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Accounting is primarily concerned with recording, maintaining and reporting of financial data of business entities. It provides information about the resources available to the firm, the means employed to finance those resources and the result thereof. When publishing financial statements, Accountants need a set of standards to look up to, so that the data published can be consistent through the years. Also reliable and relevant to the users of such information. This is where the need for conceptual framework comes in.
What is Conceptual framework??
A Conceptual framework is said to be a foundation within which the accounting principles are based.
According to the FASB - "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"
IASB - "This Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users"
The idea of a conceptual framework surfaced long before it was formally recognized. FASB was created in 1973 for this purpose. The board realized that the first thing it had to do was to develop certain fundamental concepts that it could look to for consistent guidance in analyzing and resolving issues such as income and liability etc.
Between 1974 and 1985, the FASB issued 30 publications (eight discussion memoranda, seven research reports, eight exposure drafts, one invitation to comment, and six concepts statements) in its massive conceptual framework project.
The Statements of Financial Accounting Concepts issued by the FASB are:
- SFAC No.1: Objectives of Financial Reporting by Business Enterprises
- SFAC No.2: Qualitative Characteristics of 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.
- SFAC No.7: Using Cash Flow Information and Present Value in Accounting Measurement.
The SFAC No.1 issued in November, 1978 talks about the objectives of financial reporting and that business enterprises have the responsibility to publish financial information showing financial performance and changes in financial position. The statement however, confines its attention to the needs of investors and creditors ignoring other groups such as labor and tax authorities.
The SFAC No.2 issued in May, 1980 defines the characteristics of useful financial information.
Information plays a very important role for any user to make the right decision. The attributes that make information useful to users include:
Understandability - the information provided by the conceptual framework should be easily understandable by the users
Relevance - the information should be current
Reliability - the information provided should be trustworthy
Comparability - it should also be easy to compare with other information so that the users can reach the correct decision.
The SFAC No.6 issued in December, 1985 It replaces SFAC No.3 and re-defines the basic elements of financial statements. Financial statements consist of Balance sheet and Income statement. The balance sheet describes the financial position of the business entity as on a particular date whereas the income statement portrays its financial performance for a certain period of time. The elements of the Balance sheet which relate to financial position are: Assets, Liability and Equity. And the elements of the Income statement which relate to financial performance are: Revenue & Expenses.
It is in this statement that the FASB favors "Asset and Liability view" over the "Revenue and Expense view" to define earnings.
Assets: "probable future economic benefits obtained or controlled by a particular entity
As a result of past transactions or events"
Liabilities: "probable future sacrifices of economic benefits arising from present obligations
Of a particular entity to transfer assets or provide services to other entities in the
future as a result of past transactions or events"
Revenues: "inflows or other enhancements of assets of an entity or settlements of its liabilities (or a
combination of both) during a period from delivering or producing goods, rendering
Services or other activities that constitute the entity's ongoing major or central
Expenses: "outflows or other using up of assets or incurrences of liabilities (or
a combination of both) from delivering or producing goods, rendering services,
or carrying out other activities that constitute the entity's ongoing major or
The definitions provided are not consistent with the Accounting Standards in many cases. They do not solve any purpose and are inconclusive because FASB does not define the concept of income, which should have been the threshold for these definitions. And so in July, 2001 the FASB/IASB/ASB concluded that the definitions were deficient.
The SFAC No. 5 was issued in December, 1984. This statement defines the criteria to recognize and measure elements that can be used in the financial statements of Business Enterprises. To be recognized, it should be able to be defined under the elements of financial statement, it should be measurable, relevant and reliable. There are various ways for measurement and some of them are the following:
In the statement, the board did not conclude as to which method business entities should rely on to measure the elements of the Financial Statement or in other words which method should it prefer over the other. This in turn created a lot of problems since there was no fixed measurement system therefore it became difficult to compare different information's. Therefore, the Statement was given a grade "F" by Solomon [1986, p. 124].
The SFAC No.7 was issued in 2000; this statement can be seen as a subset to SFAC No.5. It applies to situations where present market determined amounts such as cash received or paid and current cost or market value are not available at the point of recognition. Instead estimated future cash flows must be used for asset or liability measurement.
The ASB (UK) issued its Conceptual framework in March, 2000. The statement consists of 8 Chapters and is more or less a copy of the framework of the FASB, the differences being the basis for valuation of a business entity. Initially the ASB suggested deprival value to be used as the system of measurement but later changed it to a mixed measurement method. Deprival value or current cost which was the initial approach adopted by the ASB was basically the value the firm incurs because of losing an asset or replacing it, keeping in mind that the manager takes the appropriate measures.
The IASB's framework is a much smaller document as compared to the other boards and is also very similar to the FASB's framework.
The conceptual framework projects by all the boards cannot be seen as a success in any manner as they fail to deal with the fundamental issues of recognition and measurement. At no point do they define income throughout the framework, they coin the term "Comprehensive Income".
Comprehensive income can be defined as "the change in equity (net assets) of an entity during a period from transactions and other events and circumstances from non owner sources"
Also, the conceptual framework is very broad, and as each individual can read and interpret it in a different manner as it is not conclusive.
Commentators on the project have given various negative feedbacks on the project. Solomons concluded that the project was a failure. Miller et al. Says that although not a complete failure, it definitely was a disappointment. He says that it's not a complete failure as it address's the primary objective of accounting i.e. to provide useful accounting information to those who need it.( Accounting Historians Journal, December 1999 pg. 120).
Kenneth Most [1993, pp. 107, 109] saw the project as "seriously flawed," and he registered his "great surprise . . . that the FASB's conceptual framework has been imitated in other countries." (Accounting Historians Journal, December 1999 pg. 120)
Although seen as an overall failure, in terms of contribution to "Better" financial reporting it has made a giant leap as it changed the overall perspective that the financial information was traditionally for legal purposes. It argues that "Useful" Financial information should be available to present and potential investors, creditors etc.
To discuss the relationship between the current IASB/FASB approach and concepts of valuation of economic income, we first have to differentiate between accounting income and economic income. Accounting income takes into account only realized gains and losses whereas Economic income takes into account both realized and unrealized gains and losses.
IASC initially emphasized on Fair value, but later changed their methodology to a mixed measurement system, where some assets were recorded at current market prices and others at historical cost. Historical cost is the cost of the asset/liability at the time of acquisition.
The IASB and FASB clearly prefer Fair Value or current market value as a method of measurement (IAS 16). Fair value can be defined as:
'Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction.' (IAS 16, 6)
IAS 39 also states that investments and other assets held for trading should be valued at current market value, as in normal market conditions the fair value of some assets held for trading can change drastically, and if recorded at historical cost in the balance sheet the information provided is unreliable or in other words does not give the true picture of the balance sheet. IAS 39 was later amended and the final issue restricted the use of the option of recording a financial asset at fair value in the P&L account.
FRS 15 issued by the ASB stated that a business entity could re-value assets but that if such a policy of revaluation was followed it should apply it consistently among all assets in that particular asset class.
FRS11 issued by the ASB, deals with the issue of impairment of Financial assets, impairment occurs when the value of an asset falls below its book value.
The transition of accounting standards has happened from time to time, to accommodate new and complex problems in today's business world. These changes are to interpret the company's performance better by the users of the financial data. But since these standards can be interpreted differently by different people which it makes it hard to standardize. Also since neither of the boards were able to define income, and be conclusive on methods of measurement. .The Conceptual frameworks are being revisited again. This time by a convergence project between the IASB and the FASB.
According to FASB/IASB May, 2008 Conceptual Framework is defined by: 'To be consistent, principles must be rooted in fundamental concepts rather than a collection of conventions. To consistently achieve useful financial reporting, the body of standards taken as a whole and the application of those standards should be based on a framework that is sound, comprehensive and internally consistent'