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A conceptual framework has its basis in a set of concepts. These concepts are linked to a system of methods, behaviors, functions, relationships and objects. The conceptual framework for financial reporting “…..seeks to identify the nature, subject, purpose and broad content of general-purpose financial reporting and the qualitative characteristics that financial information should possess”. (Deegan, 2005, p.1184). It is of fundamental importance to the future development of International Financial Reporting Standards (IFRS).
Conceptual framework of an Accounting Board:
- Defines the objective of financial statements
- Identifies the qualitative characteristics that make information in financial statements useful
- Defines the basic elements of financial statements
- Specify how the elements are recognised and measured in financial statements.
The focus of this essay is on conceptual frameworks propounded by Accounting Standards Board (ASB), the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) and also the improvements proposed in the IASB and FASB Joint Discussion Paper.
ASB is a subsidiary company of the Financial Reporting Council (FRC) responsible for formulating Financial Reporting Standards.
FASB is an Accounting Board that establishes rules governing accounting practices throughout the US. The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.
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IASB is the youngest Accounting Board of the three. It was founded on April 1, 2001 as the successor of International Accounting Standards Committee (IASC) based in London, UK. IASB is responsible for setting International Accounting Standards. IASB has adopted many of the regulations of its predecessor. It uses IASCs 1989 ‘Framework for the Preparation and Presentation of Financial Statements’. Thus, IASB’s conceptual framework of accounting standards are outdated as the accounting standards prescribed by IASB reflect the accounting thought in1989. In contrast, ASB pronouncements are more contemporary.
IASB and FASB Joint Discussion Paper
In October 2004, US FASB and the IASB accepted that their existing frameworks move in different directions and were not complete and up to date. They decided to develop a single common conceptual framework that converges and improves the existing individual conceptual frameworks of the boards. They published a consultative document in 2006 setting out their preliminary views on an enhanced conceptual framework.
Differences between Conceptual Frameworks
The conceptual frameworks put forward by the three Boards can be compared on the basis of:
- Purpose of the framework
- Objectives of financial statements
- Qualitative characteristics
- Elements of financial statements
- Recognition and measurement criteria
These are examined in detail below:
Purpose of the Framework
The three conceptual frameworks have similar purpose. The purpose of each framework is described below:
ASB: The framework seeks to describe the fundamental approach propounded by ASB to strengthen the financial statements of profit-oriented entities. It provides a reference point to help ASB in developing new accounting standards and reviewing existing ones.
IASB: Like ASB, IASB’s framework also serves as a guide to the Board in developing accounting standards. It also acts as a guide to resolving accounting issues that are not addressed directly in an IAS or IFRS or Interpretation. With a revision to IAS 8 in 2003, the importance of conceptual framework has increased further.
The IASB framework applies to all business entities both in the private or public sector.
FASB: The purpose of the FASB framework is also to assist standard setters in developing and revising accounting standards. The framework does not override accounting standards, and therefore in this respect it has a lower status than specific accounting standards. The FASB framework applies to both business and not-for-profit entities in the private sector.
Despite the similar purpose of all frameworks, the emphasis of the framework differs from board to board. For instance, the IASB framework has a broader purpose than the FASB framework. The IASB framework not only assists IASB in developing or revising accounting standards but also assists preparers, auditors, and users of financial statements.
There is also a difference in the status of the frameworks. For instance, the IASB framework is considered at a higher level in its GAAP hierarchy than the FASB framework in the U.S. GAAP hierarchy. The management of entities preparing financial statements under IFRS is expressly required to follow the IASB framework.
IASB and FASB Joint Discussion Paper: The Discussion Paper states the purpose of conceptual framework to establish a common framework of the concepts that underlie financial reporting. The common framework is expected to suit the requirements of both FASB and IASB. However, this may lead to a problem. If the arguments contained in the discussion paper are adopted as the common framework, this will distance preparers and auditors as the framework will become theoretical and long and act only as a reference manual for standard setters.
Objectives of Financial Statements
Conceptual frameworks put forward by Accounting Boards put forward similar objectives of financial statement.
ASB: According to ASB “…the objective of financial statements is to provide information about the financial position, performance and the financial adaptability of an enterprise that is useful to a wide range of users” (1999:1)
FASB: The FASB framework specify objectives for business entities and non-business entities. According to FASB in SFAC 1 “…financial reporting is not an end in itself but is intended to provide information that is useful in making business and economic decisions”. (1978:9)
IASB: According to the IASB’s Framework for the Preparation and Presentation of Financial Statements “…the objective of financial statements 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.” (2001:12)Unlike FASB framework, the IASB framework has a more limited scope. It discusses objectives in the context of business entities only.
IASB and FASB Joint Discussion Paper: The discussion paper states that the objectives of financial reporting are to provide information:
- Useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions.
- Useful in assessing cash flow prospects
- About an entity’s resources, claims to those resources, and changes in resources and claims
Despite the similarity of objectives propounded by the various frameworks, the differences may arise due to the focus on users. The focus depends on the body producing the statements and establishing parameters.
The conceptual frameworks identify primarily four principal qualitative characteristics in common: Understandability Relevance, Reliability and Comparability. However there are differences in terms of what constitute ‘relevant’ and ‘reliable’ information and which characteristic is more important than others.
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ASB: The ASB narrow down the scope of their conceptual framework by establishing parameters which clearly defines the inclusions and exclusions. It defines the qualitative characteristics of the information which merits inclusion, for example, relevance, reliability, and comparability. UK ASB treats information to be reliable if it is free from material errors. Though freedom from material error is included as a sub-quality of reliability, the framework excludes verifiability as an essential element for reliability of information.
The conceptual framework of ASB favours relevance over reliability if there is a conflict between relevance and reliability concept.
IASB: According to IASB, information is relevant when it influences the economic decisions of users and is reliable if it is free from material error and bias and can be depended upon by users to represent events and transactions faithfully.
IASB framework treats all four qualitative characteristics as primary qualitative characteristics. It treats materiality of information and its timeliness as a component of relevance. IASB does not give importance to one characteristic over the other. There is sometimes a tradeoff between relevance and reliability and judgement is required to provide the appropriate balance. IASB expects management to exercise prudence or conservatism to provide this balance.
FASB: Unlike IASB, FASB framework set out the qualitative characteristics in a hierarchy, treating understandability as a user-specific quality separate from the others, relevance and reliability as the primary qualities, and comparability as a secondary quality.
IASB and FASB Joint Discussion Paper: The discussion paper proposes replacing the qualitative characteristic of ‘reliability’ in the current frameworks with ‘faithful representation’. The paper also highlights areas where the qualitative characteristics of both IASB and FASB conceptual framework can be improved. For example, both frameworks emphasise neutrality, prudence or conservatism and expect that the exercise of prudence or conservatism does not allow the deliberate understatement of net assets and profits. However, the hard fact is that a concept of prudence or conservatism is inconsistent with the concept of neutrality.
Elements of Financial Statements
There are differences, though not major, between frameworks in relation to elements of financial statements
ASB: ASB classifies transactions and other events into 5 elements: assets, liabilities, ownership interests, gains and losses. Assets, liabilities and ownership interest are included in the Balance Sheet and gains and losses in the Profit & Loss Account.
IASB: Like ASB, IASB framework also has 5 elements of financial statements: Assets, Liabilities, Equity, Liabilities, Income and Expenses. The first three elements form a part of the Balance Sheet and the last two a part of the Income Statement or Profit & Loss Account. The assets, defined as a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise, has a central role. All other element definitions are based on the definition of assets.
FASB: FASB framework has seven elements in all. Elements, such as assets, liabilities, and equity are for describing the financial position. Unlike two elements for IASB, the FASB framework includes five elements relating to financial performance: revenue, gains, expenses, losses, and comprehensive income.
Though assets definition is still primary, there are differences in terms of how assets are defined by IASB and FASB. The FASB framework includes “probable” as part of the definition of assets and liabilities, whereas the IASB framework includes the term in its recognition criteria, and the meaning of the word is not the same. In addition to this, as per IASB, the asset is the resource from which future economic benefits are expected to flow, whereas as per FASB, the asset is the future economic benefits themselves.
IASB and FASB Joint Discussion Paper: The discussion paper finds gaps in the existing frameworks in respect of the following aspects of elements of financial statements and requires the converged conceptual framework to focus on these:
- The distinction between liabilities and equity
- Definition of a liability
- The effect of conditions, contingencies, or uncertainties
- Accounting for contractual rights and obligations
Recognition criteria for financial reporting
The objective of financial statements is achieved by depicting in the primary financial statements the effects that transactions and other events have on the elements. This process is known as recognition. Frameworks differ with regard to recognition of effects of transactions.
ASB: According to ASB framework, if a transaction leads to creation of a new asset or liability or to adds to an existing asset or liability, the effect will be recognised in the balance sheet. This recognition will happen only if there is sufficient evidence that the asset or liability exists and can be measured reliably enough in monetary terms. Except when there has been no change in the total net assets or the whole of the change is the result of capital contributions or distributions, a gain or loss will be recognised at the same time. ASB does not take into account probable effects.
IASB: Unlike ASB, IASB framework includes ‘probable’ test for recognizing effects of transactions. For example, the IASB framework requires that an asset is recognised in the balance sheet 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. Similarly, a liability is recognised in the balance sheet 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.
FASB: FASB framework also specifies a criteria to be satisfied before items are recognized in the financial statements. The framework also requires that only items that are relevant should be recognised. Like ASB, FASB framework also does not include probability as a recognition criterion.
Measurement of the Elements of Financial Statements
Measurement of elements of financial statements means assigning a monetary value to it. Frameworks differ on this account.
ASB: ASB uses ‘value to the business’ (VTB), or ‘deprival value’ of the asset for measurement of asset. Similarly, liabilities are measured on the basis of the ‘relief value’. Moreover, ASB adopts mixed measurement system as against outdated frameworks that adopt a single consistent system. Mixed measurement system is flexible and allows the historical cost and current value to be changed as accounting thought develops and markets evolve. This implies that the use of current value will become more prevalent as markets develop and evolve. This approach is used by the majority of large UK listed companies and involves measuring some balance sheet categories at historical cost and some at current value.
IASB: The IASB Framework acknowledges different measurement bases including: historical cost, current cost, net realisable value, present value. However, it does not recommend a preferred technique for measurement of assets and liabilities. The most common basis of measurement adopted by the framework is historical cost. Thus, there is no formal recognition of a ‘mixed measurement’ system in the framework. This is its biggest drawback and makes it an outdated framework as it belongs to a different period. This approach was abandoned by the ASB in favour of a ‘mixed measurement’ system. Even though many existing IFRSs are based on the concept of ‘fair value’, it is not referred to in the Framework. Again, such an omission suggests that the international framework measurement provisions are limited and out-of-date.
FASB: Like IASB, measurement is one of the most underdeveloped areas of FASB framework. FASB frameworks also provides a list of measurement attributes similar to ones prescribed by IASB that are used in practice. However, like IASB, FASB framework does not recommend measurement criteria for any element. In other words, it too lacks fully developed measurement concepts.
IASB and FASB Joint Discussion Paper: The discussion paper clearly highlights a need to consider whether the conceptual framework should include not just measurement concepts, but also guidance on the techniques of measurement.
The conceptual framework(s) contained in the ASB, the FASB, and the IASB have formed the basis of accounting standards for some time. The current IASB and FASB frameworks are increasingly out-of-date, as they ignore many of the developments that have been undertaken by national standards. There are certain limitations that need to addressed in a way that issues that cross-cut across standards are taken care of. For instance, a new framework is required which is not based on a single value-based model but a ‘mixed measurement system’.
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