the time and resources needed to develop a universally agreed conceptual framework perhaps are some of the factors inhibit the development of a universally agreed conceptual framework. Activity 1.4: Review questions 1. Briefly discuss the objectives of financial reporting. 2. Discuss the importance of a conceptual framework to financial accounting 3. Of what importance in a conceptual framework are definitions of element of the financial statements. 4. Explain the difference between revenue and a gain. 5. A conceptual framework for financial accounting and reporting

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sets forth objectives and fundamentals that should provide the basis for developing financial accounting and reporting standards. The framework also examines the qualitative characteristics that make accounting information useful. Required: Identify and discuss the benefits that can be expected from such a framework. Activity 1.5: Exercises 1. Are feedback value and predictive value independent of each other or is there some degree of overlap? 2. A conceptual framework for financial accounting and reporting sets forth objectives and fundamentals that should provide the basis for developing financial accounting and reporting standards. The framework also examines the qualitative characteristics that make accounting information useful. Required: What limits the application of the desirable characteristics of accounting information? 3. Two accounting students, Grace and Joseph, were discussing the recognition and measurement guidelines as an influence on financial reporting. Joseph argued that the guidelines are often used as a means of understanding net income for the current period and the financial position at the end of the period. Grace on the other hand, defends the guidelines on the ground that they provided ground rules for preparation of financial statements. Further, she argued, accountants frequently have to make choices among alternative assumptions under conditions of uncertainty and that making such choices based on the guidelines would help avoid bias and dangerous overstatement of net income that could injure both investors and Certified Public Accountants. Grace and Joseph considered the following five independent situations but were unable to reach an agreement on the proper accounting treatment of any of them and have therefore approached you for an advice. Recently Mafuta Oil Company built a pipeline to carry petroleum products from the oil field to its refinery. The cost of the pipeline, which was Sh.30 million, was expensed. Mafuta s net assets have averaged Sh. 50
i)

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million over the past 15 years. ii) Deep Punguza sells microwave ovens on a deferred payment plan. The company recognizes revenue on a cash-collection (i.e., installment) basis even though no uncollectible accounts have occurred since the company began operating 20 years ago. iii) Mwangalifu Enterprise adopted a depreciation policy by which the depreciation method used each year would be selected in accordance with its ability to permit the firm to maintain (and thus report) a 20 percent rate of return on beginning owners equity. iv) Upon learning that the replacement cost of its forklift was Sh.1,200,000 more than its book value, Walsh Company added Sh.1,200,000 to the forklifts book value. v) The Wangari Authority filed and won a Sh. 85 million lawsuit against French Chemicals for polluting a local lake. French Chemicals, with annual profits in excess of Sh.5 billion, did not separately report either the lawsuit or its settlement in its financial statements or accompanying footnotes. Required: For each of the five situations, state your position on the proposed action and explain the reasoning in your proposition using the recognition and measurement guidelines as per the conceptual framework of financial reporting. 4. It has been suggested that corporate reports which possess desirable characteristics of good accounting information sometimes recognize the economic substance of a transaction in preference to its legal form. Describe two examples of where this may occur.

5. Accounting assumptions and accounting principles are not like physical laws; they do not exist in nature awaiting discovery by man. In many ways they are similar to rules established for an organized sport. Explain this statement. What limits the application of the desirable characteristics of accounting information?
6.

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1.8
1.

References Barry Elliot and Jamie Elliot (2006): Financial Accounting and Reporting, 10th Edition, Prentice Hall, Chapter 7 Hennie van Greuing(2005): International Financial Reporting Standards: a Practical Guide, Washington, Chapter 1 International Accounting standards Board (2007), International Financial Reporting Standards (IFRSc), London, Framework for the Preparation and Presentation of Financial Statements

2.

3.

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