1. . 2-1 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Chapter 2 The Conceptual Framework of Accounting and its relevance to financial reporting

2. . 2-2 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Objectives of this lecture Understand the role of a conceptual framework of accounting Be able to define the elements of financial reporting Be able to explain the recognition criteria of the elements of accounting Be able to explain the meaning of ‘reporting entity’ Understand the objectives of general purpose financial reporting Understand the desirable qualitative characteristics that financial information should possess Be able to critically evaluate the existing conceptual framework

3. . 2-3 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Conceptual Framework (CF)—an introduction Initially we had an Australian Framework developed by the AASB Adoption of IFRSs required us to also adopt the conceptual framework developed by the IASB It was generally accepted, however, that the Australian Conceptual Framework was more robust than the IASB Framework—although work is currently being undertaken to further develop the IASB Framework

4. . Conceptual Framework (CF)—an introduction (cont.) CFs prescribe the nature, function and limits of financial accounting and reporting Central goal in establishing a CF is general consensus on: –scope and objectives of financial reporting –qualitative characteristics that financial information should possess –elements of financial reporting 2-4 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

5. . 2-5 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Benefits of a Conceptual Framework Accounting standards would be more consistent and logical because they are developed from a clearly developed set of concepts Increased international comparability of financial information Should result in the Boards (e.g. IASB, AASB) being more accountable for their standard-setting decisions Enhanced process of communication between the Boards and constituents More economical accounting standard development

6. . 2-6 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Current initiatives to develop a revised conceptual framework In Australia we are using the IASB Framework In the United States they have their own conceptual framework (they have not adopted either IFRSs or the IASB Framework) Both the IASB and the US Conceptual Frameworks are considered to have shortcomings As a result, the IASB and FASB are jointly developing a revised conceptual framework A revised conceptual framework is also necessary because of the joint efforts of the IASB and FASB to converge their accounting standards—with uniform accounting standards there is also a need to have a uniform conceptual framework The discussion that follows will relate to the existing IASB Framework, but it needs to be appreciated that this framework will be replaced in the near future (as will many accounting standards!)

7. . 2-7 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Structure of the Conceptual Framework Until 2004, four Statements of Accounting Concepts (SACs) were issued From 2005 we no longer used the entire conceptual framework that was developed in Australia –SAC3 and SAC4 were replaced by the ‘Framework for the Preparation and Presentation of Financial Statements’ (released July 2004)—in Australia known as the AASB Framework –SAC1 and SAC2 to be temporarily retained but their requirements expected to be incorporated in a later document

8. . 2-8 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Structure of the CF (cont.) It would appear that the Framework must be adhered to by preparers of GPFSs. As paragraph 11 of AASB 108 states: In making the judgement described in paragraph 10, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Australian Accounting Standards dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework. The development of a conceptual framework is based upon a number of building blocks which need to be developed in sequence—see the next slide

9. . 2-9 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Components of CF

10. . 2-10 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Consideration of the building blocks of a CF The first matter to be addressed is the definition of financial reporting. Unless there is some agreement on this it would be difficult to construct a framework for financial reporting Having determined what ‘financial reporting’ means, we then turn our attention to the subject of financial reporting— specifically which entities are required to produce general- purpose financial statements, and the likely characteristics of the users of these statements Then we look at the objective of financial reporting Once we have determined the objective of financial reporting, the next step is to determine the basic underlying assumptions and qualitative characteristics of financial information necessary to achieve the stated objective We can then define the elements of financial reporting, their respective recognition criteria, and the basis of measurement

11. . 2-11 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e What are general-purpose financial statements and reporting entities? SAC1—Definition of the Reporting Entity Defines general-purpose financial statements (GPFSs) –Financial statements intended to meet the information needs common to users who are unable to command the preparation of reports tailored to their specific needs

12. . What are general-purpose financial statements and reporting entities? (cont.) SAC1—Definition of the Reporting Entity (cont.) –GPFSs to be produced by entities who have users who cannot command the preparation of specific information  Such entities are deemed to be ‘reporting entities’  If an entity is not deemed to be a ‘reporting entity’ it will not be required to produce GPFRs—and not necessarily be required to comply with all accounting standards 2-12 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

13. . 2-13 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Reporting entities Factors that may indicate that an entity is a ‘reporting entity’ include: –separation of management from those with an economic interest in the entity –economic or political importance/influence Financial characteristics of an entity –amount of sales –value of assets –extent of indebtedness –number of customers –number of employees

14. . Reporting entities (cont.) Small proprietary companies are frequently not considered to be reporting entities—it is assumed that most people who require financial information about the entity will be in a position to specifically demand it We must understand the implications of being deemed to be a reporting entity—if an entity is deemed to be a reporting entity then it is expected to provide financial statements in accordance with accounting standards 2-14 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

15. . 2-15 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Objectives of GPFSs SAC2—Objective of GPFSs To provide relevant and reliable information to assist users to make and evaluate decisions about the allocation of scarce resources and to allow management and governing bodies to discharge their accountability The rest of the framework is developed around this objective. Do we believe this is a good objective? If we dismiss this objective then we might be inclined to dismiss the balance of the framework The objective above refers to ‘users’ … but who are perceived to be the users of GPFSs?

16. . 2-16 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e The users of financial statements If conceptual frameworks are designed to meet the ‘information needs of a wide range of users’, they need to identify potential users and their main information needs The definition of users provided in the AASB Framework encompasses investors, employees, lenders, suppliers, customers, government agencies and the public (although the AASB Framework does embrace the assumption that information designed to meet the needs of investors will usually meet the needs of other groups) The AASB Framework has also embraced the assumption that ‘users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence’. What do we think are some of the implications of the above definition of users and the assumptions about their accounting expertise?

17. . 2-17 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Qualitative characteristics of financial information The AASB Framework identifies the characteristics of financial information necessary to allow users to make and evaluate decisions about the allocation of scarce resources Four principal characteristics of financial reporting are identified in AASB Framework: 1.understandability 2.relevance 3.reliability 4.comparability

18. . 2-18 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Qualitative characteristics (cont.) Understandability –To whom? What is the expectation about accounting proficiency? (as already indicated the assumption is that users have a reasonable level of business and accounting knowledge) Relevance –Something is deemed relevant if the information influences decisions about the allocation of scarce resources –Consider relationship to concept of ‘materiality’ (materiality thresholds considered shortly). Materiality is a threshold concept in that if something is potentially relevant, but is deemed to be immaterial, then disclosure is not necessary

19. . Qualitative characteristics (cont.) Reliability –Faithfully represents the entity’s transactions and events –Free from bias –Free from undue error Comparability Ideally, information should be comparable across time and across organisations 2-19 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

20. . 2-20 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Qualitative characteristics (cont.) As noted, relevant and reliable information is also subject to the test of materiality –Something is ‘material’ if its omission, misstatement or non- disclosure can affect economic decision making (AASB Framework, par. 30) –Above definition of materiality is consistent with AASB 1031 ‘Materiality’ –Tests for materiality provided in AASB 1031 (par. 13)

21. . Qualitative characteristics (cont.) Relevant and reliable information also subject to materiality test (cont.) –Guidelines for materiality—in determining whether an item, or an aggregate of items, is material then:  An amount equal to or greater than 10% of the appropriate base amount is considered material  An item that is equal to or less than 5% of the appropriate base amount is not considered material  Between 5 and 10%—grey area where professional judgment required 2-21 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

22. . 2-22 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Relevance versus reliability Is one more important than the other? Is there a trade-off between the two?

23. . 2-23 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements of accounting Five elements of accounting are defined in the AASB Framework –assets –liabilities –equity –expenses –income

24. . 2-24 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of assets Assets are defined as (AASB Framework, par. 49): –a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity Three key characteristics of the definition: 1.There must be future economic benefits 2.The reporting entity must control the future economic benefits 3.The transaction or other event giving rise to the control must have occurred

25. . 2-25 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of assets (cont.) An asset is to be recognised in the financial statements if (AASB Framework. par. 83): –it is probable that any future economic benefit associated with the asset will flow to or from the entity; and –the item has a cost or value that can be measured with reliability

26. . Elements (cont.) Definition and recognition of assets (cont.) ‘Probable’ is not defined in AASB Framework but ‘probable’ is generally considered to mean ‘more likely rather than less likely’ If an asset or other element fails to meet the recognition criteria in one period but satisfies them in another period, the asset can be reinstated (subject to requirements in particular accounting standards)—AASB Framework (par. 87) 2-26 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

27. . 2-27 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of liabilities Liabilities defined as (AASB Framework, par. 49): –a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits There are three main characteristics 1.There must be a future disposition or sacrifice of economic benefits to other entities 2.It must be a present obligation 3.A past transaction or other event must have created the obligation

28. . 2-28 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of liabilities (cont.) Recognition in financial statements consistent with those of assets—AASB Framework (par. 91) –a liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably Where a liability cannot be reliably measured but is potentially material, the liability should be disclosed within the notes to the financial statements

29. . 2-29 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Liabilities do not necessarily need to be ‘legally enforceable’ An essential characteristic of a liability is that the entity has a present obligation. Obligations can be legally enforceable However, obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner Hence the liabilities that appear within an entity’s statement of financial position might include obligations that are legally enforceable as well obligations that are deemed to be equitable or constructive An equitable obligation is governed by social or moral sanctions or custom rather than legal sanctions. A constructive obligation is created, inferred or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government So … don’t assume that all liabilities shown in a statement of financial position (balance sheet) are legally enforceable

30. . 2-30 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Liabilities do not necessarily need to be ‘legally enforceable’ (cont.) Whilst legal enforceability is not a prerequisite for liability recognition under the AASB Framework it is interesting to note that as part of the work being done on a revised conceptual framework, the IASB and FASB in 2008 suggested a revised definition of liabilities, this being ‘a present economic obligation that is enforceable against the entity’. While the above definition might not ultimately be adopted … if it is then it might have significant implications for reported liabilities in the future.

31. . 2-31 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Contingent liabilities What is a contingent liability and how is it different from a liability? How would we disclose contingent liabilities?

32. . 2-32 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements of accounting (cont.) Definition and recognition of expenses The definition is dependent upon the definitions of ‘assets’ and ‘liabilities’ Expenses are defined as (AASB Framework, par. 70): –decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to equity participants Usual tests of probability and measurability apply

33. . 2-33 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of expenses (cont.) Expenses are recognised in the statement of comprehensive income when (AASB Framework, par. 94): –a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen that can be measured reliably If a resource is used up or damaged by an entity but that entity does not control the resource (not an asset of the entity), to the extent that no liabilities or fines are imposed, no expenses will be recorded by the entity

34. . 2-34 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of income Again, the definition is dependent on those of ‘assets’ and ‘liabilities’ Income defined as (AASB Framework, par. 70): –increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants

35. . 2-35 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of income (cont.) Income can be recognised in the financial statements when: –it is probable that the inflow or other enhancement or saving in outflows has occurred; and –the inflow or other enhancement or saving in outflows of economic benefits can be measured reliably

36. . 2-36 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition and recognition of income (cont.) ‘Revenues’ and ‘gains’ distinguished between in AASB Framework –Revenue arises in the course of the ordinary activities of an entity and includes: sales, fees, interest, dividends, royalties, and rent –Gains represent other items that meet the definition of income and might or might not arise in the ordinary activities of an entity, e.g. disposal of non-current assets –Some professional judgment is required to determine whether a component of income should be classified as revenue or a gain

37. . 2-37 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Elements (cont.) Definition of equity (AASB Framework, par. 49): –residual interest in the assets of the entity after deducting all of its liabilities Directly a function of the definitions given to assets and liabilities No need for separate recognition criteria for equity

38. . 2-38 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Measurement principles Conceptual frameworks have provided little guidance in relation to measurement issues We currently have a multitude of measurement bases for assets and liabilities Do we think it is conceptually valid to have different measurement bases for different classes of assets and liabilities?

39. . 2-39 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Implications of convergence with IFRSs for our Conceptual Framework Standards issued by IASB are developed to be consistent with the IASB Framework As we are embracing IASB standards, we must adopt the IASB Framework IASB Framework has no equivalent for SAC1 or SAC2 AASB retained (for the time being), SAC1 and SAC2 IASB Framework adopts definition of ‘reporting enterprise’—a narrower definition than that of ‘reporting entity’ The Framework is currently in a period of redevelopment so more changes to be expected

40. . 2-40 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Critical review of conceptual frameworks Objective of GPFRs in SAC2 implies that reports should be primarily economic in focus –Should social issues be ignored in the annual report? An individual's view of business responsibilities directly impacts on perceptions of accountability In determining whether or not an entity is a reporting entity, should the need for information to enable informed ‘resource allocation decisions’ be the only or dominant consideration?

41. . 2-41 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Critical review of conceptual frameworks (cont.) Economic focus of GPFSs ignores transactions or events not resulting from market transactions or an exchange of property rights Ignores environmental externalities caused by business Financial statements included within reports reflect only financial performance and do not provide a means of assessing social or environmental performance

42. . 2-42 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Critical review of conceptual frameworks (cont.) Financial press also generally use financial indicators as a guide to a firm’s success It has also been argued that: Conceptual frameworks simply codify existing practice and therefore provide little hope for improving financial reporting Conceptual frameworks have been used as devices to legitimise the existence of the accounting profession