A conceptual framework for financial accounting and reporting

Ahmad Balkaoui

1.

2.

Often the lack of impact is attributed to basic methodological weakness in the research. Or, the prescriptions offered are based on explicit or implicit objectives that frequently differ from writers. Not only are the researchers unable to agree on the objectives of financial statements, but they also disagree over the methods of deriving the prescriptions from the objectives.

Classification and Conflicts of Interests

Formulating

the objectives of accounting depends on resolving the conflicts of interests that exist in the information market. More specifically, financial statements result from the interaction of three groups: firms, users and the accounting profession.

Firms

Firms comprise the main party engaged in the accounting process. By their operational, financial and extraordinary (that is, nonoperational) activities, they justify the production of financial statements. Their existence and behaviour produce financial results that are partly measurable by the accounting process. Firms are also the prepares of accounting information.

Users
Users

comprise the second group. The production of accounting information is influenced by their interests and needs. Although it is not possible to compile a complete list of users, the list would include shareholders, financial analysts, creditors and government agencies.

Accounting Profession
The

accounting profession constitutes the third group that may affect the information to be included in financial statements. Accountants act principally as "auditors" in charge of verifying that financial statements conform to generally accepted accounting principles.

The interaction between these three groups may be represented by a Venn diagram
The accounting profession

corporations users

Toward a formulation of the objectives of financial statements

The objectives of financial statements as stated in APB Statement No. 4

1.The

particular objectives of financial statements are to present fairly and in conformity with generally accepted accounting principles, financial position, results of operations, and other changes in financial position.

The general objectives of financial statements are as follows: (a) To provide reliable information about the economic resources and obligations of a business enterprise in order to:

evaluate its strengths and weaknesses; show its financing and investments; evaluate its ability to meet its commitments; show its resource base for growth.

To provide reliable information about changes in net resources resulting from a business enterprise's profit-directed activities in order to: show expected dividend return to investors; (ii)demonstrate the operations ability to pay creditors and suppliers, provide jobs for employees, pay taxes and generate funds for expansion; (iii) provide management with information for planning and control;
(iv)show its long-term profitability.

(c) To provide financial information that can be used to estimate the earnings potential of the firm.

(d) To provide other needed information about changes in economic resources and obligations.
(e) To disclose other information relevant to statement users' needs.

The qualitative objectives of financial accounting are the following:

(a)Relevance, which means selecting the information

most likely to aid users in their economic decisions. Understand-ability, which implies not only that selected information must be intelligible, but also that the users can understand it. Verifiability, which implies that the accounting results may be corroborated by independent measures, using the same measurement methods. Neutrality, which implies that the accounting information is directed toward the common needs of users, rather than the particular needs of specific users.

Timeliness, which implies an early communication of information, to avoid delays in economic decision-making. Comparability, which implies that differences should not be the result of different financial accounting treatments. Completeness, which implies that all the information that "reasonably" fulfills the requirements of the other qualitative objectives should be reported.

Report of the study group on the objectives of financial statements

Methodology used

In response to the criticism of corporate financial reporting and the realization that a conceptual framework of accounting is urgently needed, the Board of Directors of the American Institute of Certified Public Accountants announced the formation of two study groups in April 1971. The study group on the establishment of accounting principles, known as the "Wheat Committee", was charged with the task of improving the standard setting process. Its report resulted in the formation of the Financial Accounting Standards Board (FASB). A second study group, known as the "True blood Committee", was charged with the development of the objectives of financial statements; that is, with determining

1.who needs financial statements; 2.what information they need; 3.how much of the needed information can be provided through accounting; and 4.what framework is required to provide the needed information.

Six objective levels may be derived from the "Trueblood Report":

 The

basic objective of financial statements is to provide information on which to base economic decisions.

2: An objective of financial statements is to serve primarily those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise's activity.

No.

No. 3: An objective of financial statements is to provide information useful to investors and creditors for predicting, comparing, and evaluating potential cash flows to them in terms of amount, timing and related uncertainty.

4: An objective of financial statements is to provide users with information for predicting, comparing and evaluating enterprise earning power.

No.

5: An objective of financial statements is to supply information useful in judging management's ability to utilize enterprise resources effectively in achieving the primary enterprise goal

No.

No. 6: An objective of financial statements is to provide factual and, interpretive information about transactions and other events that is useful for predicting, comparing and evaluating enterprise earning power. Basic underlying assumptions with respect to matters subject to interpretation, evaluation, prediction or estimation should be disclosed.

An objective is to provide a statement of financial position that is useful for predicting, comparing and evaluating enterprise earning power. This statement should provide information concerning enterprise transactions and other events that are part of incomplete earnings cycles. Current values should also be reported when they differ significantly from historical cost. Assets and liabilities should be grouped or segregated by the relative uncertainty of the amount and timing of prospective realization or liquidation.

No. 8: An objective is to provide statement of periodic earnings useful for predicting, comparing and evaluating enterprise earning power. The net result of completed earnings cycles and enterprise activities resulting in recognizable progress toward completion of incomplete cycles should be reported. Changes in the values reflected in successive statements of financial position should also be reported, but separately, since they differ in terms of their certainty of realization.

No. 9: An objective is to provide a statement of financial activities useful for predicting, comparing and evaluating enterprise earning power. This statement should report mainly on factual aspects of enterprise transactions having or expected to have significant cash consequences. This statement should report data that require minimal judgment and interpretation by the preparer.

10: An objective of financial statements is to provide information useful for the predictive process. Financial forecasts should be provided when they will enhance the reliability of users' predictions.

No.

No. 11: An objective of a financial statement for governmental and not-for-profit organizations is to provide information useful for evaluating the effectiveness of the management of resources in achieving the organization's goals that are primarily nonmonetary. Performance measures should be expressed in terms of the not-forprofit organization's goals.

Objective No. 12 adds a socioeconomic dimension to the scope of financial accounting. It recognizes the possible interactions between the private goals of the enterprise and its social goals. There may be reciprocal or direct interactions when the enterprise derives social benefits, such as fire and police protection, in exchange for tax payments or private costs. In the case of direct and reciprocal interactions, therefore, the firm enjoys benefits and incurs costs. Interactions may also be nonreciprocal or indirect

Qualitative characteristics of reporting

To satisfy users' needs, information contained in financial statements must possess certain characteristics. The "Trueblood Report" mentions seven qualitative characteristics of reporting: 1. relevance and materiality; 2. form and substance; 3. reliability; 4. freedom from bias; 5. comparability; 6. consistency; and 7. understand-ability.

The nature of a conceptual framework

A conceptual framework is a constitution, 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 . The objectives identify the goals and the purposes of accounting.

The fundamentals are the underlying concepts of accounting concepts that guide the selection of events to be accounted for, the measurement of those events and the means of summarizing and communicating to interested parties. Concepts of that type are fundamental in the sense that other concepts flow from them and repeated references to them will be necessary in establishing, interpreting and applying accounting and reporting standards.

Conceptual framework issues

Before

starting effective work on the conceptual framework, the FASB attempted to identify the most important conceptual issues of concern to standard-setting. Nine issues were presented for discussion and resolution.

Issue 1: Which view of earnings should be adopted?

Three

distinct views about measuring earnings are identified:

the

asset/liability view; the revenue/expense view; the non-articulated view.

Issues 2-7: Definitions

Definitions of each element of financial statements may be provided by both the asset/liability view and the revenue/expense view.

According to the asset/liability view, assets are the economic resources of a firm; they represent future benefits that are expected to result directly or indirectly in a net cash inflow. Alternatively, we may exclude from the definition of "assets" economic resources that do not have the characteristics of exchangeability or sever ability. In either case, based on the asset/liability view, assets are restricted to representations of economic resources of the firm.

The economic resources of the firm are: 1. 2. 3. 4. 5. 6. productive resources of the enterprise; contractual rights to productive resources; products; money; claims to receive money; ownership interests in other enterprises.

Revenues and expenses:

According to the asset/liability view, revenues, which encompass gains and losses, are defined as increases in the assets or decreases in the liabilities that do not affect capital. Similarly, expenses, which encompass gains and losses, are defined as decreases in the assets or increases in the liabilities arising from the use of economic resources and services during a given period.

Gains and losses:

According to the asset/liability view, gains are defined as increases in net assets other than increases from revenues or from changes in capital. Similarly, losses are defined as decreases in net assets other than decreases from expenses or from changes in capital. Thus, gains and losses constitute that part of earnings not explained by revenues and expenses.

Relationships between earnings and the component of earnings:

Three major relationships exist between earnings and the component of earnings:

(a)Earnings = Revenues - Expenses + Gains Losses (b) Earnings = Revenues Expenses (c) Earnings = Revenues (including gains) Expenses (including losses)

Accrual accounting:
Accrual

is the accounting process of recognising non-cash events and circumstances as they occur, specifically, accrual entails recognizing revenues and related increases in assets and expenses and related increases in liabilities for amounts expected to be received or paid, usually in cash, in the future ...

Deferral is the accounting process of_ recognizing a liability for a current cash receipt or an asset for a current cash payment (or current incurrence of a liability) with an expected future impact on revenues and expenses ... Allocation is the accounting process of assigning or distributing an amount according to a plan or a formula. It is a broader term than "amortization", that is, amortization is an allocation process ...

Amortization is the accounting process of systematically reducing an amount by periodic payments, or write-downs ...

Realization is the process of converting noncash resources and rights into money; it is most precisely used in accounting and financial reporting to refer to sales of assets for cash or claims of cash. The related terms, "realized" and "unrealised", therefore identify revenues or gains and losses on assets sold and unsold, respectively ...

Recognition is the process of formally recording or incorporating an item in the accounts and financial statements of an enterprise. Thus, an element may be recognized (recorded) or unrecognised (unrecorded). "Realization" and "recognition" are not used synonymously, as they sometimes are in the accounting and financial literature?'

Issue 8: Which capital maintenance or cost recovery concepts should be adopted?

The concept of capital maintenance allows us to make a distinction between the return on capital or earnings and the return of capital or cost recovery. Earnings follow from recovery or maintenance of capital. Two concepts of capital maintenance exist:

the financial capital concept, and the physical capital concept.

Both concepts use measurements in terms of units of money or units of the same general purchasing power

Concepts of Capital Maintenance:

1. financial capital measured in units of money; 2. financial capital measured in units of the same general purchasing power; 3. physical capital measured in units of money; 4. physical capital measured in units of the same general purchasing power

Issue 9: Which measurement method should be adopted?

The

issue of measurement method concerns the determination of both the unit of measure and the attribute to be measured. As far as the unit of measure is concerned, the choice is between actual dollars and general purchasing power adjusted dollars.

As far as the particular attribute to be measured is concerned, we have five options: 1. historical cost method; 2. current cost; 3. current exit value; 4. expected exit value; and 5. present value of expected cash flows.

The objectives of financial reporting

Financial

reporting includes not only financial statements but also other means of communicating information that relates, directly or indirectly, to the information provided by the accounting system - that is, information about an enterprise's resources, obligations, earnings, etc.

The objectives of financial reporting are summarized in the following excerpts from the statements: Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.

The Statement Also Points Out That:

Financial reporting is not an end in itself, but is intended to provide information that is useful in making business and economic decisions. The objectives of financial reporting are not immutable - they are affected by the economic, legal, political, and social environment in which financial reporting takes place. The objectives are also affected by the characteristics and limitations of the kind of information that financial reporting can provide.

The objectives in this statement are those of general-purpose external financial reporting by business enterprises. The terms "investor"' and "creditor" are used broadly, and apply not only to those who have or contemplate having a claim to enterprise resources, but also those who advise or represent them. Although investment and credit decisions reflect investors' and creditors' expectations about future enterprise performance, such expectations are commonly based, at least partly, on evaluations of past enterprise performance.

Fundamental concepts

The fundamental concepts include both qualitative characteristics of accounting information and the definitions of the elements of financial statements. The FASB issued Statement of Financial Accounting Concepts No. 2, "Qualitative Characteristics of Accounting Information", to provide criteria for choosing between: 1. alternative accounting and reporting methods; and 2. disclosure requirements.

Recognition and measurement

The recognition criteria include: Definition: The item meets the definition of an element of financial statements. Measurability: It has a relevant attribute measurable with sufficient reliability. Relevance: The information about it is capable of making a difference in user decisions. Reliability: The information is representational, faithful, verifiable and neutral.

The Corporate Report

In 1975, the Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales published The Corporate Report,

a discussion paper intended as a- first step toward a major review of users, purposes and methods of modern financial reporting in the United Kingdom. The report presented the efforts of an eleven member party, working within the following frame of reference:

The purpose of this study is to re-examine the scope and aims of published financial reports in the light of modern needs and conditions.

 It

will be concerned with the public accountability of economic entities of all kinds, but especially of business enterprises. It will seek to establish a set of working concepts as a basis for financial reporting. Its aims will be to identify the persons or groups for whom published financial reports should be prepared, and the information appropriate to their interests.

 It

will consider the most suitable means of measuring and reporting the economic position, performance, and prospects of undertakings for the purposes and persons identified above.' How well the report lives up to its stated aims is evidenced by its major findings and recommendations

The "Stamp Report"

The Canadian Institute of Chartered Accountants (CICA) published a research study in June 1980 entitled Corporate

Reporting: Its Future Evolution, written by professor Edward Stamp The main motivations behind this effort were,
first,

the FASB conceptual framework is not suitable for Canada, given the environmental, historical, political and legal differences between the United States and Canada;

 and

second, the framework will provide a Canadian solution to the problem of improving the quality of corporate financial accounting standards

 The
It

approach advocated in the "Stamp Report" is evolutionary.

identifies problems and conceptual issues and provides solutions in terms of the identification of the objectives of
corporate financial reporting, the users of corporate reports, the nature of the users' needs and the criteria for the assessment of the quality of standards and of corporate accountability as the possible components of a Canadian conceptual framework.

Problems faced by standard-setters

The "Stamp Report" begins with an examination of some of the problems accounting standard-setters have to face:

How is economic reality to be measured in an unambiguous manner? What is the nature of accounting, since the question of how best to develop accounting standards rests on it? Are there permanent and universal concepts on which financial reporting and accounting standards rest? Who are the users, what kind of decisions are they up to make as the result of reading an annual report and what kind of information will they be looking for in the report on which to base these decisions?

Conceptual issues in standard-setting

In

addition, Stamp has identified some complex conceptual issues that accountants must face in formulating their standards:
Allocation

problems Income problems Reporting focus Capital-maintenance concepts Assets-valuation base Economic reality

The objectives of corporate financial reporting

The first major objective concerns accountability The second major objective concerns uncertainty and risk. Although it is impossible to eliminate uncertainty and risk,it is an objective of good financial reporting to provide such information in such a form as to minimize uncertainty about validity of the information, and to enable the user to make his or her own assessment of the risks associated with the enterprise.

 The

third major objective concerns change and innovation The fourth major objective concerns complexity and the unsophisticated user.
The

objectives of financial reporting should be taken to be directed towards the needs of users who are capable of comprehending a complete (and necessarily sophisticated) set of financial statements

Users of corporate reports

The range of Canadian users includes the following fifteen categories: shareholders (present and potential); long-term creditors (present and potential); short-term creditors (present and potential); analyst and advisers serving the above (present); employees (past, present and potential); non-executive directors (present and potential); customers (past, present and potential);

suppliers (present and potential); industry groups (present); labour unions (present); governmental departments and ministers (present); the public (present); regulatory agencies (present); other companies, both domestic and foreign (present); and standard-setters and academic researchers (present).

Users' needs

After the types of users are determined, the next step is to determine their informational needs. This task is complicated by the difficulties of determining the users' decision models. The "Stamp Report" emphasized that one of the most difficult problems in developing accounting standards arises from our ignorance about the nature of users' decisionmaking processes and about the rational (and often irrational) mental processes that users go through in reaching their decisions.

User Categories

assessing performance; assessing management quality; estimating future prospects; assessing financial strength and stability; assessing solvency; assessing liquidity; assessing risk and uncertainty;

aiding resource allocation; making comparisons; making valuation decisions; assessing adaptability; determining compliance with the law or regulations; and assessing contributions to society.

Discussion and conclusions

Logically,

the formulation of an accounting theory entails a sequential process that begins with the development of the objectives of financial statements and ends with the derivation of a conceptual framework or constitution to be used as a guide to accounting techniques.

The FASB's conceptual framework was by far the most advanced project in the creation of an accounting constitution. Its major benefit was to facilitate the resolution of conceptual disputes in the standard setting process.

To be effective, this constitution would have to gain general acceptance, represent collective behaviour and protect the public interest in areas in which it is affected by financial reporting.

Could this be achieved? Several issues would have to be resolved before this question could be adequately answered.