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In this essay we will assess the extent to which a conceptual framework can be developed in accounting, with examples of past and current attempts from standard setters. Accounting is a subject which is based on economic information about entities financial affairs. Accounting is defined as a process of identifying, measuring and communicating economic information according to US Generally Accepted Accounting Policies (GAAP).
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Accounting is not an exact science and therefore, consists of many subjective areas, namely in the valuation of assets, provision policies, recognition of revenue and costs etc. Some commentators are of the option that economic theory should form the basis of any conceptual framework within accounting.
In recent times with the issues facing the financial markets, accounting framework has come under increased scrutiny, with both UK and International standard setters having to define the fundamental concepts of accounting, namely, accruals, going concern, prudence, consistency and materiality. The conceptual framework has now placed greater emphasis on ‘true and fair view’ within financial reporting standards. The International Accounting Standards Board (IASB) working closely with the Financial Accounting Standards Board (FRSB) is developing a new conceptual framework which is based on qualitative characteristics as well as historical quantitative characteristics (Accruals, Prudence, and Consistency). The aim of the joint conceptual framework is to ensure that companies annual reports represent a true and fair view of the entities financial health, the new concepts being considered for inclusion within the framework are, Understandability, Rationality, Preciseness, Simplicity and Acceptability.
In developing the conceptual framework the IASB and FRSB need to decide if it should be rules based or principles based.
Conceptual Framework of Accounting
The FASB (US Accounting Body) attempted to form a conceptual framework during the 70’s and during the late 80’s the International body (IASB) developed a summary revised conceptual framework for companies, specifically dealing with the preparation and presentation of financial statements. This was followed by the Statement of Principles for financial reporting in 1999. The ASB has embraced current value accounting, which is based on value to the business measurements like Replacement Cost, Economic Value and Net Realisable Value (NRV).
In order to determine the extent to which a conceptual framework can truly be developed for accounting, we must first examine the definitions of a conceptual framework. The Accounting Standards Community defines it as “a consultative document, which is a set of broad, internally consistent fundamentals and definitions of key terms” (ASC, 1978)
FASB defined the conceptual framework as part of the scope and implications of the conceptual framework project in 1976 as “a constitution a coherent system of interrelated objectives and fundament’s that results in consistent standard and prescribe the nature, function and limits of accounting standards”.
The qualitative characteristics in the FASB’s conceptual framework above forms the fundamentals and enables financial statements to be objective and sets out the alternative accounting methods. The measurement at the operational level sets out the rules for determining the monetary amounts within financial statements, i.e. historical cost, present value, replacement costs etc.
Therefore, we can conclude that the purpose of a conceptual framework is to provide standard setters with a consistent guideline of accounting principles which are consistent with each other. It will also offer guideline in applying accounting standards in the most appropriate form with treatment of transactions when the standard offers scope for judgement. Other purposes of conceptual framework are found in the ASB Statement of Principles for Financial Reporting (1991):
- Assist in development of future standards
- Assist in reduction of alternative treatments
- Assist in preparation of financial accounts and guidance on areas where no specific standards exist
- Assist auditors in forming opinion on adherence to standards (Thomas, A. (2005) pp.499)
Issues Surrounding the Development of a Conceptual Framework of Accounting
In recent times there has been much debate in the UK surrounding the development of a conceptual framework. The main issue in the development has been in terms of costs and whether it was beneficial and possible to develop a consistent set of fundamentals that would lead to improvements in the UK accounting standards. The other issue is in terms of whether standards will make companies accounts more consistent rather than comparable.
The development of conceptual framework will presumably result in more standardisation of accounts. There are two schools of thoughts on development of conceptual framework and its underlying theme.
Normative Vs. Deductive Theories
Normative theories are concern with technical processes which aim to measure ‘true income’ as influenced by Hicks (1946). Normative theories would produce a set of consistent rules that would form the basis of the conceptual framework. Accounting is also viewed as a technical process via deductive theory, but supports a user needs approach in identifying the objectives of financial statements. This is the view taken in all current projects trying to deliver a comprehensive and definitive conceptual framework of accounting. Lastly, positive views accounting and in particular the process of setting standards as a political process, which can lead to exploitation of class interests. This results in standard setting being viewed as quasi-legislation as company law is set by the parliament; therefore, it’s a political process.
Standard setting process need to be one of consensus and not dictatorial assertion based on a conceptual framework, which is itself is the product of a particular set of class interest namely, shareholder’s interest.
Environmental Issues and Accounting Framework
An Example of an area which requires guideline from published conceptual framework is environmental and social reporting issues. Currently there is no legal or accounting standards in operation and no legal requirement for companies to carry out such accounting. But, many large companies carry out environmental and social accounting and reporting, as it’s a part of their core business values. The body Shop, Traidcraft and others now see environmental reporting as increasingly significant issues in business and regard it as important to gather and present information about their activities in these areas. In the past traditional accounting framework has neglected such environmental matters as it was not capable of being measured objectively. Environmental accounting has proven to be technically easier than social accounting, as social accounting is seen as more political and forms part of a company’s Corporate Social Responsibility Reporting (CSR). Due to the varying nature of environmental and social accounting within individual companies, any conceptual framework would find it difficult to promote consistency and comparability of accounting policies.
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The above example highlights of how accounting is changing in the area of social and environmental accounting. This change has resulted in extension to both UK GAAP and US GAAP. This has come about as a result of the growing concern over the impact of organisations on society
Financial reporting has come under scrutiny post Asian crisis in the global markets and the fairness of accounting standards has been questioned. The global financial crisis has illustrated that under the forces of financial globalisation it is vital for standard setters to increase the regulation and transparency of financial reporting, in order to achieve global market efficiencies.
It is without doubt very important to have a flexible conceptual framework of accounting in order to tackle the diverse and complex markets in which companies operate today. The FASB, IASC and ASB have all published conceptual frameworks of accounting. The conceptual framework must ensure the development of relevant accounting standards which the users can understand. However, in developing conceptual framework the standard setters need to be mindful of the fact that organisational practices and market conditions will evolve, and the standards need to evolve in order to remain relevant. The framework needs to be one that is compliant with Corporate Governance rules and regulations.
Rule based standards are easier to police than principles based standards, which can lead to inconsistencies within accounts of companies within the same industry, therefore, not promoting comparability and reliability. Conceptual framework development has adopted the principle based approach in allowing companies to be flexible in order to deal with new challenges of the global market place. Rule based method had come under intense criticism post Enron failure.
Supporters of a pragmatic deductive theory of accounting seem to have been triumphant in the conceptual framework debate within the UK. What is still unclear is whether the monetary costs of developing a conceptual framework by the ASB can be supported in terms of the potential benefits it will deliver in financial reporting through improvements in ASB’s standard setting process.
The development of a conceptual framework is regarded as unbeneficial by those who believe that the framework may lead standards which will promote more consistency between financial accounts of entities but it will not achieve greater comparability. This is due to the fact that standards set in accordance with the new conceptual framework will push organisations to use similar accounting treatments, when those may not necessarily be the most appropriate for the individual company and this will result in misleading comparisons. Therefore, oppositions to the development of a conceptual framework in accounting argue that it will lead to misleading standardisation due to lack of flexibility being offered within accounting standards, hence, more rigidity and less innovation.
However, the need for a conceptual framework of accounting is recognised and being addressed around the world, with the USA, the UK and IASB all taking the same principle based approach in its development and commencing with a consideration of the objectives of financial reporting, qualitative characteristics and description of elements and when these are to be recognised in the financial statements. However, concurrence on measurement has yet to be achieved.
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