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WEEK III A CONCEPTUAL FRAMEWORK Chapter 4 of Accounting Theory (GOD)

I.

The Role of Conceptual Framework

The conceptual accounting framework to provide structured accounting theory. At the highest theoretical level, this states the scope and purpose of financial reporting. Then, at the next fundamental conceptual level will identifies and defines the qualitative characteristics of financial information such as relevance, reliability, comparability, timeliness, and basic understanding and accounting elements such as assets, liabilities, equity, income, expenses, and profits. Last, at a lower operational level, the conceptual framework relates to the principles and rules of recognition and measurement of the basic elements and types of information that will be displayed in financial statements.

The FASB has defined the conceptual framework as a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting.

There are several issues among others: 1. Do we need a general theory of accounting? Argument: The conceptual frameworks are not needed, because the accounting profession has survived without a formally constructed theory. However, a problem has arisen. 2. Is current accounting too permissive? Accounting practices are too permissive "... let each company be free to choose its own accounting method (NYSE, 1934) 3. Are current accounting practices too inconsistent? Inconsistency in practice, lack of conceptual frameworks 4. Is there too much political interference in the neutrality of accounting reports? Accounting practices based on valuation, conceptual frameworks as a defence against political interference

The benefits of a conceptual framework:

Weekly Summary – Financial Accounting Theory

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Reporting requirements will be consistent and logical reporting requirement with set of concept, greater compliance, more accountable, the need for specific accounting standards will be reduced to those circumstances, minimising the risk of over regulation, auditors will be able to better understand the financial reporting requirements they face, and there will be more economical standard setting.

II.

Objectives of Conceptual Frameworks

Financial reporting must provide useful information for potential investors, creditors, and other users. So that they can make rational investment decisions, credit, and produce decisions that are similar between each other.

Informations contained in financial reporting must be useful for making economic decisions, useful in assessing cash flows, and about enterprise resources, claims for those resources and changes in them.

Source: FASB/IASB, ‘Revisiting the concepts: A new conceptual framework project’

The framework describes the basic concepts by which financial statements are prepared. It serves as a guide to the IASB in developing accounting standards and as a guide to resolving 1

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accounting issues that are not addressed directly in an International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS). 

Understandability has been done from the existing framework. Financial information classified, characterized, and presented in a clear and concise manner can be understood.

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Useful financial reporting; Financial information that is relevant and honestly presented is assumed to produce more efficient financial market functions and reduce capital costs for reporting entities.

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Relevant financial information can make a difference in decisions made by users. Financial information has predictive value, confirmation value or both.

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Reliability; faithfully represent financial position, performance, and cash flow, neutral, prudent, and complete in all material respects.

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Comparability, timeliness, certainty, and understanding are directed at improving financial information that is relevant and faithfully represented.

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Timeliness of financial information is a qualitative characteristic under the existing framework. However, instead of emphasizing the balance between timely reporting and reliable information, the revised framework refers more broadly to timeliness because it can influence decision makers.

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Verifiability is a new concept in the revised Framework. Financial information can be verified when it allows a knowledgeable and independent observer to reach a consensus about whether a particular description of an event or transaction is a faithful representation.

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Faithful representation replaces the term 'reliability' were previously used, because the Board decided there was a general lack of understanding of reliability. Financial information that faithfully represents an economic phenomenon has three characteristics: complete, neutral and free from error.

III.

Developing a Conceptual Framework

Principles-based and rule-based standard setting

The IASB aims to produce principle-based standards and thus it looks to the conceptual framework guidance. It represents the basic ideas which underpin the development of the standards and assist users in their interpretation of the standards. While the IASB aims to be a 2

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principle-based standard setter, standards such as IAS 39 have been criticized as being overly rule-based. Nobes suggests that the reasons standards become rule-based is that they are inconsistent with the conceptual framework of standard setter. He argues that the need for rules results from lack of principles or use of an inappropriate principles. However, rule-based standards have some advantages which explain their popularity. These include increased comparability and increased verifiability for auditors and regulators. Rule-base standards may reduce the opportunities for earnings management, however they allows for the specific structuring of transaction to work around the rules.

The accounting standards of U.S. have often been described as rule-based standards because they contain many detailed requirements in relation to treatments which must be followed to comply with the accounting standards. In 2002 the Sarbanes-Oxley Act required the U.S. regulator (SEC) to conduct a study of the use of principles in the standard setting process. The study recommended that accounting standards be developed using a principlebased approach and that standards should have the following characteristics: 

Be based on an improved and consistently applied conceptual framework.

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Clearly state the objective of the standard.

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Provide sufficient detail and structure that the standard can be operationalized and applied on a consistent basis.

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Minimize the use of exceptions from the standards.

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Avoid use of percentage test that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.

The greater emphasis on the conceptual framework, principles and objectives arises from events in 2001-2002 in the U.S. that is corporate collapses at Enron and WorldCom, which have been blamed in part on the rule-based approach taken in preparation of financial statements. The Sarbanes-Oxley Act introduced many changes to improve the quality of financial reporting and auditing. Establishing a principle-based approach as a FASB objective is timely in terms of the IASB/FASB convergence program.

One of the reason for the preponderance of rules in standards in the U.S. was that SEC staff requested rules from FASB to use in interpreting accounting standards. One role of SEC staff is to determine whether companies have complied with the financial reporting requirements contained in accounting standards. 3

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Information for decision making and the decision-theory approach

Accounting information for decision making begins with the stewardship function. In earlier times, the steward in charge of the estate had to account to the master. In Pacioli’s era, an accounting had to be made to the ‘silent’ partners after a venture was completed. Today, managers are accountable to the equityholders of the company. The information on how managers have discharged their stewardship responsibility is used by the equityholders to evaluate the performances of the managers and the firm.

Since the early 1960s, emphasis have been placed on the decision-making aspects of accounting information. Information for decision making implies more than information on stewardship. First, the users of financial information are greatly expanded to include all resources providers, recipients, of goods and services and parties performing a review or oversight function. Second, accounting information is relevant to users’ predictions of future performance and position. Third, whereas stewardship is concerned mainly with the past in order to assess what has been accomplished, based on past events, but the future cannot be ignored when decision making is emphasis as the objective of accounting.

For many, the emphasis on decision making strongly implies the use of current values. The decision-theory approach to accounting is helpful to test whether accounting achieves its purpose. The process of decision-making theory: Overall theory of accounting→ individual accounting system→ prediction model of users → decision model of user

International developments: the IASB and FASB Conceptual Framework

In October 2004, the FASB and IASB added a joint project to their agendas to develop an improved, common conceptual framework. The Board state that such a framework is essential to fulfilling the Boards’ goal of developing standards that are principle-based, internally consistent, and internationally converged. The FASB states that the project will do the following:

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a.

A Conceptual Framework

Focus on changes in the environment since the original framework were issued, as well

as omissions in the original framework, in order to efficiently and effectively improve, complete, and converge the existing frameworks. b.

Give priority to addressing and deliberating those issues within each phase that are

likely to yield benefits to the Board in the short term. c.

Initially consider concepts applicable to private sector business entities.

The boards are conducting the joint project in eight phases. Each of the first seven phases will address and involve planning, research, initial Board deliberations, public comment, and redeliberations on major aspects of the Boards’ frameworks. The phases and topics are shown in following: Phase A: objective and qualitative characteristics Phase B: elements and recognition Phase C: measurement Phase D: reporting entity Phase E: Presentation and disclosure, including financial reporting boundaries (inactive) Phase F: Framework purpose and status in GAAP Hierarchy (inactive) Phase G: applicability to the not-to-profit sector (inactive) Phase H: Remaining issues (inactive)

For each phase, the Boards plan to issue documents that will seek comments from the public on the Boards’ tentative decisions. The decision to defer consideration or not-for-profit sector issues has been contentious. Feedback from national standard setters has suggested three areas where current Board deliberations raise issues for the not-for-profit sector. They are: 

An insufficient emphasis on accountability and stewardship

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A need to broaden identified users and establish an alternative primary user group

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The inappropriateness of the pervasive cash flow focus.

Entity vs proprietorship perspectives

The entity and proprietorship represent different approaches to financial reporting. The Boards recommended that financial reports should be prepared from the perspective of the entity rather than the perspective of the owners or a particular class of owners. Many

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respondents agreed that the entity is distinct from its owners and thus concurred with reporting from the perspective of the entity.

Primary user group

The Board proposed that the primary user group for general purpose financial reporting is present and potential capital providers. Most respondents agreed with the Boards’ approach that present and potential capital providers (equity investors, lenders, and other creditors) of the entity are the primary user group.

Decision usefulness and stewardship According to the Boards, the objective of financial reporting should be ‘broad enough to encompass all the decisions that equity investors, lenders, and other creditors make in their capacity as capital providers, including resource allocation decisions as well as decisions made to protect and enhance their investments’. Whittington considers that the objectives of stewardship has been ‘sidelined’ in the ED and notes that this is not acceptable to many constituents, particularly in Europe, where stewardship is a key part of corporate governance and company regulation.

Quality characteristics

The IASB Framework includes four principal qualitative characteristics, namely understandability, relevance, reliability, and comparability. The exposure draft proposes that the qualitative characteristics that make information useful are relevance, faithful representation, comparability, verifiability, timeliness and understandability, and that the pervasive constraints on financial reporting are materiality and cost. The qualitative characteristics are distinguished as either fundamental or enhancing, depending on how they affect the usefulness of information.

The Boards are continuing their work on Phase B and C Measurement. In relation to Phase B, the existing definition of the elements of financial reporting are being modified and new recognition criteria are being proposed. As noted earlier, prior conceptual framework have struggled to deal effectively with the issue of measurement. The IASB and FASB need to make 6

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progress on the conceptual framework as it is fundamental to developing standards and it underpins convergence effort.

IV.

A Critique of Conceptual Framework Projects

Conceptual framework aims to provide guidance and prescriptions to practising accountants on how to account information, which is relevant to economic decision making. It answers value and how basic elements of accounting, such as assets and liabilities, be valued, thus, avoiding repetitive arguments over the meaning of such terms. Prior agreement on these fundamentals minimise inconsistencies and inequities arising from differences in judgement. It is clear that the conceptual framework is intended as a fundamentally prescriptive project.

Some argue that the attempt to base accounting practice on preconceived definitions risks a kind of mechanical decision making. Although a conceptual framework may provide a consistency in that it is efficient and orderly, it is a consistency of trivial sort — consistency with an abstraction, not consistency with real ends. This trivial consistency is a direct consequence of dogmatism whereby pronouncements issued by the authoritative are accepted by the profession. Still, the conceptual framework is necessary and a common understanding of definitions is crucial to consistent preparation and interpretation of financial statements.

However, the development of conceptual frameworks met with criticisms. An analysis of these criticisms help explain reasons for the previous slow development of the frameworks and highlight issues relevant to achieving progress in the current IASB or FASB project. There are two approaches to analyze these criticisms: a.

scientific criticisms - the conceptual framework should be a scientific approach Accounting prescriptions or observations arising from such an approach must justify their validity by recourse to logic, empiricism, or both. b. descriptive and non-operational Similar to constitutional approach to rule setting, the second approach concentrates on prescribing the best course of action by recourse to professional values.

Criticism on FASB’s Conceptual Framework

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It is within the FASB’s conceptual framework project that these crucial issues of recognition and measurement that dissension arose. By the time SFAC No. 5 was issued, the Board’s approach had become almost totally descriptive. Yet, SFAC No. 5 states in several places (paragraphs 35, 51, and 108) that concepts are to be developed as the standard setting process evolves. This evolution philosophy, which sees concepts as being the residual of the standard setting process, is in direct contradiction to the purpose of the conceptual framework. Dopuch and Sunder argue that nothing in FASB’s conceptual framework seems to be of much help in resolving contemporary measurement and disclosure issues. They support this assertion by selecting the issues of deferred tax credits, treatment of costs of exploration in the oil and gas industry, and current value accounting. Dopuch and Sunder conclude: 1. The definition of liabilities is so general that we are unable to predict Board’s position on deferred taxes 2. The framework supports two opposing principles of accounting, which is full cost and successful efforts, and is preliminary evidence that the framework is unlikely to be useful guide in resolving the measurement issue 3. It does not address the problem of estimation, on which past efforts to encourage publication of current costs have foundered Criticism on IASB’s Conceptual Framework

In IASB Framework, assets and liabilities are defined rather vaguely, while the recognition criteria are couched in terms of probability, which is a subjective concept. In addition, the recognition criterion fails to offer any guidance on the measurement problem, which is fundamental to accounting. As the definition is open-ended, it appears that any measure would be acceptable as long as the cost or value can be reliably measured.

Ontological and Epistemological Assumptions

The focus of conceptual framework projects has been to provide information to users of financial reports in an unbiased and objective manner. Freedom from bias, or neutrality, has been defined as an information quality that avoids leading users to conclusions that secure the particular needs, desires, or preconceptions of the preparers. Solomon explains freedom from

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bias as a financial mapmaking — the better the map, the more completely it represents the complex phenomena that are being mapped. However, Feyerabend, a philosopher, argue that scientific truth is not absolute — it refers only to a statement about a constructed reality. The philosophy of realism comes about in accounting from the assumption that we can observe, measure, and communicate an objective economic reality. A given statement on belief warrants acceptance only after the evidence conforms with prescribed and agreed-upon rules about what is scientific methodology.

Hines points out that the problem with economic realism or measurement approach adopted by the conceptual framework project is that within many scientific communities, reality is now viewed as being constructed and sustained by social practices, thereby polluting accountants’ perceptions of economic reality. This makes it questionable whether theories forming the basis of a framework can ever be neutral, independent, and free from bias. The extension of this argument is that a conceptual framework cannot provide a completely objective means of measuring economic reality, since such a reality does not exist independent of accounting practices.

Further, the structure of conceptual framework projects bears some resemblance to a hypothetico-deductive approach. This approach to scientific explanation has two main consequences: 

it leads to universal laws or principles from which lower level hypotheses may be deduced

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there is a tight connection between explanation, prediction, and techniques applied

This hypothetico-deductive approach influences the epistemological and methodological assumptions about test of truth and the manner in which most accounting research is undertaken.

Circularity of Reasoning

One of the stated objectives of a conceptual framework is to guide the everyday practice of accountants. A superficial view of the conceptual frameworks indicates that accountants at least follow one scientific path: deducting principles and practice from generalised theory. However, 9

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various countries’ existing conceptual frameworks are typified by an internal circularity. The FASB framework attempts to break out of, or justify, this circularity of reasoning by referring to the notion of an informed accounting person, who will have sufficient and appropriate knowledge to determine and interpret financial reports. Still, it provides no specific guidance yet on how this should be achieved.

An Unscientific Discipline

Conceptual framework may have attempted to adopt the deductive (scientific) approach. Nonetheless, this approach is questionable if accounting does not qualify as science to begin with. In 1981, Stamp said “until we are sure in our minds about the nature of accounting, it is fruitless for the profession to invest large resources in developing a conceptual framework to support accounting standards”. Stamp considers that accounting is more closely aligned to law than to physical sciences, since both the accounting and legal professions deal with conflicts between different user groups with varying interests and objectives — normative discipline. In contrast, the physical sciences are considered to be positive disciplines — descriptive in nature and characterised by value-free concepts. Theoretical and empirical elements are somewhat loosely defined and applied in accounting. It also lacks a definitive scientific paradigm. This does not necessarily indicate the lack of scientific approach, however. Provided the theoretician is rigorous in applying the ontological, epistemological and methodological rules relating to the field of study, the scientific methodology may be said to be applied.

Positive Research It has been argued that the basic focus of the conceptual framework projects — providing financial information to help users make economic decisions — ignores the empirical findings of a positive accounting research. Nonetheless, for decisions with multiple choices, accounting information may be useful. This is an area that behavioural research has not yet fully considered. Furthermore, those who argue that positive accounting research and a conceptual framework are in conflict sometimes ignore the mounting evidence that capital markets are not completely efficient. Even if they are efficient, the fact that the market responds immediately 10

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does not mean that individuals process the information efficiently or cannot make incorrect investment, lending, supply, or purchase decisions. If a conceptual framework could ensure that these people received useful information, it would serve a useful purpose.

The Conceptual Framework as A Policy Document

As a generalised body of knowledge, the conceptual frameworks fail a number of scientific tests. An alternative to viewing the conceptual frameworks as either scientific or deductively derived normative models is to consider them as policy models. Ijiri differentiates between normative and policy models. Normative models is based on certain assumptions concerning the goals to be served. The researcher does not necessarily subscribe to the assumed goals. Thus, although a normative model has policy implications, it is different from a policy judgement, which involves a commitment to goals. Ijiri also points out that theories and policies are intermingled in accounting, whereas in other empirical sciences the distinction is well established.

Meanwhile, according to Tinker, another way to validate the theoretical levels of accounting is through descriptive approach. Descriptive theories is a way to find the actual relationship, including inductive reasoning. Descriptive approach have implications to decide whether conceptual framework is a reflection of professional value.

Then, Buckley on his book have policy model, through constitutional approach. whereby principles are derived from axioms. Such truths as continuity, objectivity, consistency, materiality, and conservatism are considered self-evident. This is similar to how FASB defines a conceptual framework as a constitution. Constitutional approach also conforms with the assertion that accounting largely relies on self-evident or dogmativ bases for establishing criteria for truth. Chambers claimed that “all we have as fundamental or basic is a set of proposition that are more or less arbitrary established, or which are plain dogmas. There is no body of ideas or knowledge by reference to which we can judge whether or not the proposition are preferable to others, we must simply accept them”. In defending the FASB approach to building a conceptual framework, FASB’s chairman at the time, Kirk, claimed that the view that standards can be set by consensus is part of a belief 11

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that standards are conventions and conventions are formed by agreement. He promotes the idea that a conceptual framework best serves the public interest because it is a conceptual approach. This is problematic since the public interest is represented by users who have conflicting needs. Miller has claimed that the FASB and its conceptual framework will survive only by maintaining a position that reflects the interest of the beneficiaries of the capital market.

Professional Values and Self-Preservation

An explanation of conceptual frameworks in terms of self-preservation and professional values may at first appear to be a contradiction in terms: self-preservation implies the pursuit of self-interest, whereas professional values suggests idealism and altruism. Gerboth considers that this sense of personal responsibility, which is the essence of professionalism, is what makes accountants’ decisions objective. He argues “of necessity, accountants makes many judgments. And when they do, their decision may differ from those that other accountants would make. But that does not make the decision arbitrary. Accountants’ freedom is not freedom to decide as they please. Their personal responsibility for the decision forces a diligent search for the best obtainable approximation of accounting truth, and that responsibility leaves no room for arbitraries”.

Conceptual frameworks do not operate in a social vacuum. When complex human affairs are involved, it is probably impossible to develop a comprehensive, prescriptive framework, and decision model. Greenwood refers to this as the value of rationality where there is commitment to objectivity in the realm of theory and technique. The impossibility of agreeing on normative accounting standards (a prescriptive framework) is supported by Demski. Demski offers mathematical evidence that, in general, no set of standards exists that will identify the most preferred accounting alternative, without specifically incorporating an individual’s beliefs and values. This concept conforms with the constitutional approach argued by Buckley, which is extended by the proposition that standard setting is connected with monopoly-seeking behaviour by the profession. This is achieved by issuing increasingly complex standards and concepts. The result is that the general public does not understand that the paraphernalia of complex accounting principles and rules. This leads to the need for a conceptual framework: “viewing conceptual framework project as constituting a strategic manoeuvre to assist in socially constructing the appearance of a coherent differentiated knowledge base for accounting standard, thus legitising standards and the power, authority, and self regulation of 12

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the accounting profession, may help in explaining why conceptual framework projects are continually undertaken by the profession”.

V. Conceptual Framework for Auditing Standards

The first major attempt to state a general comprehensive theory of auditing was by Mautz and Sharaf in 1961. In a contemporary review of the text, Miller emphasized that Mautz and Sharaf attempted to provide theoretical underpinnings for a discipline which at that time was primarily regarded as a practical exercise. Fundamentally, Mautz and Sharaf saw auditing not as a subdivision of accounting, but as a discipline based in logic. This led them to the conclusion that auditors are not naturally limited to a verification of accounting information. Mautz and Sharaf’s work was developed further in the early 1970s by the Statement of Basic Auditing Concepts (ASOBAC), issued by the American Accounting Association. The focus of theoretical debate in auditing during the 1980s was the role of structure and quantification in the evidence gathering and evaluation process. Knechel describes this as a period of rapid growth in audit practices, the expansion of the professional personnel pool, improvements in technology, and the perceived need to reduce costs in the audit process. All these contributed to the movement towards highly structured and formalistic processed in accounting firms. However, Knechel argues that by the 1990s the traditions of auditing and the profession’s efforts to formalize audit processes began to face opposition from other forces. These forces included pressure from clients on auditors to reduce audit fees and deliver more value. Knechel proposes that one interpretation of the interplay between these factors was that it led to change in traditional auditing methods. There began to be less emphasis on direct testing of transactions and balances and more reliance on testing clients’ control systems as a means to gather evidence on the financial statements that are produced by those systems. This involved a reduction in time devoted to an audit, and a reduction in substantive testing and sample sizes. This process became known as business risk auditing.

Business risk auditing is a form of auditing that considers client risk as part of the audit evidence process. The audit risk model requires an auditor to consider the risk of an inappropriate audit opinion as a function of the inherent risk of errors occurring, the risk that 13

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the client’s control system will not prevent or detect those errors, and the risk that the auditor’s procedures will not detect the error. The focus on audit risk was not new; even in the 1940s, auditors were instructed to begin their audit with a thorough investigation of the client’s system and consider its safeguards against fraud and error. However, Knechel argues that the profession’s perceptions of risk began to change dramatically with the release of the 1992 report ‘Internal Control – Integrated Framework’ by the Committee of Sponsoring Organizations (COSO). Auditors became more aware of the relation between internal controls and the conduct of an audit. Clients with more effective internal controls were seen to be at lower risk of fraud and error, and this provided the opportunity to justify a reduction in resources, costs, and audit fees for these clients. In addition, gaps in clients’ internal controls provided an opportunity to sell non-audit services. Business risk auditing emphasizes the threats to a client’s business model from the complexities in its business environment, and business risk is seen to drive audit risk. The key conceptual change that business risk auditing brought to auditors was the requirement to think through the causal relation from the client’s business model and operations to the financial accounts, rather than to think in terms of accounting errors first. Business risk auditing meant the audit had to expand its horizon beyond the strict confines of the client to include key process owners outside the organization.

Critics argue that not only was business risk auditing used to justify a push to sell consulting services; it ultimately led to the accounting scandals at Enron and elsewhere. This criticism implies auditors misused business risk auditing methodology to justify opportunistic behavior. Regulators have acted through with the Sarbanes-Oxley Act (2002) in the US and the CLERP 9 revisions to the Australian Corporations Act to restrict the opportunities for auditors to provide consulting services to their clients, and there is evidence of increased emphasis on fraud detection in the 2000s. Knechel suggests that the future of business risk auditing could be constrained, but the focus on auditing clients’ internal controls in the US legislation still provides a clear focus for auditors to consider risks in the client’s processes and environments as part of the financial statement audit.

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