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A Conceptual Framework Chapter 2 (Rankin) What is a conceptual framework?

A conceptual framework is defined in the text as a set of broad principles that provide the basis for guiding actions or decisions. An accounting conceptual framework can be described as: a coherent system of concepts that underlie financial reporting. As the Conceptual Framework (page 26) states ‘This Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users.’

What is the difference between a conceptual framework and accounting standards? Essential points relate to: 

The conceptual framework provides high level concepts such as definitions of elements of financial statements, qualitative characteristics, definition of the objective of general purpose financial reporting. Standards apply the concepts in specific situations — for example, accounting for financial instruments, leases and inventory.



The standards setters base new accounting standards, and amendments to old, on the conceptual framework.



Standards take precedence in the event of conflict as the Conceptual Framework (page 6 notes). In Australia, the Conceptual Framework does not have legal force for reporting entities subject to the Corporations Law; accounting standards do. However, concepts from the conceptual framework are now included in all new and reissued accounting standards. Therefore, application of such embedded concepts is mandatory because these are included in accounting standards.

The differences are illustrated with the following examples.

IAS 1/AASB 101 para 9 outlines information about the purpose and elements included in a financial report:

Financial statements are a structured representation of the financial position and financial performance of an entity. The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of the management’s stewardship of the resources entrusted to it. To meet this objective, financial statements provide information about an entity’s: (a) assets; (b) liabilities; (c) equity; (d) income and expenses, including gains and losses; (e) contributions by and distributions to owners in their capacity as owners; and (f) cash flows. This information, along with other information in the notes, assists users of financial statements in predicting the entity’s future cash flows and, in particular, their timing and certainty.

The Conceptual Framework (para. 4.4) provides definitions of basic elements to be included in the statement of financial position such as: (a)

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Accounting standards provide specific requirements for a particular area of financial reporting. These are required to be complied with via corporations law.

For example: IAS 1/AASB 101 Presentation of Financial Statements specifies that: particular assets or liabilities must be included on the face of the report itself (such as intangibles).

AASB 102 Inventories (para. 5.2) specifies that: inventories shall be measured at the lower of cost and net realisable value

Outline the technical benefits of a conceptual framework. What problems could occur if accounting standards were set without a conceptual framework?

The technical benefits relate to improving how financial reporting works — either though improving quality, or accounting practice, via improving understanding. The Conceptual Framework outlines these under its purpose section (page 6). (a) to assist the Board in the development of future IFRSs and in its review of existing IFRSs; (b) to assist the Board in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs; (c) to assist national standard-setting bodies in developing national standards; (d) to assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet to form the subject of an IFRS; (e) to assist auditors in forming an opinion on whether financial statements comply with IFRSs; (f) to assist users of financial statements in interpreting the information contained in financial statements prepared in compliance with IFRSs; and (g) to provide those who are interested in the work of the IASB with information about its approach to the formulation of IFRSs.

In the AASB Framework these are listed para. 1 (a) to (g).

The problems that could occur if standards set without a conceptual framework is:  Inconsistencies between standards if different concepts/principles used to develop different

accounting standards  Time frame for developing standards could be longer as would need to debate underlying

principles/concepts each time new standard developed/changed.

Why is accounting said to be ‘political’ in nature? How can a conceptual framework help in the setting of accounting standards in a political environment? The political nature of accounting is due to the fact that accounting information is used in, and influences, decisions. Thus, the accounting ‘rules’ determine what information is

provided and therefore what information is used in decisions. Recall that the objective of financial reporting is to provide information useful to users in making economic decisions. If economic decisions change and are influenced by accounting then this means that accounting information has economic consequences (i.e. can result in transfers of wealth). Thus, people will try to influence the accounting rules (the accounting standard) to try to ensure that their own interests are met.

The claim is that the conceptual framework provides some defence against ‘political interference’ as the framework can be used to justify the choices/decisions made by accounting standard setters in determining accounting rules. Also, individuals arguing against standards will find this more difficult if their arguments are inconsistent with the agreed Conceptual Framework.

It is claimed by some that the reason for conceptual frameworks in accounting is to protect the accounting profession rather than improve accounting practice. Explain the basis for this claim. Students should note the following major points. 1.

Accountants have a special status in society. In Australia, this is witnessed by the Royal Charter endowed on the Institute of Chartered Accountants, the media profile associated with the CPA program of the Australian Society of CPAs, and the professional monopoly (or almost) by the two major accounting bodies.

2.

The hallmark of a profession is possession of a unique body of knowledge. Loss of professional status means that the power, prestige, self regulation and economic position of accountants are eroded.

3.

The ability of the accounting profession to retain legitimacy as a profession will be judged by society, in terms of the apparent coherence and theoretical defensibility of the profession’s body of knowledge; hence the need for a conceptual framework (Hines, 1989).

4.

The conceptual framework plays a vital political role in maintaining self-regulation and in lobbying against increased regulation by government bodies.

5.

According to a social constructionist view, as put by Hines, the conceptual framework project is not about setting rules for accounting practice; rather, it is about legitimising the process by which accounting practice is done. That is, the accounting profession: 

does not really value a conceptual framework for its potential technical benefits



does value the appearance of having a conceptual framework to claim a unique body of knowledge to maintain its professional status, associated privileges and power.

Accounting Regulation Chapter 3 (Godfrey) The text describes a theory of regulatory capture. (a) What is regulatory capture?

(a)

(b)

How can standard-setting bodies such as the AASB avoid regulatory capture?

(c)

If a standard-setting body is ‘captured’ by the profession, are there any steps that the government can take to make the body independent? If so, should the government take those steps? Justify your answer.

(d)

Do you believe that the current international accounting standard-setting arrangements, based around the IASB, are at risk of regulatory capture? Why or why not?

Regulatory capture is the domination (capture) of a regulatory agency by the industry it seeks to regulate, thus rendering it unable to balance competing interests when making social decision choices. The industry can then direct topics for possible legislation and reject others, which are not seen as important or in the interests of the industry. Walker (1987) argues that the ASRB was effectively captured by the accounting profession (see Chapter 3). (b) A possible means of avoiding capture for the AASB is to:  expand the number of members on the panel and/or restrict the number of members that can come from any one industry. However, a large panel may still see groups concentrate as a voting block, and the larger the panel, the greater the organisational costs and the potential for ineffective of inefficient decision making.  provide the board with adequate resources to promulgate and review standards so that the board is truly financially independent.

 adopt a more relaxed format for proposed standards. This will allow non-technical groups to make submissions for standards. However, this approach is also likely to result in less effective standards because of greater scope for misinterpretation.  subject the board and the constitution of its members to annual review. (c) If the AASB is captured or there is a perception of capture, the government should conduct a review to determine the source of the capture. Then, it should take appropriate steps to remedy this particular problem. However, where will it end? One would expect an ongoing cycle of capture–adjustment–capture adjustment. The Financial Reporting Council was established as a result of reforms to accounting standard-setting arrangements pursuant to CLERP1. The Council is responsible for setting the AASB’s agenda, but it is not to get involved in technical deliberations. The establishment of the FRC is designed to give more stakeholders a say in the accounting standard-setting process. The FRC comprises members representing interests such as public and private entities, regulators, directors and shareholders. This reform reduces the possibility of regulatory capture as parties other than accountants are included in the accounting standard setting arrangements. (d) The structure of the IASB from 2001 aims to ensure the Board is independent. Members are appointed based on their expertise and experience. They do not represent the countries from which they are drawn. The Board has an oversight body (the IASC Foundation) which acts to ensure the Board can operate without interference. Fund raising is the responsibility of the IASC, allowing the Board to be independent of parties providing contributions. A large number of parties are involved in the operations of the IASC and the IASB. These include organisations (companies, audit firms, government bodies, standard setters and professional bodies) which contribute cash resources and skilled personnel. A range of people serve on the Board, its technical staff and advisory committees. These organisations and people are drawn from many countries throughout the world, suggesting that any one country or group of constituents is unlikely to come to dominate the standard setting process. Nevertheless, some commentators have expressed concern that the IASB is at risk of being captured by the USA, through the operation of the FASB. The concern is that IASB standards will align with US GAAP but the process will be one-way. Current participants in the standard setting process deny that the IASB is captured by the FASB, although the FASB is influential in the IASB’s processes and outcomes. The FASB makes a significant contribution to the IASB through its work on various IASB projects. IASB members point to the fact that the IASB and FASB work together and that convergence involves changes to both sets of standards (US GAAP and IFRS) not just to IASB standards. How do you think accounting standards should be set? Is that the approach currently taken by the IASB? Here is one possible answer. The most feasible way may be to be aware of both the politics of the environment and the significance of scientific evidence in the formulation and implementation of standards. Where there is substantial theoretical and empirical evidence in

support of a proposal, the IASB should be resolute in seeking to establish the standard. But presently such strong support does not occur often. The fact is that pressing issues need to be resolved immediately, and there may be little, if any, empirical evidence pointing to any particular direction. In such cases, the IASB needs to follow a theoretical (rational) argument, based on the objective of providing more useful information. There is no question that the IASB needs to be politically aware. However, to be aware of the political environment means different things to different people. If it means to do a better marketing job of explaining to all interested groups why a given proposal is being made, then that is acceptable. To receive and be aware of the points of view of various groups of a proposal should be helpful to the IASB because the proposed standard may not be as rational as the IASB believes. The due process procedure should be taken seriously and not be a perfunctory routine. Contrary arguments may have salient, legitimate points. The IASB does attempt to be independent in the formulation of accounting standards. Because the support of its standards is mainly theoretical (based on rational arguments), and interpretation of theory can result in different viewpoints, strong opposition is seriously considered and is likely to cause a change in the proposed standard. Empirical evidence is considered. However, that the evidence is often not persuasive; perhaps because it is not understood by the non-academic community. With the adoption of international financial reporting standards (IFRS), it has been suggested that the AASB and Australian constituents will have less influence over the IASB due process than was possible in the domestic standard setting environment. The AASB has a specific strategy of contributing to standard setting at the IASB to maintain its influence.

What are ‘free-riders’? How can a system ensure that those who benefit most from an accounting standard requiring certain disclosures also bear the greatest costs of it? Free-riders are people that can utilise information once it is publicly available. Although information may be sold to certain people only, others who did not pay cannot be easily excluded from using the information. Examples of free-riders are financial analysts and potential investors. There is no simple solution to the problem. Students should be encouraged to offer ideas. Companies may act to restrict access to the financial statements to shareholders and associated parties. Companies may establish a userpays system where financial information is available to non-shareholders on a fee-forinformation basis. If the fee was sufficiently high, those who pay are less likely to share the information. Nonetheless, such systems would be difficult to administer and control, and are unlikely to be successful. In 2001 and 2002 there were several high-profile US corporate collapses associated with misleading financial statements and accounting practices. Following these collapses, new laws were introduced to improve the quality of financial reporting.

(a)

In your opinion, will further regulation prevent deliberately misleading reporting? Explain.

(b)

Are additional laws likely to prevent corporate collapses? Why or why not?

(c)

How important is the enforcement of financial reporting requirements in promoting high quality reporting?

Answer: A ) Opinions may differ about the extent to which regulation can prevent deliberately misleading reporting. One effect of regulation may be to make directors and auditors more careful in relation to financial reporting. That is, directors and auditors both want to see compliance with accounting standards to ensure there are no adverse monetary or reputational effects from non-compliance. We could expect that the effect of regulation which imposes harsher penalties for non-compliance would be to increase the extent of compliance, assuming non-compliance attracts penalties from regulators. However, deliberately misleading reporting implies the perpetrators know that they are breaking the law. We can assume they have a motivation to do so which must be weighed against the likelihood of being caught and the possible penalty. If the motivation for misleading reporting outweighs possible costs for the perpetrators, then regulation will not prevent misleading reporting. b) The extent to which additional laws can prevent corporate collapses will depend on the cause of the corporate collapse. If the cause is failure of the audit function, it is possible that effective regulation to improve independence and performance of auditors could reduce the likelihood of corporate collapse. However, if the corporate collapse stems from fraudulent behaviour of company officers, it will not be prevented by additional laws. If a person considers that the benefits of breaking the law outweigh the risk of being caught and punished, then the law will not be effective in preventing criminal behaviour leading to corporate collapse. It may be that a government introducing additional regulation will be satisfied with a law that makes corporate collapse less likely, even if it does not remove it completely. c) Regulators have indicated that they consider enforcement to be an important element in promoting high quality reporting. In its Concept Release, issued in 2000, the US Securities and Exchange Commission (SEC) argued that high quality financial reporting required not only high quality accounting standards but that there should be enforcement mechanisms to ensure companies comply with standards. A similar view was endorsed by the Committee of European Securities Regulators (CESR) who required that all EU countries set up an independent enforcement body responsible for promoting compliance with IFRS following their adoption in the EU from 1 January 2005.

Enforcement agencies have increased their activities since the corporate scandals in 2001 and 2002. The SEC has been given a larger budget and increased its surveillance activities. In Australia, ASIC has been very active. The Federal Government provided funding for ASIC to review the financial statements of all listed companies in 2003. ASIC now has a program of reviewing all listed companies at least every four years. These activities suggest that governments consider the presence of an active regulator (i.e. one that conducts proactive, not just reactive, surveillance of financial reporting) is important to promote high quality reporting by companies, to ensure auditors are active in obtaining compliance with accounting standards and to improve investor confidence following significant corporate collapses....