Chapter 6

A conceptual framework for financial accounting and reporting

 Accounting theory constitutes the frame of reference on which the development of accounting techniques is based. In the United States, the importance of the development of financial statements objectives was first expressed by the report of the Study Group on the Objectives of Financial Statements

 In the United Kingdom, the importance of these objectives was highlighted by publication of The Corporate Report by the Institute of Chartered Accountants in England and Wales. In Canada, interest in the subject resulted in the publication of Corporate Reporting

6.1 Classification and Conflicts of Interests

Financial Statements result from the interaction of three groups: firms, which by their operational, functional and extraordinary activities, justify the production of financial statements users, which include investors, financial analysts, bankers, creditors, consumers, employees, suppliers and government agencies the accounting profession, which acts principally as auditor in charge of verifying that financial statements conform to generally accepted accounting principles

Venn Diagram

6.2 Toward a Formulation of the Objectives of Financial Statements

6.2.1 The Objectives of Financial Statements as Stated in APB Statement No.4

APB Statement No.4 classifies objectives: 1. particular 2. general 3. qualitative

Objectives according to APB Statement No. 4 (contd)

1. Particular objectives of financial statements are to present fairly, and in conformity with GAAP, financial position, results of operations and other changes in financial position 2. The general objectives are: a. to provide reliable information about the economic resources and obligations of a business enterprise in order to: i. evaluate its strengths and weaknesses ii. show its financing and investments iii. evaluate its ability to meet its commitments iv. show its resource base for growth

Objectives according to APB Statement No. 4 (contd)

b. to provide reliable information about changes in net resources resulting from a business enterprises profit-directed activities in order to: i. show expected dividend return to investors ii. demonstrate the operations ability to pay creditors and suppliers, provide jobs for employees, pay taxes and generate funds for expansion iii. provide management with information for planning and control c. to provide financial information that can be used to estimate the earnings potential of the firm d. to provide other necessary information about changes in economic resources and obligations e. to disclose other information relevant to statement users needs

Objectives according to APB Statement No. 4 (contd)

3. The qualitative objectives of financial accounting are: a. relevance b. understandability c. verifiability d. neutrality e. timeliness f. comparability g. completeness

6.2.2 Report of The Study Group on The Objectives of Financial Statements

Methodology used

In 1971, The American Institute of Certified Practicing Accountants formed two study groups: 1. the Wheat Committee, which was a study group on the establishment of accounting principles, and which was charged with the task of improving the standard-setting process

6.2.2 Report of The Study Group on The Objectives of Financial Statements

2. the Trueblood Committee, which was charged with developing the objective of financial reporting in terms of: a. who needs financial statements b. what information they need c. how much of this information can be provided through accounting d. what framework is required to provide the information

6.2.2 Report of The Study Group on The Objectives of Financial Statements

The Objectives of Financial Statement as expressed in the Trueblood Report The Trueblood Report identified six objective-levels: 1. The basic objective to provide information on which to base economic decisions 2. Four objectives that specify the diverse users and uses of accounting information 3. Two objectives that specify enterprise earning power and management ability as the type of information needed

Objectives of financial statements (contd)

4. One objective (No. 6) that specifies the nature of the needed information as factual and interpretive 5. Four objectives that describe the financial statements required to meet objective No. 6 6. A number of specific recommendations for the financial statements are made in order to meet each of the preceding objectives (Nos 7,8,9 and 10)

TRUEBLOODS OBJECTIVES

Qualitative Characteristics of Reporting

The Trueblood Report mentions seven qualitative characteristics of reporting: 1. Relevance and materiality 2. Form and substance 3. Reliability 4. Freedom from bias 5. Comparability 6. Consistency 7. understandability

6.3 Toward a conceptual framework

6.3.1 The Nature of a conceptual framework

According to standard setters, the following situations demonstrate the need for a conceptual framework: Two or more methods of accounting are accepted for the same facts Less-conservative accounting methods are used rather than earlier, more conservative methods Reserves are used to artificially smooth earnings fluctuations

6.3.1 The Nature of a conceptual framework (Contd)

Financial statements fail to warn of impending liquidity crunches Deferrals are followed by big bath write-offs There is unadjusted optimism in estimates of recoverability Off balance-sheet financing is common An unwarranted assertion of immateriality has been used to justify non-disclosure of unfavourable information or departures from standards Form is relevant over substance

6.3.1 The Nature of a conceptual framework (Contd)

A 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. A Conceptual framework purpose is to guide in resolving disputes that arise during the standard setting process by narrowing the question to whether or not specific standards conform to the conceptual framework

6.3.1 The Nature of a conceptual framework (Contd)

FASB has identified four specific benefits that would result from a conceptual framework. A conceptual framework, when completed, would: 1. guide the FASB in establishing accounting standards 2. provide a frame of reference for resolving accounting questions in the absence of specific promulgated standards 3. determine the bounds of judgment in preparing financial statements 4. enhance comparability by decreasing the number of alternative accounting methods.