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Type:

Solution Manual

Resource:

Contemporary Issues in Accounting

Edition:

1st Edition

Author(s):

Michaela Rankin Patricia Stanton Susan McGowan Kimberly Ferlauto Matthew Tilling

Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Sue McGowan

Chapter 1: Contemporary Issues in Accounting

CHAPTER 1 CONTEMPORARY ISSUES IN ACCOUNTING Contemporary issue 1.1 Abstracts from critical accounting research

1. In each of these abstracts the notion of true or fair accounting or financial statements is considered. Identify any requirements in accounting standards or corporations legislation that relate to the truth or fairness of financial statements or reports. (K) The accounting standards require that the financial statements provide a fair presentation and state: Financial statements shall present fairly the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. (IAS 1/AASB 101, para 15). (It should be noted that the concept of faithful presentation and whether there can be a true and fair view is contested and this is discussed in Chapter 2).

In Australia Corporations Law, S297, requires that :

The financial statements and notes for a financial year must give a true and fair view of: (a) the financial position and performance of the company, registered scheme or disclosing entity; and (b) if consolidated financial statements are required--the financial position and performance of the consolidated entity. This section does not affect the obligation under section 296 for a financial report to comply with accounting standards. Note: If the financial statements and notes prepared in compliance with the accounting standards would not give a true and fair view, additional information must be included in the notes to the financial statements under paragraph 295(3)(c).

There is similar legislation in many countries.

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Solution manual to accompany: Contemporary Issues in Accounting

2. Can you think of reasons why there could be claims that financial statements that are prepared in accordance with accounting standards are not true or fair? (J, K, SM) The assumption made in the standards is that compliance with accounting standards will, expect in rare cases, result in a true and fair view. Reasons for considering that financial statements prepared in accordance with accounting standards may not present a true and fair view could include: • Some accounting standards do not allow professional judgment and have set rules, regardless of whether these rules reflect the substance. For example, in current leasing standards treat no assets or liabilities are disclosed for operating leases despite the fact that most of these leases would meet the definition and recognition criteria for such elements under the conceptual framework (Note: this deficiency is acknowledged and it is intended that this standard be revised). Another example is that internally generated intangible assets (such as goodwill, brands) are not permitted to be recognised under current standards, yet these may be valuable assets to an entity. •

From a critical perspective, the limitations of information provided by accounting render these statements incomplete and biased, toward financially measurable elements, and so would not be considered true and fair (see answer to 3 below)

Students may identify further reasons. 3. The first extract states that current accounting “may disenfranchise those parties to the dispute whose issues are not readily expressed in the common vocabulary of business’. What do you think the author means by ‘the common vocabulary of business’? Given this, what type of issues may not be included in accounting reports/statements and how could their exclusion impact on decision making? (J, AS) • The common vocabulary of business here would refer to monetary or dollars values (so financially measurable elements). This is also normally restricted to ‘direct’ and measurable costs and benefits (so other factors, eg: externalities such as pollution or employee satisfaction/morale are not included unless directs costs associated with these). Further, the prime objective of business is ‘profit’ and this profit orientation is reflected in what is included and how measured and gives primacy to economic factors/issues and often short term outcomes. • A few of the issues not included would be social justice, environmental concerns, and

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Chapter 1: Contemporary Issues in Accounting

social equity issues. Typically decision making frameworks suggest that decision makers should take into account both qualitative and quantitative factors. However if the variable /factors considered are restricted to those in the financial statements this will effectively exclude most qualitative factors. A quote by John F Kennedy (although this is in the context of gross national product, this illustrates the limitations of quantitative information and hence can be extrapolated to accounting issues) Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armoured cars for the police to fight the riots in our cities. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children. Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile. (Robert F. Kennedy, University of Kansas, March 18, 1968)

Review questions 1. Define what is meant by ‘theory’ and explain how theory is useful. Do you think theory needs to be considered in financial accounting? There is no simple definition of ‘theory’ and in usage it is simply an opinion or explanation. Macquarie dictionary definition states that ‘theory’ is:

1. a coherent group of general propositions used as principles of explanation for a class of phenomena 2. a proposed explanation whose status is still conjectural, in contrast to well-established propositions that are regarded as reporting matters of actual fact 3. a body of principles, theorems, or the like, belonging to one subject 4. distinguished from the practice of it

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Solution manual to accompany: Contemporary Issues in Accounting

5. a particular conception or view something to be done or of the method of doing it; a systems of rules or principles 6. conjecture or opinion.

A theory may well be born in the human mind, and for it to be useful it must relate to the ‘real’ world. Theory needs to be considered in financial accounting to reflect the decisionmaking behaviour of managers and investors, company policies, political activity or professionalism of accountants. Accounting theory definition therefore means as stated by Henderson et al. 2004 p. 4 ‘a description, explanation or a prediction [of accounting practice based] on observations and/or logical reasoning’…‘Logical reasons in the form of a set of broad principles that (1) provide a general framework of reference by which practice can be evaluated and (2) guide the development of new practice and procedures’

Students should discuss how theory can help in accounting. Theories can: •

describing and explaining current accounting practices.

•

predicting accounting practice.

•

providing principles to take into account when taking action or making decisions.

•

help to identify problems and deficiencies with current accounting practice and improve accounting practice.

Examples are that a theory of accounting can: a. provide a basis for action: for example, a theory of capital budgeting helps us with choosing among investments; a theory of revenue recognition helps to determine when and how revenue should be recognised; a theory of lease accounting helps with accounting for leases b. reveal deficiencies in practice: a theory of profit determination might reveal deficiencies in the way we presently measure profit c. improve practice: understanding deficiencies may promote change; understanding the behaviour of decision makers may help us to supply better information

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Chapter 1: Contemporary Issues in Accounting

help with accounting standard setting; the conceptual framework is used as a basis for drafting accounting standards.

2. Explain what is meant by positive theory.

Positive accounting theory can: •

Describe what is actually happening

•

Explain what is happening

Positive theories are concerned with ‘what is’ and should relate to the facts or the real world through hypotheses. For example, there may be a theory about how individuals or groups actually use accounting information and this would result in predictions (hypothesis) about how we would expect information to be used by particular individuals/groups. The hypothesis is usually to test the theory. Many positive theories are generally concerned with predicting how accounting information is used in economic decision-making and often referred to as ‘empirical’ theories. In the main positive theories are developed from observation through the process of induction and deduction.

3. Explain what is meant by normative theory. Normative accounting theory is concerned with ‘what should’ be done or ‘what ought to be’ as they prescribe. Prescriptions or recommendations of these theories aim to achieve some goal or objective. The normative theories deal essentially with measurement and are based on classic economic concepts, especially those of income, wealth and rational decision-making.

The conceptual framework is a normative theory. It prescribes the basic principles that are to be followed in preparing financial statements. Hence an accounting conceptual framework can be described as ‘A coherent system of concepts that underlie financial reporting’. Please note that normative does not mean devoid of any empirical base — normative theories will use empirical theories/observations as assumptions from which prescriptions are deduced.

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Solution manual to accompany: Contemporary Issues in Accounting

4. Explain what is meant by induction and deduction.

Induction is the process of inferring general principles from particular instances; it is the process of moving from the specific observations (particular instances) to a general theory or conclusion.

Deduction is from the general to specific statement; it is the process of reaching a conclusion about particular instances from general principles.

The illustration explains:

Inductive

Theory

(specific > general)

Deductive (general > specific)

The inductive–deductive cycle is a common way in which researchers work and in which positive theories emerge. This is often referred to as the scientific method and is the common way in which positive theories emerge. An example of the inductive-deductive cycle is below:

1. *Identify the research problem by observation (induction)

Theory development 2. Develop theoretical framework to resolve the problem (deduction). 3. Specific hypothesis to be tested 4. Construct the research design

Use of Observation Observe via sampling and gathering data 5. Analyse the observations 6. Evaluate the results — are these consistent with the hypothesis of the theoretical framework that has been developed 7. Assess any limitations

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Chapter 1: Contemporary Issues in Accounting

1. Identify (induction) 2. Develop (deduction) 3. State Hypothesis 4. Research design 5. Observe

6. Analyse

7. Evaluate

8. Limitations

5. It has been stated that ‘many people accept theories without justification’. Identify reasons people may accept theories. Provide examples of theories that you accept or believe although you may not have direct knowledge in the area.

Students may identify various theories that they accept but have no expert or direct knowledge of: e.g. theories re global warming, theories on punishment (e.g. that deters crime), theories on black holes in space; theories on causes of diseases (such as genetic depositions).

For many theories that a person considers, that particular individual may not have an in-depth knowledge of the area relating to the theory. For example, I believe that the world is not flat and that in fact the theory that the world is round is true. However, I am not a scientist; I have not studied detailed evidence about this theory in any scientific or systematic manner, so what makes me accept this theory, or other theories that are not in my area of expertise.

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Solution manual to accompany: Contemporary Issues in Accounting

People accept theories everyday that they may not fully understand (such as theories of global warming; the theory of relativity; theories about how certain diseases are spread). There are a number of reasons why we may accept theories without ‘first–hand’ or direct knowledge, these include: 1.

The authority of the source of the theory If the theory comes from a source perceived as having specific knowledge and expertise then we may defer to their superior experience and wisdom. If the ‘experts’ in the area say it is true then we are more likely to believe it is true, particularly when the expert provides evidence to support the theory. Statements and theories from eminent scientists or researchers in an area, by teachers (such as university lecturers), from textbooks, even from media sources (such as television and newspapers) are often viewed as authoritative. We are willing to often accept a theory as correct due to who or where the information about the theory comes from (they wouldn’t say it if it isn’t true would they?).

It ‘fits’ with our own experience We are also more willing to accept a theory if the theory matches our own experiences and observations. The theory that the earth is not flat and is in fact round agrees with my own observations of the slightly curved horizon, and the sun setting so I am willing to accept this theory.

It makes sense If a theory seems reasonable and sensible we will often accept it. ‘If a man is offered a fact that goes against his instincts, he will scrutinize it closely, and unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is offered something which affords a reason for acting in accordance to his instincts, he will accept it even on the slightest evidence. (Bertrand Russell).

For example, there are various debates about how much alcohol is safe to drink and that one or two drinks a day may actually be of benefit to a persons health. Many people would believe this is reasonable and further it may fit with their own preference to drink alcohol so would accept this.

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Chapter 1: Contemporary Issues in Accounting

Perceived level of general acceptance A key influence on many people’s beliefs is what other people believe. If a theory appears to be accepted by many people, particularly if it is repeated. For example, if a poll shows that 82% of people believe that introducing gun controls will reduce violent crime, you may be more likely to accept this. This appeal to general acceptance is often used in advertising and political campaigns, such as ‘3 million Frenchmen can’t be wrong. Buy a Renault’. Of course, just because most people believe something does not make it true. As we noted earlier, many people believed the world was flat but this did not mean that the world was in fact flat.

These approaches to accepting theories are intuitive rather than scientific or systematic and given that any individual’s expertise is necessarily limited, provide a practical and rational way of determining whether an individual accepts a specific theory.

6. Identify a positive theory (this can be about any area; e.g. global warming). Consider how you would test whether this theory was true. Do you think you could prove it?

Recall that a positive theory describes what is happening or explains what is happening. The first step in testing the theory would be to evaluate its logic. Is the theory logical and a valid conclusion given its premises. So for example, there may be a theory about global warming that measures the hole in the ozone layer and links this to changes in average temperatures.

For a positive theory to be able to be tested by observation it must then make a predication that can be tested. For example, if the theory regarding temperature change related to global warming simply predicted that the temperature may change whatever happened, would fit with the theory and this could not really be tested. However if it made a clear prediction — for example, that in 2008 temperatures in a particular region would increase by 1% then we could test this by observing the temperatures in that region. If the observations are not consistent with the predictions of the theory we have established then the theory is incorrect. If the observations ‘fit’ with the theory then we can claim that the theory has not been falsified. It is generally accepted that theories cannot be ‘proved’ correct because of the problem of determining how many ‘correct’ observations are enough to establish the truth of a theory.

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Solution manual to accompany: Contemporary Issues in Accounting

Students should recognise that even well accepted theories (such as Einstein’s theory of the Big Bang) have been later proven wrong when better observations have been able to be made. 7. What is your understanding of the term ‘research’? The Macquarie dictionary states that ‘research’ is:

1. diligent and systematic enquiry or investigation into a subject in order to discover facts or principles 2. to make researches; investigate carefully. 3. to investigate carefully; to research a subject exhaustively 4. of or pertaining to research A view of research taken from FASB’s research and development is:

Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or new process or technique or in bringing about a significant improvement in an existing product or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other ongoing operations even though these alternations may represent improvements and it does not include market research or market testing activities. 1

8. Explain the role of research and how this relates to theory.

Students should firstly understand that research is activity. The relationship to theory depends on the reason for the research being undertaken, the type of research and/or the results/findings of the research. Research can be undertaken before any theory has been formed or considered. The findings of such research could lead to the formation of a theory (either positive or normative). Research can also be used to test theories. For example, you Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 2 ‘Accounting for Research and Development Costs’. Stamford, C.T: FASB, 1974).par 8. 1

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Chapter 1: Contemporary Issues in Accounting

could test the hypothesis of a positive theory and see if the findings match the predictions of the theory. Below some types of research are listed – these are not discussed in the text but may be useful to provide examples to students of research. It may also be useful to have students examine abstracts of academic articles and consider how the research in these relates to theory.

Research may be exploratory, descriptive, investigative, causal or some combination of these (Kent, 2001). Exploratory research aims at finding out whether or not something exists (Dane, 1990, p. 8). As such it is about generating ideas, insights or hypotheses rather than measuring, testing or evaluating those ideas, insights or hypotheses. For example, early research in environmental accounting was aimed at finding out if companies were providing environmental information in their annual reports. Descriptive research is concerned with providing more detail (a more complete picture) about something, and so may involve measuring the sizes, quantities or frequencies of characteristics, but not investigating the relationships between them. For example, research in environmental accounting has investigated the exact nature of the environmental disclosures made by companies by recording the quantities of words included in reports about the environment and the nature and type of environmental information provided. When the research focuses on the extent of association or correlation between two or more variables, the research is investigative. This may often involve predictions (i.e. if one event occurs can predict that another event will occur) although it may not explain the cause of this link or correlation. For example, researchers have investigated the question of what factors are associated with companies that report environmental information and others that do not. Findings in this area have indicated that there appears to be a correlation between the size of a company and the type of industry, and whether it reports environmental information (e.g. that larger companies or companies in more environmentally sensitive industries, such as mining, are more likely to include this type of information in their annual reports).

Causal research extends the investigation by distinguishing between dependent and independent variables, and examines the degree of, and reasons for, the influence of one or more independent variables upon the one or more dependent variables. For example, this may investigate the question as to why (what causes) companies that are large include

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Solution manual to accompany: Contemporary Issues in Accounting

environmental information in their annual reports more often? Researchers have considered that one reason could be to manage the relationships and expectations with stakeholders.

9. Is the following statement correct: ‘Empirical research is only related to positive theories.’? This statement is incorrect. Recall that ‘empirical research’ is defined as ‘research based on observation and experience’. As the text states, this can also be associated with normative theories. As normative theories do not make predictions about what is happening we cannot use observations of the real world (what is happening) to test these theories — normative theories are making recommendations and stating what should happen, not what is happening. However empirical research is often a catalyst for normative theories. For examples, empirical research that identifies the impact that companies have on the environment may lead to a normative theory about requirements for companies to include information about their environmental performance in their annual reports.

10. Research can be classified in several ways. Outline them.

There are 2 broad classifications of accounting research. These are: •

research of or about accounting. This considers the broader role of accounting

•

research in accounting which focuses more on the actual practice of accounting.

In addition research in accounting can be classified into particular areas (although these overlap). The text identifies •

Capital markets research. Capital-market research was undertaken by Ball & Brown (1968) and Beaver (1968) that began the positive research stream. Their studies investigated the use and impact of accounting information by capital markets.

•

Accounting Policy choice research. Accounting policy choice research is commonly known as positive accounting theory for its domination of research which began with Watts & Zimmerman (1978). This research attempted to explain the motivation.

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Chapter 1: Contemporary Issues in Accounting

•

Accounting Information Processing Research. Accounting information processing research investigates the use and users of information in the decision-making process and uses theories and models from psychology.

•

Critical Accounting Research. Critical accounting research considers the role of accounting in society and the social content.

•

International Accounting Research. International accounting research considers the call for uniform accounting standards worldwide and to harmonise financial accounting.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Sue McGowan

John Wiley & Sons Australia, Ltd 2012

Chapter 2: The Conceptual Framework of Financial Reporting

CHAPTER 2 THE CONCEPTUAL FRAMEWORK OF FINANCIAL REPORTING Contemporary Issue 2.1 The usefulness of financial reporting 1. Should information in the financial reports be limited to financial or numerical information? (J)

First it should be noted that the information in the financial statements is supplemented by notes and in these there is non-finical and numerical information, although this could be argued to be restricted primary to explaining the numbers or financial information (so for example, explaining assumptions used , methods of estimations etc.

There are 2 views here: • One view is that the role of accounting is limited in scope to financial issues and, hence,

limited to largely financial information. Recall that the objective of financial reporting is not to provide all information users need but to meet information needs common to the specified users. It could be argued that providing information outside of this realm is not within the scope of financial reporting, by definition, and would also not be within the expertise of preparers. It is necessary to restrict information in these reports to make these comparable, understandable and also auditable. It should be noted, however, that in the annual reports (of which the financial statements and notes are a part) reviews by directors often provide some of this information (often required by corporations law), and many particularly larger companies voluntarily provide non-financial information about environmental and social performance. • As noted in this extract relevant information is not limited to numbers. It could be argued

that given that accounting is about ‘accountability’ the scope and role of accounting should be broadened to reflect the wider accountabilities of corporations in particular, or even that limiting reporting to financial information is not providing the information

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Solution manual to accompany: Contemporary Issues in Accounting

required by decisions makers (users). The examples, provided in the extract: if a technology company hires one of the best minds in the field, would that information be an important factor in making an informed decision about the company’s future economic prospects? Or if a bioengineering company lost its most productive R&D scientist, might that information influence stakeholders’ decisions?- are pertinent ones. Given new technologies and developments (as outlined in the extract) is ‘traditional’ accounting failing its users.

2. What are the difficulties or problems in requiring companies to provide nonfinancial information about, for example, human capital, intangibles, or innovations? (J, K AS)

Students may identify a range of problems or difficulties including: •

If there are no ‘standards;’ concerning such items and their disclosure this could lead to inconsistencies even as to what information should be provided about, as well as level of detail of information. This of course would reduce comparability.

•

How difficult would it be to provide assurance that this information is representationally faithful (i.e. how would you audit this information, particularly in relation to completeness).

•

The incorporeal nature of items such as (for items such as human capital, innovations) necessarily means that in many instances identifying these and deciding on what impact or significance they have or may have is inherently subjective. This could impact on the usefulness of any information provided.

It should be noted that IAS 38/AASB 138, para 128 encourages entities to provide a description of significant intangible assets that have not been recognised as assets due to failing the recognition criteria.

Cleary including as financial information would be problematic: •

Whether these items would meet definition of assets; if not should we introduce new elements into the financial statements

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Chapter 2: The Conceptual Framework of Financial Reporting

•

How would we measure such items? These would be difficult to value (either in attributing costs or future economic benefits)

•

Inclusion of such items may involve subjectively. Could this result in difficulty auditing such information or provide directors or others with opportunities to bias results..

Note: a later chapter in this text discusses issue involved with accounting for intangibles.

Contemporary Issue 2.2 New lease accounting to have big impact 1. Consider the definitions of an asset and liability in the Conceptual Framework. Would a 5-year lease for land meet these definitions? (J, K)

Student should apply the definitions of an asset and a liability from the conceptual framework:

An asset is 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 • Future economic benefits would be the right to use the assets (and the revenue/benefits that you obtain from using the land) • Control would be established as given the contract the lessee can obtain the benefits from using the asset (remember that assets do not need to be owned). • Past event – would be lease contract that gave rise to lessee having right of use of asset and controlling and accessing benefits.

A liability is 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 • The future outflow of economic benefits/resources would be the meeting of lease payments) • Present obligation – under leasing contract would assume have legal obligation to make payments.

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Solution manual to accompany: Contemporary Issues in Accounting

• Past event – would be lease contract that gave rise to obligation.

Note:

The current accounting standard on leases, AASB 117 Leases, overrides the general

recognition criteria for liabilities and requires liabilities in relation to finance leases to be recognised. A finance lease is a lease in which substantially all of the risks and rewards incidental to ownership have been transferred from the lessor (legal owner of the property) to the lessee (one who is using the property) (AASB 117 para 4). Given that land has an indefinite life a 5 year lease of land would be classified as an operating lease and would not give rise to an asset or liability. Under the proposed leasing standard this would change and an asset and a liability would be recognised.

2. The extract discusses the fact that these changes reflect the way in which accounting is moving — that is, towards putting all assets and liabilities on the balance sheet. What reasons could there be for this move? Given the identified impact on key company ratios, do you believe this approach is justified? (J)

Reasons towards the move towards putting all assets and liabilities on the balance sheet would be: • Based on principles & objectives of financial reporting: To be consistent with the conceptual framework all items that meet the definition and recognition criteria of assets and liabilities should be included on the balance sheet. Also to be complete and so representationally faithful would argue that need to include all elements. Surely information about the assets and liabilities of an entity would be relevant to users. • Improves comparability as does not distinguish on form or arbitrary rules but reflects economic substance. For example, under current lease accounting 2 entities could have identical items of land – one entity owns and one leases (as operating lease). The different accounting treatment would result in one entity including an asset but the leasing one not. This would distort rations such as return on assets etc and make comparison difficult. • Reduces opportunities to structure transactions on order to reflect a particular financial position (this could include maintaining certain ratios).

If all assets and liabilities meeting the

recognition criteria are required to be included on the balance sheet then this limits the ability of entities to choose or plan transactions to avoid including these on their balance sheet or in particular to ‘hide’ obligations/ /commitments.

Under the current leasing arrangements

company may decide to lease land rather than purchase (even those costs and commitments may be relatively equal) as leasing will avoid the recognition of the lease liability and asset. It could be argued that the use of special purpose entities by Enron which were not required to be

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Chapter 2: The Conceptual Framework of Financial Reporting

included on the balance sheet and were used to hide debt is an example of structuring transactions to reflect a particular financial position. Cleary including all assets and liabilities on the balance sheet would impact on key financial ratios. Whilst it could be argued that this could disadvantage some companies (for example, if they are now required to include such assets and liabilities this could mean that they may breach debt covenant ratios and incur costs unless they are able to renegotiate debt terms/covenants). However an alternative argument is that if all assets and liabilities are included then this provides a more complete and representationally faithful view of the financial position and hence the ratios are more ‘accurate’ and useful.

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Solution manual to accompany: Contemporary Issues in Accounting

Review questions 1.

What is a conceptual framework?

A conceptual framework is defined in the text as a set of broad principles that provide the basis for guiding actions or decisions. An accounting conceptual framework can be described as: a coherent system of concepts that underlie financial reporting. As the Conceptual Framework (page 26) states ‘This Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users.’

What is the difference between a conceptual framework and accounting standards?

Essential points relate to: •

The conceptual framework provides high level concepts such as definitions of elements of financial statements, qualitative characteristics, definition of the objective of general purpose financial reporting. Standards apply the concepts in specific situations — for example, accounting for financial instruments, leases and inventory.

•

The standards setters base new accounting standards, and amendments to old, on the conceptual framework.

•

Standards take precedence in the event of conflict as the Conceptual Framework (page 6 notes). In Australia, the Conceptual Framework does not have legal force for reporting entities subject to the Corporations Law; accounting standards do. However, concepts from the conceptual framework are now included in all new and reissued accounting standards. Therefore, application of such embedded concepts is mandatory because these are included in accounting standards.

The differences are illustrated with the following examples.

IAS 1/AASB 101 para 9 outlines information about the purpose and elements included in a financial report:

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Chapter 2: The Conceptual Framework of Financial Reporting

Financial statements are a structured representation of the financial position and financial performance of an entity. The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of the management’s stewardship of the resources entrusted to it. To meet this objective, financial statements provide information about an entity’s: (a) assets; (b) liabilities; (c) equity; (d) income and expenses, including gains and losses; (e) contributions by and distributions to owners in their capacity as owners; and (f) cash flows. This information, along with other information in the notes, assists users of financial statements in predicting the entity’s future cash flows and, in particular, their timing and certainty.

The Conceptual Framework (para. 4.4) provides definitions of basic elements to be included in the statement of financial position such as: (a)

An asset is 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.

Accounting standards provide specific requirements for a particular area of financial reporting. These are required to be complied with via corporations law.

For example: IAS 1/AASB 101 Presentation of Financial Statements specifies that:

particular assets or liabilities must be included on the face of the report itself (such as intangibles).

AASB 102 Inventories (para. 5.2) specifies that:

inventories shall be measured at the lower of cost and net realisable value

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Solution manual to accompany: Contemporary Issues in Accounting

Outline the technical benefits of a conceptual framework. What problems could occur if accounting standards were set without a conceptual framework?

The technical benefits relate to improving how financial reporting works — either though improving quality, or accounting practice, via improving understanding. The Conceptual Framework outlines these under its purpose section (page 6).

(a) to assist the Board in the development of future IFRSs and in its review of existing IFRSs; (b) to assist the Board in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs; (c) to assist national standard-setting bodies in developing national standards; (d) to assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet to form the subject of an IFRS; (e) to assist auditors in forming an opinion on whether financial statements comply with IFRSs; (f) to assist users of financial statements in interpreting the information contained in financial statements prepared in compliance with IFRSs; and (g) to provide those who are interested in the work of the IASB with information about its approach to the formulation of IFRSs.

In the AASB Framework these are listed para. 1 (a) to (g).

The problems that could occur if standards set without a conceptual framework is: • Inconsistencies between standards if different concepts/principles used to develop

different accounting standards • Time frame for developing standards could be longer as would need to debate underlying

principles/concepts each time new standard developed/changed.

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Chapter 2: The Conceptual Framework of Financial Reporting

How can the conceptual framework help users and preparers understand accounting requirements and financial statements?

The conceptual framework can assist users and preparers as: • Accounting standards based on the conceptual framework should be more consistent • Rationale for standards should be apparent as based on underlying concepts which are

explicitly stated in the conceptual framework.

What is the objective of financial reports according to the Conceptual Framework?

Historically, external financial reports were prepared (and required) to ensure minimum information was given to investors to make informed judgements about the performance of management and the security of investments. The need to protect the rights of external users of information, who are not involved in the operations of the company, is the primary justification for the need for external financial reporting. Such reports are used as a source of information for those parties who are planning to transfer resources to an organisation.

The Conceptual Framework outlines the purposes of financial reports:

The objective of general purpose financial reporting* is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. (OB2)

Hence should note: • Objective is to provide information for decision making • Identifies specific decision makers and types of decisions and limits to these.

Students should note that the revised Conceptual Framework: • Restricts users and decisions whereas previously these were much broader • Does not explicitly include in its objectives the discharge of accountability/stewardship.

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Solution manual to accompany: Contemporary Issues in Accounting

How is the decision usefulness approach reflected in the Conceptual Framework?

An essential point to note is that the conceptual framework is based on the decision usefulness approach to accounting theory. The outputs of the accounting system are inputs to user decision processes.

This emphasis is reflected both in the objective of general purpose financial reporting (this is to provide information … that is useful to ... in making decisions) and in the qualitative characteristics.

Paragraph QC1 of the Conceptual Framework defines qualitative characteristics as:

The qualitative characteristics of useful financial information discussed in this chapter identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information).

Although all aim of all of the qualitative characteristics is to ensure that information is useful the one that best reflects the decision–usefulness approach in the conceptual framework is relevance.

The qualitative characteristic, relevance, is one of the qualities that should be reflected in the information provided by general purpose financial reports. Relevance is outlined in the Conceptual Framework (para. QC6) as: Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources.

Paragraph QC7 of the Conceptual Framework states:

Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both.

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Chapter 2: The Conceptual Framework of Financial Reporting

You should see that this has two roles: predictive and confirmatory (or feedback) and that these are interrelated (refer QC8 to 10). Prediction: Part of the definition of relevance focuses on accounting information as an input to user prediction models. Information may help to predict future earnings or cash flows from future dividends, for example.

Confirmation (Feedback): Part of the definition notes that information is also relevant if it plays a feedback or confirmatory role in the decision process.

Most descriptions of decision processes view decision makers as seeking information: • to help predict the future values of variables of interest for a decision, for example future

revenues and future costs. Information plays a predictive role. Information about past events is fed into a decision model to help predict future values of the variables of interest (part (a) of the definition); and • for confirmation or feedback, to help monitor the outcomes of past decisions part (b) of

the definition).

The Conceptual Framework states that ‘general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need’ (para. OB6). What information is not provided and why?

As stated in the Conceptual Framework: IOB6 However, general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks. OB7 General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity. OB8 Individual primary users have different, and possibly conflicting, information needs and desires. The Board, in developing financial reporting standards, will seek to provide the

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Solution manual to accompany: Contemporary Issues in Accounting

information set that will meet the needs of the maximum number of primary users. However, focusing on common information needs does not prevent the reporting entity from including additional information that is most useful to a particular subset of primary users.

There are a number of key limitations and/or omissions to the information provided in the financial reports: • Information on general contextual issues (such as economic conditions) is not included. • Information is limited to common information needs; so is not tailored to individuals or

even individual user groups, which may require information specific to their decisions. • The financial reports do not provide future orientated information. The focus of

information provided in the financial statements is on past performance/position, and while these can be used to make predictions, these in themselves are not future orientated. • Non-financial information is also limited. Although limited non-financial information is

provided, the main information in financial reports is financial. Relevant information is not limited to numbers. For example, if a technology company hires one of the best minds in the field, would that information be an important factor in making an informed decision about the company’s future economic prospects? Or if a bioengineering company lost its most productive R&D scientist, might that information influence stakeholders’ decisions? It should be noted, however, that in the annul reports (of which the financial statements and notes are a part) reviews by directors often provide some of this information (often required by corporations law), and many particularly larger companies voluntarily provide non-financial information about environmental and social performance.

Why is this information not provided? There are alternative views, and also advantages and disadvantages, in providing such information. One view is that the role of accounting is limited in scope to financial issues and, hence, limited to largely financial information. Others would argue that given that accounting is about ‘accountability’ the scope and role of accounting should be broadened to reflect the wider accountabilities of corporations in particular, or even that limiting reporting to financial information is not providing the information required by decisions makers (users).

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Chapter 2: The Conceptual Framework of Financial Reporting

What is the underlying assumption to be applied in preparing financial reports according to the Conceptual Framework? How does this assumption affect the financial report items?

The underlying assumption identified in the Conceptual Framework in the preparation of the financial statements is the going concern basis.

The going concern basis is described in paragraph 4.1 of the Conceptual Framework. The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.

Applying this basis means that a longer term view of economic benefits and outflows can be considered. If this was not used (i.e. it was assumed that a company as at balance date would not be continuing in its operations) this would require assets/liabilities etc. to be measured on a liquidation basis. For many items this would significantly impact on their measurement and even whether they would be recognised at all (for example, prepaid insurance if the company was not continued would be unlikely to provide any future benefits). Of course if this does not apply (i.e. the entity is not a going concern) then as stated, disclosure of this is required and a different basis would normally be appropriate.

Identify the qualitative characteristics of financial information in the Conceptual Framework. How are these related to the objectives of general purpose financial reports?

The Conceptual Framework states that: QC 1. The qualitative characteristics of useful financial information discussed in this chapter identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information).

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Contemporary Issues in Accounting Solutions Manual