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The conceptual framework for Financial Reporting establishes the concepts that underlie financial reporting. The framework is done based on the objective that was stated. This exposure draft is divided into two parts which are the objectives of financial reporting and qualitative characteristic and constraints of decision-useful financial reporting information.
The first part of the exposure draft focuses on the objectives of the financial reporting. The boards had decided that an entity should prepare its report based on the entity perspective rather than owners' perspective. Next, the boards also decided to recognize present and potential capital providers as the primary user group for general purpose financial reporting. Besides, the boards decided that the objective should be broad enough to involve all of the decisions that equity investors, lenders, and other creditors make in their capacity as providers, including resource allocation decisions and decisions made to protect and enhance their investments.
The second part of the exposure draft discusses the degree of the usefulness of the financial information which depends on its qualitative characteristics. Qualitative characteristics are the attributes that make the financial information useful. The usefulness of the financial information is limited by two pervasive constraints on financial statement which are materiality and cost.
The fundamental qualitative characteristics distinguish the usefulness of the financial reporting from the viewpoint of relevance and faithful representation. Financial reporting information may have varying degrees of usefulness to different capital providers. It is important to enhance the degree of usefulness to the extent of comparability, verifiability, timeliness, understandability and vice-versa.
Besides, the comparable information also enables users to identify similarities and differences between the two sets of economic phenomena. The users need to have a great understanding of the information. Then they are able to comprehend its meaning. Timeliness also provides information to decision makers when it has the capacity to influence decisions.
Useful financial reporting information is limited by two pervasive constraints such as materiality and cost. Information is material if its omission or misstatement could influence the decisions that users make on the basis of an entity's financial information. The benefits of providing financial reporting information should justify the costs of providing that information.
PART 1: THE OBJECTIVE OF FINANCIAL REPORTING
This part of theoretical framework discusses on the objective of general purpose financial reporting by the private sector business entities. It is the base of the framework and other features of the framework will follow reasonably to ensure this objective is met.
The main intention of general purpose financial reporting is to provide useful financial information to capital providers in making decisions about the reporting entity. Capital providers include present and potential investors, lenders and other creditors.
Motivation for the proposed framework
The objective of general purpose financial reporting serves as a guideline for the Boards to help in the efficient operation of economies and the efficient provision of resources in capital markets.
The basis of general purpose financial reporting is initiated by the information needs of a broad range of users. They have to rely on the information given in financial reports because they are unable to prescribe all the information they need from an entity.
Consideration factors for the proposed framework
There are a few factors that need to be considered when deciding the objective of general purpose financial reporting. The factors are as followed:
1) Who are the targeted users?
2) What types of information they need?
3) How can the information assist them?
Each of the above mentioned factors will be discussed in this section.
1) The targeted users
The needs of all capital providers are the focus of the information given by general purpose financial reporting. Capital providers are those with a claim to the entity's resources. An entity's economic resources are its assets and the claims to those resources are its liabilities and equities. An entity is funded by the resources given by capital providers. In exchange of the given resources, they have the rights to claim over those resources. Thus, they have the most essential and direct needs for general purpose financial information. The types of capital providers are being classified as follow:
a) Equity investors
They are holders of equity securities, holders of partnership interests, and other equity owners. They usually invest cash in an entity and expect to receive a return higher than their investment.
They are the purchasers of traded debt instruments. They give financial capital to an entity usually by lending cash with the expectation of receiving interests as their return, repayments of borrowings, and increases in the prices of debt securities.
c) Other creditors
They are those related to the entity such as employees, suppliers and customers. Employees provide human capital in exchange for a salary. Suppliers give credit to facilitate a sale. Customers may make payment in advance for goods and services to be provided by the entity.
These capital providers are the primary user group. When preparing the financial reports, the entity perspective is being adopted. Entity perspective refers to the company being classified as an independent entity from its shareholders or investors. This is to ensure an unbiased perception of reporting so that the information given is not in favour of any particular group.
2) Types of information
The types of information provided in financial reporting must be useful for capital providers to assess an entity's ability to produce net cash inflows and the effectiveness of stewardship responsibilities which the management has to perform. The types of information will be discussed below:
a) Economic resources and claims to the capital providers
This refers to the entity's financial position. It gives an insight into the amount, timing, and uncertainty of its future cash flows. Capital providers can identify the entity's financial strengths and weaknesses and measure its liquidity and solvency. It also acts as indicators of the cash flow potentials and the required cash to satisfy the claims. Comparison between the expected and the actual results can be used to assess the effectiveness of management in performing their stewardship responsibilities. Estimation of the value of the entity can also be done by knowing the nature and quantity of the resources.
b) Changes in resources and claims resulting from financial performance
This information helps to ascertain the return produced by the entity on its economic resources. An entity must produce a positive return to its capital providers in the long run. The uncertainty of future cash flows is assessed based on the variability of the return. Information about the entity past financial performance is also useful in estimating future returns and measuring the management's responsibilities performance towards its capital providers. Financial performance is reflected by accrual accounting and cash flow accounting of that entity. Accrual accounting is the occurrence of transactions that affect the resources and claims but do not match with the cash receipts or payments of the period. This provides a better basis in assessing the performance. Cash flow accounting is the receipts and payments of cash in a period. It indicates the receiving and spending of cash which affect the entity's liquidity and solvency. Evaluation of its financing and investing activities can also be done.
c) Changes in resources and claims not resulting from financial performance
Information such as financing transactions between the entity and its owners enable capital providers to differentiate between changes resulted from financial performance and those that are not. They can use it to measure the degree of total change in the resources and claims which are associated to management's ability in protecting and enhancing the resources and thus, create expectations about its future financial performance.
3) Information and decision usefulness
This part explains on how the information can help the capital providers in making decisions. They make decisions on the allocation of their resources to a particular entity and enhancement in their investments. To make these decisions, they need to consider the entity's ability to produce net cash inflows and management's ability to guard and boost their investments. The assessment is based on the information derived from the general purpose financial reporting.
a) Cash flow prospects assessment
This information is useful for capital providers in terms of the amount, timing and uncertainty of cash flows. It enables them to make judgments about the entity, its values of debt or equity interests and then decide on their investment.
b) Stewardship assessment
It is used by the capital providers to determine the accountability and responsibility of the management. The management is responsible in protecting the entity's economic resources from any unwanted effects of economic factors. They must also comply with the law and regulations imposed on their entity. It is important for the equity owners to decide on the appointment of the management team, their compensation and voting of management's policies.
Limitations of general purpose financial reporting
Sometimes information from other sources is not included in the financial reports such as changes in the general economic conditions and political events. These are unpredictable events which could affect the financial performance of an entity but hard to be determined and included in the financial reporting.
Most of the time, financial reporting information is based on estimation, judgments and models of the financial effects on an entity that have existed rather than the exact information of those effects. Technical infeasibility and cost is also one of the limitations to achieve an ideal financial reporting in the long term.
Basis for conclusions
This part will explain the conclusions for the proposed conceptual framework discussed above. The Board members arrived at these conclusions after considering comments given by the public. The boards concluded several things as stated below.
The objective must be broad enough to include information given by financial reporting but outside of financial statements. Financial statements are a fundamental component but the objective covers financial reporting as a whole. The objective should also cover all decisions made by capital providers based on their legal dependence on financial reporting information. The objective should be the same for all entities whether small or large and public or private.
General purpose financial reporting encompasses the ordinary information needs of users, especially capital providers. If other users' needs do not overlap with these common needs, they are regarded as out of the scope of general purpose financial reporting. These users' information needs have general concern in the evaluation of the entity's ability to produce net cash inflows and management's capability to safeguard capital providers' investment.
Entity perspective reflects a realistic observation of financial reporting. It has a substance distinct from their capital providers and thus, more consistent with the financial reporting of today's business entities.
Primary user group of financial reports must be identified because they give a significant focus for the objective and other aspects of the conceptual framework. This primary user group is the present and potential capital providers as they have the most crucial and urgent needs for the information.
Accrual accounting is used to measure an entity's financial performance which is used to assess the entity's ability to produce net cash inflows and its management's performance of stewardship responsibility.
Information provided in the financial statements should help in evaluating solvency because it is of concern to capital providers. The principal objective of general purpose financial reporting is to provide useful information for them in making decisions.
PART 2: QUALITATIVE CHARACTERISTICS AND CONSTRAINTS OF DECISION-USEFUL FINANCIAL REPORTING INFORMATION
Economic phenomena refer to not only economic resources but also claim to those resources as well as the transactions and other events and circumstances that affect them. Financial reporting information represents economic phenomena, whether they are anticipated or have already occurred, in the forms of words and numbers in financial reports. Qualitative characteristics are the traits that make such financial information useful. They are subsequently divided into two groups, namely fundamental and enhancing characteristics, depending on how they affect the usefulness of information. However, materiality and cost are the barriers to obtain useful financial information.
Fundamental qualitative characteristics
Relevance and faithful representation are grouped under this category. Once relevance is applied to decide which economic phenomena are related to users' decisions, faithful representation is then applied to decide which depictions of those phenomena best correspond to the relevant phenomena.
Information considered relevant if it possesses the capability of making a difference in the decisions made by capital providers. It has to have predictive value, confirmatory value, or both in being relevance. Information itself does not need to be predictable, only that it should provide input to capital providers to shape their expectation regarding the future. Besides, information that confirms past expectations enhance the probability that outcomes will be as previously expected.
Faithful representation is achieved via a complete, neutral, and free from material error depiction of an economic phenomenon. In this case, complete means no omission of necessary information, while neutrality means absence of bias intended to gain a predetermined outcome or to encourage certain behaviour. It is also important to note that a faithful representation does not mean total freedom from error, as the presentation in financial reports usually are measured under conditions of uncertainty and thus involve an amount of management judgments.
Enhancing qualitative characteristics
Enhancing qualitative characteristics complement fundamental qualitative characteristics. They can differentiate more-useful information from less-useful information. In other words, they can improve the decision usefulness of presentation on financial reporting which is already relevant and faithfully represented. These characteristics include comparability, verifiability, timeliness, and understandability. Each of them is discussed in the following.
Firstly, consistency is a way to reach comparability, either from period-to-period within an entity or in a single period across entities. By maximizing the fundamental qualitative characteristics, some degree of comparability is supposed to be achieved.
Next, verifiability reassures users that information presented on financial reports does depict the economic phenomena that it intends to represent. This also implies that any knowledgeable and independent observer is able to reach the same general consensus though not necessarily complete agreement. Besides, when an amount or other representation itself is verified, it is called direct verification; while with indirect verification, such representation is verified by examining the inputs and outputs applying the same accounting methodology or convention.
The third characteristic would be timeliness which suggests information should be made available to users before it loses its capacity in influencing decisions. Certain information could continue to be timely though long after the end of accounting reporting period.
Lastly, understandability means whether the information have the quality which facilitates the comprehension of users about the meaning of it. To improve understandability, information is recommended to be characterized, classified, as well as presented clearly and concisely.
However, users of financial reports are always expected to possess a reasonable knowledge in economic and business and dealings as well as to be able to read the financial statements. It is also assumed that those users will be seeking advisor when the underlying economic phenomena are particularly complex, so an entity should not exclude information that is relevant and faithfully represented solely because the information may be too complex or difficult for some users to comprehend without aid. One or more enhancing qualitative characteristics, from time to time, may be given up to different extent in order to maximize another qualitative characteristic.
Constraints on financial reporting
Materiality is one of the constraints which limit the information provided by financial reporting, and cost would be another one. If the decisions of users could be influenced when certain information is omitted or misstated, then this information is material. The outcome of such material omissions or misstatements is information that is biased, incomplete, or erroneous.
Cost limitation in this case refers to a situation where the benefits results from financial reporting should justify the costs imposed by the same reporting work. The costs are costs to collect and process the information, costs to verify it, as well as costs of disseminating it. Besides, users themselves also incur extra costs for the purpose of analysing and interpretation. Nevertheless, information from financial reporting can help capital providers make better decisions, which will definitely lead to more efficient functioning of capital markets and thus a lower cost of capital for the economy as a whole. Also, the entity's management will benefited from the information too as they based at least partly on the above mentioned information for the business dealings.
Basis for conclusions
Discussion under this appendix summarizes the viewpoints of Board members in reaching the conclusions of this chapter of the proposed conceptual framework. It consists of reason to accept some alternatives and rejecting others. The Board also takes public comments into account by issuing a Discussion Paper called "Preliminary Views [on an improved] Conceptual Framework for Financial Reporting: [The] Objectives of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information." The Board then received a total of 179 comment letter on the Discussion Paper and they subsequently come out with this Exposure Draft.
1) Fundamental qualitative characteristics
There are several issues. First of all, the Board concluded that relevance refers to information quality which is capable of making a difference in a decision actually does not make a difference. This is because users are making various decisions not only based on single information but also along with other kinds of information from different sources. To determine how much of users' decisions are affected by a particular item in financial reporting information is not an easy job. Furthermore, the Board see relevance as related to a decision but not to particular decision makers. The reason is that when some users have put an effort in obtaining certain information elsewhere may thus say the information is relevant, but those who choose not to take advantage of it would say it is irrelevant.
Secondly, the Board has decided to use the word "confirmatory value" even though they have also confirm that "confirmatory value" and " feedback value" are having the same meaning. The Board suggests that the terminology is closer to the nature of "confirming the validity of prior predictions or correcting them."
Thirdly, the Board comes to the conclusion that to adopt statistics notions and terminology such as "predictive value" because the term implies that relevant information must, in itself, predicts the future. However, this is not true as mentioned in earlier discussion.
Fourthly, the Board suggests that the term "reliability" need to be reconsidered as neither of the existing framework communicate the meaning of reliability clearly enough to stay away from misunderstandings. Besides that, the Board also came across that "faithful representation" covers all the major qualities that previously included as aspects of "reliability". As a result, the Board decided to replace "reliability" with "faithful representation". Therefore, it is important to note that, in order to avoid confusing in these two terms, the remainder of this discussion uses the term "faithful representation" rather than "reliability" unless quoting.
Fifthly, the Board concludes that "substance over form" is not considered as a component of "faithful representation" in the proposed framework because it is redundant to do so. In their opinion, "faithful representation" would more than enough to give the meaning that information should represent the substance of an economic phenomena rather than solely its legal form.
Sixthly, the Board concludes that it is a conflict with the quality of "neutrality" if "prudence" and "conservatism" are described as quality characteristics or desirable response to uncertainty. This is due to the reason that even with the proscriptions of deliberate misstatement that appear in the existing frameworks, an admonition to be prudent is possible to direct to a bias in the reported financial position and financial performance.
Lastly, the Board concludes that "faithful representation" cannot be measured or quantified. This is because empirical accounting research done previously did not provide relevant useful techniques, and also, if the method such as overall degree of faithful representation is used then this idea would be so subjective and so controversial which is likely to fail. Besides, the Board also mentions that "faithful representation" (which is "reliability" before the Board's decision) is narrower in econometrics and statistics, any effort in quantifying it would require reconciliation.
2) Enhancing qualitative characteristics
There are four enhancing qualitative characteristic discussed as below:
Firstly, board concluded that comparability was an enhancing qualitative as comparability achieved when information is being compared is a faithful representation. Besides, comparability will not be useful if it is irrelevant to users' decision or does not faithful represent the economic phenomena it purports to represent. In addition, standard setters sometime temporarily sacrifice some consistency to achieve improved relevance or faithful representation or both of the information in financial reports.
Secondly, verifiability was a component of faithful representation in IASB Framework and Conceptual Statement 2. However, board observed many pieces of information included in financial statement are not verifiable and agreed that information that is verifiable is generally more decision useful than information that cannot be independently verified. Therefore, verifiability was not a component of faithful representation as include verifiability as a component of faithful representation could result in some information being excluded from financial reporting. Therefore, Board concluded that variability is an enhancing qualitative characteristic instead of a component of faithful representation.
Thirdly, some respondents pointed out the timeliness affects many of the qualitative characteristic and thus should not characterize as a component of relevance. Besides, board stated that timeliness is different from other component of relevance as when something has predictive value or confirmatory value is relevant , then information can be reported in a timely manner and have no relevance at all or information can be delayed in reporting and remain relevant. Therefore, board concluded that reporting information in a timely manner can enhance both the relevance and faithful representation of that information, so timeliness is an enhancing qualitative characteristic.
Lastly, users should have reasonable degree of financial knowledge and a willingness to study the information with reasonable diligence to understand the financial reporting information. The board concluded that the proposed framework needed to clarify both the qualitative characteristic of understandability and users' responsibilities in understanding financial reports and the revised discussion explains that users are responsible to study the financial reporting information with reasonable diligence rather than only being willing to do so as a result of the misunderstanding. In addition, board explain that user may need to seek an advisor to understand a particular transaction when economic is particularly complex.
Besides, standard setter and those who prepare financial reports should take steps to improve the clarity and preciseness of financial reporting information in order to make intended users can understand it. The proposed framework explains that understandability will be enhanced when information is clear and concise. Meanwhile, irrelevant information or unnecessarily lengthy narratives will result the lower understandability of financial information and diminishing its usefulness.
3) Consideration for additional qualitative characteristics
Transparency increased the frequency in describing high quality financial reporting. IASB and FASB both are uses this term in the similar way to describe the objectives of ensure the economic efficiency on making the decision of resources allocation.
However, Boards concluded that transparency should not be added as a qualitative characteristic of decision- useful financial reporting to avoid redundancy. This is because transparent information already incorporates in the draft framework result from applying several qualitative characteristic which included faithfulness and understandability.
True and fair view
IASB framework explained that the application of the principle of qualitative characteristic and appropriate accounting standards normally will result a true and fair view on the presentation of financial reporting and information even though the framework does not deal directly on this concept.
The board agreed with the conclusion derived from the IASB framework thus true and fair view is not a qualitative characteristic and instead it should result from applying the qualitative characteristics. Besides, Boards also observed that for the financial reports to present true and fair view or present fairly is the same as faithful representation which already included as qualitative characteristic.
The board finalized that credibility is not a characteristic of decision- useful financial information even it is a desired attribute by which information is developed. This is because the credibility of the financial statement is depend on users' view on the trustworthiness of the entity management and auditors as well as the view of relevance of the information and the degree to which it faithfully represents the underlying economic phenomena.
Japanese Discussion Paper focused on the internal consistency of financial reporting standards rather than financial reporting information where the any individual standard adopted should be consistency. Accounting Standard Board of Japan explained that internal consistency is needed to infer relevance in developing financial reporting standard. If the economic environment has not changed radically then a standard setter may infer that a proposed standard is internally consistent with the existing system of standards.
The boards pragmatic that internal consistency of accounting standards id desirable and it should naturally result from the developing standards that are consistent with the same conceptual framework. However, Board concluded that internal consistency should not added as a qualitative characteristic as to do so could hinder evolution in the body of financial reporting standards to improve the financial reports' decision usefulness.
In the report of International Standard Setting: A Vision for the Future. This report indicates that application of objectives and qualitative characteristic should lead to high quality accounting standards and this should lead to improve the high quality of financial reporting information. The board concluded that, high quality is not added as qualitative characteristic because of high quality can be achieved by adherence to the objective and qualitative characteristics of the financial reporting information.
Other decision criteria sometimes suggested
The criteria that are included are simplicity, preciseness, operationality, practicability and acceptability. The board concluded that these criteria generally are the part of the overall weighing of benefits and costs of providing financial information.
4) Relationship among the qualitative characteristics and the objectives of financial reporting
The board considered use a chart to explain the relationship between the qualitative characteristic such as ' A Hierarchy of Accounting Qualities' in Concepts Statement 2 , however, board agreed with the Conceptual Statement 2 stated that chart is a limited device to showing certain relationship among the qualities that make accounting information useful.
After that, boards considered a chart that would illustrate how standard setters might apply the qualitative characteristic in making the decision about the financial reporting issues. However, boards decided to have a chapter to focus on the relationship of the qualitative characteristic to the objectives of financial reporting and to each other as the chart would necessarily involve matter that not yet been addressed by conceptual framework project.
Boards proposed that qualitative characteristic should be distinguished as fundamental characteristic or enhancing characteristic to reduce the confusion on how the qualitative characteristics relate to each other.
The board also concluded that relevance is the first qualitative characteristic to be considered then followed by faithfulness characteristic. If information is not relevant then the rest of qualitative characteristics would not become a matter in the consideration of the decision making usefulness in financial reporting. Furthermore, the information is decision useful when a relevant phenomenon is faithful represented on what is supposed to represent.
Lastly, enhancing qualitative characteristic cannot make information useful for decision if the information is irrelevance and not faithful representation.
5) Constraints on financial reporting
The boards concluded the materiality is a persistent constraint on the financial reporting because it is a relevant to the other qualitative characteristics. Besides, boards also concluded that materiality is a consideration for individual entities and their auditors but not standard setter. This is because, the materiality can be assessed only in relation to a particular reporting's entity situation.
Both boards' existing framework focus on the difficulty of conducting cost- benefit analyses for the financial reporting requirement rather than on how to balance the cost and benefit on the financial reporting to the standard setters, preparers and the users of financial reports.
The major problem for the standard setter in conducting rigorous cost- benefit analyses in financial reporting is the inability to quantify the benefits of a particular reporting requirement or even to identify all of them. Therefore, standard settlers should take into account of both benefits and costs of proposed financial reporting requirement.
The board concluded that the improved framework should go further in the area of assessing benefits and costs rather than do the existing framework. The standard setter should endeavour to conduct quantitative cost-benefit that would raise expectation beyond what is feasible and this might make it harder for standard setters to financial reporting.