AF301

Topic 4
Normative Accounting Theory
The Conceptual Framework
 Reflection
When constructing a building:
 Why is the foundation completed
first?
 What could happen if the
foundation is not built well?
The IASB Conceptual Framework

Effective 1 January 2020

See IAS Plus
If this hyperlink doesn’t work, type the following URL into your web browser
http://www.iasplus.com/en/standards/other/framework
 Learning Outcomes
On successful completion of this unit, you should be able
to:
1. Explain the role of a conceptual framework and its
relationship to accounting standards
2. Critique the objective of general purpose financial
reporting (GPFR)
3. Evaluate qualitative characteristics of useful
information
4. Discuss how the conceptual framework has evolved or
changed over time
5. Evaluate the benefits of a conceptual framework
6. Analyse the limitations of a conceptual framework
LO 1

OVERVIEW
LO 1

Introduction & Role

The conceptual framework is
 a coherent system of interrelated concepts
 providing guidance for all accounting practice

It aims to
1. Reduce inconsistent practices
2. Enable better understanding of reporting requirements

Brief Introduction Video

Debrief by IASB Chairman
LO 1

Main Contents of the Framework

The IASB conceptual framework addresses the
following items
1. Objective of financial reporting
2. Users of financial reports
3. Qualitative characteristics of useful financial
information
4. Elements of financial reporting
 Definition of assets, liabilities, equity, revenue,
expenses
5. Measurement
LO 1

Relationship with Standards

The framework addresses general issues such as:
 why we prepare financial reports
 definition of assets etc.
 These issues apply to all or several standards
 don’t need to be reviewed for every new standard
Standards address issues on disclosure and
measurement of specific items
 e.g. how to measure and disclose specific
categories of assets like PP&E (IAS 16), Intangible
Assets (IAS 38) Inventory (IAS 2), Cash (IAS 7) etc.
LO 2

GPFR
General Purpose
Financial Reporting

OBJECTIVE OF GPFR
LO 2 Para 1.2
Objective of GPFR
Provide financial information about the reporting entity
 that is useful in making decisions about providing
resources to the entity
 emphasis on economic decision-making
Decisions involve
1. Buying, selling or holding equity & debt
instruments
2. Providing or settling loans and other forms of
credit
3. Exercising rights to vote on, or otherwise
influence, management’s actions that affect the
use of the entity’s economic resources
LO 2
Objective of GPFR
1. How about accountability and stewardship?
 Decision usefulness focuses on users but
accountability/stewardship focuses on assessing
managers’ effectiveness & efficiency
 Stewardship is mentioned in the framework text
IASB might say investors can use their votes and influence to
terminate non-performing managers

2. How about other users?

 Some users are interested in social and environmental
information.
 Is that less important than economic andusers
IASB might say financial
can obtain
information? that information from other sources
LO 2
Primary Users
Investors, Creditors and other Lenders
 Present and Potential
 Interested in expected returns, based on assessing:
1. future net cash flows; and
2. management’s stewardship of economic resources
 Should also consider pertinent information from other
sources
Other Users may find GPFR useful e.g.
1. Regulators (e.g. price-setters),
2. General Public e.g. communities, customers
 However, GPFR are not primarily directed towards
them Compare this with primary audience of audit reports
LO 3

QUALITATIVE CHARACTERISTICS
LO 3

Fundamental Characteristics
Characteristic Details
Relevance Capable of making a difference in
decision making, through
 prediction e.g. what is the expected
profit or cash inflow next year?; &/or
 confirmation e.g. was my investment
decision sound?

Faithful Represent underlying economic reality

Representation by maximizing
 Completeness (all necessary info.)
 Neutrality (without bias) &
 Freedom from error (including
descriptions and processes)
LO 3

Enhancing Characteristics
Characteristic Details
Comparable With other entities & periods
Understand similarities & differences
Verifiable Knowledgeable & independent
observers could reach consensus about
faithful representation
Timeliness Information is available in time to
influence decisions
Understandable Clear & concise presentation
For users with reasonable knowledge
of business & economic activities and
who analyse information diligently
LO 3

Materiality
Entity-specific dimension of relevance, based on
 nature (type of transaction) &
 magnitude (amount of the transaction)
Information is material if omitting, misstating or
obscuring it could reasonably be expected to influence
decisions made on the basis of GPFR

Note The Framework does not provide quantitative guidelines for

materiality.
The following indicators are provided for illustration only.
<5% of relevant Not material e.g. for sales, the relevant base
could be Total Sales, Profit or
base amount Receivables
5-10% Requires professional judgement
>10% Material
LO 4

CHANGES TO THE FRAMEWORK

Responding to past criticism/conflict

LO 4

Adopting a Hierarchical Approach

Addressing previous criticisms
 Ranking is important in cases of conflict
 Some preparers felt the framework was impractical
i.e. too challenging to meet all requirements
1. Users
 IASB has now distinguished between primary users
and other users
 Prioritised investment and financing decisions
2. Fundamental Characteristics
 IASB has now distinguished between fundamental
and enhancing characteristics
LO 4 Previously, this was a
Reliability qualitative characteristic

This has now been deleted, due to various problems

 Replaced by “faithful representation”
Previous Problems with reliability
1. Trade-off with relevance
 e.g. fair Value is more relevant for decision-making
but Historical Cost may be considered more
`reliable’
2. Problems with definition of reliability
 Does it mean precise, verifiable etc.?
 IASB has now clarified that it meant “faithful
representation”
LO 4

Prudence
Deleted, but now re-instated!
 Prudence was previously understood to mean (or
confused with) conservatism

IASB has now clarified that prudence means

 under uncertain conditions, accountants must use
caution in judgments/estimates
 However it is not acceptable to over-state or
under-state any item in the financial statement
LO 5

BENEFITS OF A
CONCEPTUAL FRAMEWORK
LO 5

Benefits
1. Generate consistent & logical reporting requirements
 Internally consistent standards
2. More cost-effective process for standard setting
 No need to re-debate issues when developing
standards etc.
 Minimise risk of over-regulation and unnecessary
standards
3. Preparers & auditors are better able to understand
financial reporting requirements
4. Greater accountability of standard-setters
 Justify any departure from conceptual basis
LO 5
Benefits
5. More difficult to avoid reporting requirements
 The framework establishes broad principles, rather
than specific rules
 If an issue is not specifically addressed in a
standard, preparers must seek guidance:
1. first from any other standard issued by IASB or
another standard setter
2. second from the framework
LO 5
Principles & Rules
IASB is principle-based and US GAAP is rule-
based

Example of Finance Leases under IAS 17

 Have the risks and rewards of ownership been
transferred to the lessee? (Principle)
 Is the Present Value of Minimum Lease Repayments
>= 90% of Fair Value? (Rule)
LO 6

CRITICISMS OF A
CONCEPTUAL FRAMEWORK
LO 6
Criticisms
1. Although the framework is normative, it has remained
descriptive, regarding measurement
 Historical Cost, including depreciation, impairment
 Net Realisable Value e.g. Inventory
 Present Value e.g. Lease Assets
 Fair Value e.g. PP&E
Challenges with Measurement
Framework acknowledges that qualitative characteristics and
cost constraints are likely to result in selection of different
measurement bases
 Measurement is now linked to qualitative characteristics
 Select the method that best meets the characteristics in
given circumstances
LO 6

Criticisms
2. Some have criticized the framework for seeking to
legitimise the accounting profession. They claim the
framework:
 justifies existing practices rather than generating
any radical change
 creates the illusion that accountants are
objective/neutral and can in fact determine the
“true” profit figure
 whereas in fact, accountants make subjective
judgements and there are many acceptable or
“valid” profit figures
LO 6

Criticisms
3. Some argue that the framework is driven by self-
interest of the profession
 It was developed to fend off regulation,
especially in periods of crisis/criticism
 e.g. the Convergence Project between IASB and
FASB emerged following corporate collapses and
audit failures but subsequently fizzled out.
 AF301

Topic 4
Normative Accounting Theory
The Conceptual Framework