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Accounting is a very vast subject which includes numerous accounting concepts which have undergone several changes since their introduction in the accounting system. Several regulatory bodies have tried to provide support and lay a foundation to act as a bedrock for the various accounting practices. These regulatory bodies were formed with an aim to provide a better understanding of accounting and its interpretation of income, thus trying to help the users to reach an outcome where better financial reporting can be practised with ease. In doing so it hopes to eliminate the vagueness involved in the interpretation of various accounting rules practised all over the world.
In this article I shall proceed by examining the emergence of the conceptual frameworks presented by the various regulatory bodies and in what way they have helped in improving the standards of accounting.
The regulatory bodies came up with the concept of conceptual framework to provide the underpinnings of the accounting standards set and to provide its users with a better understanding of accounting.
In 1966, the American Accounting Association (AAA) issued a highly influential paper which spoke about a 'decision usefulness' approach. This led to a publication of a report by the American Institute of CPA's Trueblood committee in 1973 which built on the 'decision usefulness' report of AAA. All this laid the groundwork of the development of the first conceptual framework by the Financial Accounting Standard Board (FASB) in the 1970's.
The FASB defines its framework in the following manner:
"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"
Other regulatory bodies such as the Accounting Standards Board (ASB) and the International Accounting Standards Board (IASB) soon followed suit and came up with their own versions of a conceptual framework to match that of FASB's. A British Attempt at determining the conceptual framework was first published as an Exposure Draft in 1995 and subsequently the ASB issued the Statement of Principles in 1999. It was too similar to the FASB's take on the conceptual framework. The International Accounting Standards Committee (IASC) issued the Framework for the Preparation and Presentation of Financial Statements in 1989 which was later adopted by the IASB in 2001. However, all these new frameworks were closely related to FASB's conceptual framework.
The definitions provided by the ASB / IASB are as follows:
ASB - "sets out the principles that the ASB believes should underlie the preparation and presentation of general purpose financial statements ... A coherent frame of reference to be used by the Board in the development and review of accounting standards"
IASB - "This Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users"
Ultimately we can see that the main reason behind the conceptual framework work was to provide useful information to the current and prospective users enabling them to take well informed decisions through a common framework and help promoting better and consistent financial reporting amongst firms. However, not only must we determine what kind of information we can deem useful but also need to determine the users of such information. The regulatory bodies included things such as understandibilty of information by users, comparability of information with other information, relevance and reliability, which altogether were quite obvious in its nature but nonetheless it was considered as an integral part in the framing of the conceptual framework. On the other hand regulatory bodies sought to define users into different classes and provide information accordingly. The IASB admitted to the fact that there are different users in the market, however they believed that if they provided information relevant to the investors then by default they satisfy everyone's needs.
The FASB cited very broad concepts as its outline for the conceptual frameworks. They subsequently issued the Statements of Financial Accounting Concepts which included the following:
- SFAC No.1: Objectives of Financial Reporting by Business Enterprises
- SFAC No.2: Qualitative Characteristics o f Accounting Information
- SFAC No.6: Elements of financial Statements [Replaced SFAC No.3]
- SFAC No.5: Recognition and Measurement in Financial Statements of Business Enterprises (issued 1984)
- SFAC No.7: Using Cash Flow Information and Present Value in Accounting Measurement, February 2000
These Statements of Financial Accounting Concepts were FASB's conceptual framework made in accordance to the standards it used. It was followed by ASB's Statement of Principles in 1999 which consisted of 8 principles as to FASB's 6. The FASB used these concepts to define its various elements of financial statements, provided guidelines as to how recognition and measurement of financial elements are to be carried out and promoting the use of 'fair value' accounting.
The FASB first decided to define certain basic elements of financial statements such as Assets and Liabilities. However quite surprisingly instead of defining income they defined another term know as 'comprehensive income'. Following are the other definitions provided by the FASB in order to provide clarity in as to what can be deemed to be considered an asset or a liability:
Assets-are probable future economic benefits or controlled by a particular entity as a result of post transactions or events.
Liabilities-are probable future sacrifices of economic benefits arising from present obligation of a particular entity to transfer assets to provide services to other entities in the future as a result of past transactions or events.
It further defined equity, revenue, expenses, gains and losses in SFAC No.6. At the time the FASB strongly believed they were heading in the right direction in terms of building a sound conceptual framework and they believed their definitions provided utmost clarity to all users.
The FASB then proceeded along with the other regulatory bodies to provide its criteria for the recognition and measurement of financial statements. It required the definition of the elements of financial statements to be given in order to recognise them. And the FASB followed a mixed measurement system when it came to determining the value of the elements of the financial statement. It adopted measurement systems such as fair value, historical cost, amortised cost, value in use etc. historical cost was the most common but FASB often used it in conjunction with other systems, therefore not favouring one system over the other. Although ASB preferred deprival value/current value as its measurement system, nonetheless they said a mixed measurement system will be used similar to FASB's.
All these measurement systems were based on current and previous standards. The conceptual framework works around the basis of supporting the prevalent standards which govern the accounting treatment. These standards form the generally accepted guidelines through which organisations can provide concise and useful accounting reports. Many standards have been issued till date and they are under constant development even today as they may not be beneficial for all users.
In 1998 the IASC issued an interim standard on financial statements known as the IAS 39. It came into effect from 2001. The IAS 39 adopted a mixed measurement model which meant that some instruments would be measured in reference to their historical cost and some would be measured on their fair value. It should be noted that the IAS 39 was heavily plagiarized from US Standard No. 115 which also talks about mixed measurement. This standard required the financial instruments to be classified into trading, available for sale, held to maturity and loans and other instruments. It wasn't all smooth sailing for the IAS 39 as it was subject to numerous changes. It first originally stated that all financial assets should be shown at fair value except those that were held to maturity, and most financial liabilities would be included at amortised cost except those held for trading purposes. In terms of treatment of gains and losses it said that changes in the fair value held for trading purposes must be taken through the profit & loss a/c whereas if they weren't held for trading purposes then you have a choice of either taking it through the profit & loss a/c or showing it directly in the equity but once an instrument has been classified it cannot be changed. However the ASB along with Americans and Australians abstained from passing it.
It was later revised and stated that all financial instruments will be measured at fair value and that all changes will be shown in the income statement. It insisted on FVPL (fair value through Profit and loss). However, it was not feasible valuing everything at fair value because the market constantly fluctuates and thus proving difficult. Prudential supervisors, security companies and insurance companies expressed concern that the FVPL option might not be used appropriately. It was again revised amid heavy political pressure. This new version of the IAS 39 which classified financial instruments differently was then sent to the European Union (EU) for approval and the European Commission (EC) proposed the adoption of an amended version of IAS 39 - 19th November 2004. The EC made the following two amendments to the IAS 39:
- Remove the fair value option to designated liabilities as measured at fair value;
- And amend the problem of interest rate hedge accounting
On 15th June 2005 the IASB issued its final amendment to IAS 39. Assets could still be measured through FVPL but in case of a liability to be measured through FVPL it must be bought in conjunction with as asset. The final amendment was done to restrict the use of the option to designate any financial asset or liability to be measured at FV through PL.
Deprival value or current cost was another very valuable measurement system in terms of measurement of fixed assets. It was proposed by the regulatory bodies and was first included in the standards in the UK as FRS 15 (Financial Reporting Standard) but later suspended. It said that companies should value their assets at current costs because the true significance of measuring at current cost provided the greatest loss an entity could suffer if hypothetically it would be deprived of the asset. The ASB truly believed that Deprival value was the correct way to consider the valuation of assets, but found it difficult to determine the replacement cost of assets due to changes in technology, no second hand market etc. Both FRS 11 and FRS 15 were discontinued but provided a detailed framework for asset valuation and revaluation. FRS 15 provided a choice of either revaluing an asset or maintaining it at historical cost in the books. However, if you decide to revalue then you must do so consistently every year. Revaluation gains were to be shown in the statement of recognised gains and losses (STRGL). However, revaluation losses were treated wholly in the P & L a/c if caused by 'clear consumption of economic benefits' (diminishing of future cash flows) or the losses will be recognised in STRGL in the absence of 'clear consumption of economic benefits'.
The IASB later came out with IAS 16 (Accounting for Property, Plant and Equipment) and IAS 36 (Impairment of Assets). IAS 16 was based on the IASB's fair value agenda for valuation of assets. IAS 16 is similar to FRS 15 in terms of valuation and it states that revaluation must be carried out regularly however, unlike FRS 15, IAS 16 fails to ask the question of what cause the change in terms of the 'clear consumption of economic benefits'. IAS 39 was based on the impairment of an asset. The thinking behind deprival value is related to concept of impairment as developed by IAS 36.
Having closely followed the development of the conceptual framework by the regulatory bodies, we now answer a simple question. Were the conceptual frameworks put forward by them successful?. The regulatory bodies failed to clearly define income which is one of the main components for accounting. Without income it is very difficult to determine what an asset is and how we are going to measure it. The FASB instead stated a term called 'comprehensive income' which was defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non owner resources. In other words 'comprehensive income' was addition of revenues and gains subtracted by the expenses and losses. However it was noted by Schuetze (1991) that the definitions of FASB's assets is very vague, so all inclusive and open ended that it does not solve any of our problems.