Tutorial Notes - Week 9 - Conceptual Framework PDF

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BUSN3001, S1 2019, Week 9 Tutorial Notes Topic: Conceptual Framework Tutorial Questions: 1. What is a conceptual framework, and what role does it have in accounting? A conceptual framework is an underpinning set of basic ideas/concepts that are designed to provide guidance to broader accounting practice. The main role of conceptual frameworks is to provide a framework of ideas to guide standardsetters when they create and revise accounting standards. This can simplify the creation of standards (as each standard doesn’t have to define everything differently (e.g. assets/liabilities). It also ensures that standards are more consistent with one another, and improves the consistency of reports between organisations. The IASB also argues that it provides foundational ideas so that all parties can understand the standards. Therefore, the primary role of the conceptual framework is to INDIRECTLY affect accounting practice, through its influence on accounting standards In addition, sometimes the CF may play a more DIRECT role on accounting practice, such as when accountants are trying to account for something for which there is no accounting standard yet (such as complicated new financial instruments) or for auditors when assessing if financial reports are ‘true and fair’. In these instances, the CF can provide general principles to guide accountants and auditors. 2. Textbook Q6.3, p263: What is the difference between an accounting standard and a conceptual framework of accounting? A conceptual framework provides guidance at a much broader level than an accounting standard. The IASB Conceptual Framework provides general guidance about such issues as the objective of financial reports, which entities should produce general purpose financial reports, the qualitative characteristics that useful financial information will possess, how the elements of financial accounting (assets, liabilities, equity, income and expenses) should be defined, and when they should be recognised. By contrast, accounting standards have a much narrower focus and tend to provide guidance on how particular types of transactions, or how particular assets and liabilities, should be accounted for. For example, different accounting standards will provide guidance on how to account for inventory (IAS 2), property, plant and equipment (IAS 16), biological assets (IAS 41), or employee entitlements (IAS 19). Such detailed consideration on particular assets or liabilities is not provided in a conceptual framework. Effectively, a central role of accounting standards is to apply the concepts included within a conceptual framework to specific transactions and events. 3. Review the proposed Conceptual Framework for Financial Reporting (from the AASB) and use it to answer the following questions: (a) What is a qualitative characteristic? How many qualitative characteristics are defined in the proposed Conceptual Framework? Describe each, and provide an example for each.

There are six qualitative characteristics, with two ‘fundamental’ qualitative characteristics, and four ‘enhancing’ qualitative characteristics. The fundamental qualitative characteristics define what information is useful:  relevance – “Relevant financial information is capable of making a difference in the decisions made by users” (s2.6) e.g. revenue information is relevant to users  faithful representation – “information that faithfully represents the substance of something…which is to the maximum extent complete, neutral, and free from error” (s 2.12-2.13) eg measurement approach chosen for an asset should be that which best represents the asset The ‘enhancing’ qualitative characteristics are secondary to the fundamental ones, and may be used to help support decision-making.  Comparability: “information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date” (s2.24) – e.g. fair value for property might be more comparable with other organisations than historical cost 

Verifiability: “Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation” (s.2.30) – e.g. think about if an auditor would arrive at a similar decision on an accounting treatment as the organisation.

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Timeliness: “Timeliness means having information available to decision-makers in time to be capable of influencing their decisions” (s.2.33) e.g. producing reports at least annually

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Understandability: “Classifying, characterising and presenting information clearly and concisely makes it understandable”(s2.34) e.g. providing detail or categories of PP&E so that users can better understand the different aspects of this asset.

(b) What is the cost constraint and how does it affect financial reporting? “Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information.” (s2.39) This constraint affects both the standard-setters and reporting entities themselves.  For standard-setters: they should consider the benefits to users from information vs costs of any proposed standard on reporting entities  For reporting entities: they can consider the cost of producing certain information when deciding whether they should produce it (i.e. when it offers a benefit to users) This requires the exercise of judgement to be used – such as estimating how much benefit a new standard may offer users, or how much cost a new form of measurement/reporting may incur an organisation. (c) What is the objective of financial reporting in the proposed Conceptual Framework?

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. (s1.2) (d) Who are the users of financial reports the proposed Conceptual Framework? What assumptions does the proposed Conceptual Framework make about the knowledge/background of these users? What implications might this have? Users are defined as “existing and potential investors, lenders and other creditors” (s.1.3) to the organisation. They are users because they must rely on financial reporting for the information they need to make decisions. The CF assumes users have the following background: “Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.” (s.2.36) These definitions can be argued to be too narrow – because they focus on a certain type of economic user, with assumptions made about their experience and background. The implication is that many potential users of financial statements are excluded – which may have further implications for the way that financial accounting is undertaken. Some of these users may include employees, regulators, the general public, or lobby groups. Those who do not have a background in finance/economics are also not considered by standard setters when creating standards. (e) How are assets and liabilities defined in the proposed Conceptual Framework? How is this different from previous recognition criteria (hint: you may need to do additional research to answer this)? Which do you think will be easier for accountants to apply? Asset: “An asset is a present economic resource controlled by the entity as a result of past events” (s.4.3). “An economic resource is a right that has the potential to produce economic benefits”. (s.4.4) Former definition: “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” Liability: “A liability is a present obligation of the entity to transfer an economic resource as a result of past events”

Former definition: “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” (f) What does recognition mean? What criteria are used to determine if an item should be recognised in financial statements? How does this vary from the former recognition criteria (i.e. from the previous Conceptual Framework)? The recognition criteria in the new CF refers to the two fundamental qualitative characteristics. That is, that items should be recognised if they are both ‘relevant’ and able to be ‘faithfully represented’. Formerly, recognition criteria for an asset is if it is (a) probable and (b) reliably measured. The criteria vary slightly, which may have implications for whether or not certain items are/not recognised in future financial statements (or appear in notes). (g) Explain how the proposed Conceptual Framework is a normative approach to accounting. Use examples drawn from the proposed Conceptual Framework. The CF is normative because it prescribes what should happen in accounting, rather than describing or predicting what An example is the use of ‘qualitative characteristics’ which prescribe what usefulness means for information. Here, the CF defines certain terms to guide accountants/standard-setters to do specific things, such as how they should make decisions about what goes into a financial report. For example, “If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent.” (s.2.4) 4. Review the article by Ford, and answer the following questions: (a) What are Ford’s concerns about the auditing profession? Ford is concerned that auditors are too oriented towards ‘checking the boxes’ in auditing – that is, following the specific directions of accounting standards: “audit bosses argue that it’s enough to follow accounting standards to discharge their accountabilities”. They do this to limit their liability. This can be a problem because accounting standards cannot provide specific instruction on every possible business transaction (e.g. dividend payouts). Ford suggests that this means that auditors can avoid making assessments about the general truth or fairness of financial statements, and that specific standards can deflect auditors from their central purpose – “to assure investors that the company’s capital is safe, and has not been abused by insiders”. He suggests that specific accounting standards do not help auditors make this holistic judgement, and provide assurance to investors. (b) How could a conceptual framework address these concerns? The CF could provide a broader set of principles about what quality looks like in financial reporting. This may help to avert Ford’s concerns about auditors focusing too much on whether companies have met specific accounting standards. The CF could provide guidance/principles that auditors can use to determine if financial reports are true and fair.

5. The new conceptual framework proposes that financial reports should be ‘neutral’. Do you think this is possible? (hint: consider a critical theory perspective) According to the CF, “A neutral depiction is without bias in the selection or presentation of financial information”(s2.15). This suggests that information should be as objective as possible. A critical perspective would argue that any information prepared by people carries bias and therefore is not neutral. This view would suggest that neutrality is impossible. Some arguments as to how reports may not be neutral include the following:  Those responsible for accounting (accountants) are responsible for determining what issues need to be accounted for and those that do not. This relies upon a great deal of judgement. If something is not separately identified and accounted for then it might be deemed unimportant. Attention will tend to be directed towards those attributes of performance that are identified and measured. Identifying what is important is a subjective process.  The recognition criteria of the elements of accounting relies upon a consideration of probabilities, for example, the probability that an item of expenditure will generate future economic benefits. The determination of probabilities can be quite subjective.  When accounting standards are developed, accounting standard-setters consider the potential economic and social consequences that might result if the standard is issued. Once standard-setters allow such considerations to influence their standard-setting activities it is questionable whether the standards are developed in an objective manner. If the accounting standards are not developed in an objective manner, then it is also questionable whether the accounting reports which are developed in accordance with those standards can be objective.  Related to the above point, the process involved in the development of accounting standards can be considered to be a political process given that constituents are encouraged to provide a lobbying submission during the process of developing accounting standards. A political process is not generally considered to be an objective process. To some extent, the ongoing existence of standard-setting bodies is reliant upon constituent support.  Some accounting researchers use various economic theories to explain what motivates managers to support one accounting method in preference to another. Proponents of Positive Accounting Theory assume that individual self-interest motivates the selection of accounting methods within a firm. Self-interest and objectivity are mutually exclusive....