Chapter 4: A conceptual framework THEORY IN ACTION Theory in Action 4.1: IFRIC 3 and Emissions Trading 1. What would be the likely impact of the ‘mismatch’ arising under IFRIC 3? The mismatch described in the article relates to (1) assets and liabilities and (2) recognition of gains and losses on assets. In relation to assets and liabilities the article implies that assets and liabilities are not reognised to the same extent, e.g. more assets recognised than liabilities (or the reverse). Therefore the balance sheet does not accurately reflect a company’s position in relation to emissions trading. There is also a timing mismatch, with assets recognised when obtained and liabilities when occurred. In addition, there is also a mismatch is the treatment of gains and losses, possibly leading to volatility in the income statement. Gains on assets are deferred (recognised in equity) while losses are recognised immediately in the period incurred. 2. To what extent is ‘matching’ a principle proposed by the IASB Framework? The Framework addresses (1) objectives of financial reports (2) qualitative characteristics of the usefulness of information (3) definition, recognition and measurement of elements of financial statements and (4) concepts of capital and capital maintenance (Paragraph 5). The underlying assumptions are accrual basis and going concern (para 22-23). ‘Matching’ of revenue and expenses is not required by the Framework although it is mentioned in para 95 as a common accounting practice. In particular, para 95 states that matching not be used to create assets and liabilities which do not meet the definitions of assets and liabilities under the Framework. Para 95 states: Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events. For example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities. 3. In what ways can you see the influence of the IASB Framework on IFRIC 3? If the Framework provides guidance to standard setters then we should observe that the requirements of IFRIC 3 are consistent with the Framework. Therefore, we should observe that IFRIC 3 meets the objective of financial reports (providing useful information for decision making) and that the information provided under IFRIC 3 meets the qualitative characteristics of financial reports (understandabilty, relevance, reliability and comparability, paragraphs 24-42). Further, the elements’ definition and recognition criteria should be consistent with those in the Framework. The discussion in the article does not suggest that IFRIC 3 was inconsistent with the Framework. Further, it specifically states that measurement of assets and liabilities would follow certain standards (IAS 38 for assets, IAS 37 for liabilities). However, the standards themselves may not be consistent with the Framework. IAS 38 applies stricter conditions to upward revaluation of intangible assets than are included for tangible assets under IAS 16 (the condition that an active market exists) thus distinguishing between how tangible and intangible assets are to be remeasured. This distinction is not made in the Framework. The IAS 37 is a more recent standard and brings in ideas not in the Framework. For example, the Framework refers to liabilities and provisions (paras 60-64) but not contingent liabilities. The IAS 37 requires a present obligation to an external party before a provision can be recognised. Some people would argue that this is not consistent with a principle of prudence, which is part of the 1989 Framework (though likely to be removed in the revised framework). 4. In relation to IFRIC 3, do you consider that the IASB Framework provides a ‘theory of accounting’ That is, does the Framework explain and predict accounting practice? The Framework fails to provide a ‘theory of accounting’ in relation to IFRIC 3. The Framework does not ‘explain and predict’ accounting practice. In fact, accounting practice (by or more precisely, practising accountants) has (have) rejected accounting for carbon trading as outlined by IFRIC 3. In Q3 we argued that IFRIC 3 recommendations were generally consistent with the Framework. Yet practitioners have rejected IFRIC 3 suggesting that the Framework is not effective in predicting how accounting will be carried out in practice. Theory in Action 4.2 Principles vs rules: Lease Accounting 1. What are the criteria in IASB and FASB standards for classifying a lease as a finance lease? the lease transfers ownership to the lessee; the lease contains a bargain purchase option to purchase that is expected to be exercised; the lease is for the major part of the economic life of the asset; the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset; only the lessee can use the leased asset. 2. What is meant by ‘bright lines’ in accounting standards? Give examples of the ‘bright lines’ in US leasing standards. ‘Bright lines’ refers to the practice of standard setters of stating specific thresholds. Consider for example the issue of materiality. IASB standard IAS 31 Materiality gives general guidance about materiality without stating a specific threshold. For instance, para 9 states that an item is material if its omission, misstatement or non-disclosure has the potential to influence the economic decisions of users taken on the basis of a financial report or affect the discharge of accountability by the management or governing body. Para 13 states that in determining if an amount is materia, the amount is compared to the total of equity and the appropriate asset or liability class total. In contrast, a bright line or specific threshold would be to say that an item is material if it is 5% of the applicable asset or liability class total. In relation to US GAAP leasing standard FAS 13, specific numbers are provided as follows: Criteria (c) above: the lease is for the major part of the economic life of the asset (75% threshold); Criteria (d) above: the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset (90% threshold). 3. Mr Ketz does not believe the IASB approach of principles-based standards will be effective for leases. Provide details of the arguments he presents in favour of his case and consider the alternative view. Ketz arguments Opposing arguments Bright lines are arbitrary but they assist preparers. ‘Bright lines’ can be worked around, principles are to be preferred. The guidance is given by the standards setters. Guidance should be given rather than left to discretion of preparers. Decisions about capitalisation are objective e.g. 75% threshold. Preparers have to make decisions about when rules for capitalisation are met and defend these decisions to their auditors. Preparers should take responsibility for these judgements, not regulators. Without thresholds decisions about capitalisation are subjective. Managers may behave opportunistically. Managers can behave opportunistically in relation to thresholds. Auditors cannot rebut managers decisions about interpretation of leasing standards Auditors can rebut managers’ interpretations in relation to accounting standards. They already do so in many areas and can do so in relation to leasing. 4. Do accounting practices under current IASB leasing standards comply with the definition and recognition criteria of the IASB Framework? The IASB Framework definitions and recognition criteria are stated in the chapter. If companies followed these definitions they would show all leases on the balances sheet because: The lease is an asset as (1) it relates to an item controlled by the entity (2) there is a past transaction (the lease agreement) and (3) future economic benefits will flow from the transaction (benefits from using the leased asset). Lease payments are a liability because (1) there is a present obligation to an external party, the lessor (2) arising from a past event (the lease agreement) (3) which will involve the outflow of future economic benefits (lease payments). In terms of recognition for both the asset and liability, (1) the amounts can be measured reliably (as per the lease contract) and (2) future economic benefits are probable (the use of the asset will generate net benefits, otherwise the contract would not have been entered into by the company). Thus current practice, where most leases are classified as operating under IAS 117, is not consistent with the conceptual framework. Under the Framework criteria, leases would be capitalised and assets and liabilities recognised in the balance sheet. Theory in Action 4.3 Guidelines for reporting ‘proforma’ earnings 1. According to the article, what is meant by ‘underlying profit’? How does underlying profit differ from statutory profit? Underlying profit is a profit figure derived from adjusting reported (statutory) profit for one-off and unusual items. Statutory profit is derived based on accounting standards (‘strict accounting rules’ in the article). Underlying profit is a ‘proforma’ profit measure. The adjustments to get to underlying profit are subjective, that is, they are under the managers’ discretion. The article states that there is ‘greater opportunity for malleability in the underlying profit figure’. 2. Why did the AICD and Finsia release guidelines about reporting underlying profit? The voluntary guidelines provide seven principles which can be used to produce more consistent reporting. Directors are encouraged to follow the principles so that investors and users can understand the adjustments to statutory profit and can compare underlying profit between entities. The guidelines are to ‘promote good reporting practice’ and to discourage poor practices such as ‘inappropriate adjustments to statutory profits or window dressing’. Issuing voluntary guidelines shows that the organisation wants to be influential in improving the quality of reporting. Guidelines may also help members determine ‘best practice’ for reporting. Issuing voluntary guidelines may also pre-empt (prevent) government intervention through regulation. 3. According to the article, why do some directors consider that statutory profit is not a ‘proper reflection’ of the underlying business? Explain whether you agree with the directors’ view. With the adoption of IFRS, new standards have been introduced and some accounting methods changed. For example, there is more market value accounting (e.g. financial instruments, share-based payments) and greater focus on impairment and write-downs of goodwill. Directors may consider that these methods mean that the performance of the underlying business is not properly reflected in statutory profit. The directors’ view suggests that they disagree with the requirements of some accounting standards. That is, they do not believe some accounting treatments measure position and performance appropriately for prediction of future performance. For example, they may disagree with the requirement to include unrealised gains and losses on certain financial instruments. They may consider that the gains and losses are not part of operating profit, and that the volatility introduced is misleading for analysts and investors. Restating statutory profit (excluding the unrealised gains and losses) allows directors to present what they consider to be ‘real’ (underlying, sustainable) profit of the entity. 4. Discuss whether the actions of (a) directors in releasing an underlying profit figure and (b) the AICD/Finsia guidelines are supportive of the IASB/FASB’s conceptual framework project. The actions of the directors suggest that they do not support some requirements of accounting standards and also some concepts of the Framework. Let us consider the example referred to in part three of the question (above), namely the recognition of unrealised gains and losses on financial instruments in the income statement. This requirement comes from IAS 39 and is also consistent with the Framework, which states that income includes revenue and gains (para 74) and that expenses include losses and items which are unrealised (paras 78-80). Therefore the directors do not appear to supportive of the underlying concepts of the Framework and standards, at least in terms of them being performance measures that are useful for evaluating the business and predicting future cash flows. If the directors claimed that unreliability of measurement leads them to exclude items then they are following the Framework. However, this argument is not persuasive, since the items have been included in statutory profit. Presumably the firms’ auditors considered that they could be measured with sufficient reliability. The actions of AICD and Finsia in releasing guidelines are consistent with the Framework in that the aim of the guidelines are to improve comparability and transparency and therefore the quality of information provided. So while the information itself is ‘outside’ the Framework and standards (that is, it is not consistent with either) the activity of issuing the recommendations is actually supportive because it is consistent with the objectives of the Framework (namely to produce high quality information which assists in decision making process of users). In terms of the current IASB/FASB project, the directors’ views may suggest that they will have a particular opinion about measurement methods, i.e. a preference that unrealised gains and losses not be included in income (in the profit and loss statement). If they feel strongly on this issue, they may attempt to the discussion of measurement objectives and measurement methods in the project to revise the Framework. CASE STUDIES Case Study 4.1 BIG GAAP, SMALL GAAP: Accounting for SMEs Under the four headings in the article, discuss the possible benefits of an SME standard identified by the author. In your discussion, name the parties most likely to benefit from the SME standard and explain the extent to which you agree or disagree with the views presented by the author. You should also consider what factors may inhibit the success of the SME standard. 1. Comparability of financial information An SME standard will improve comparability within and between industries for private entities, regardless of where a company is domiciled. Transactions and economic circumstances will be accounted for and presented more consistently than under the present various national requirements. Different recognition and valuation principles make it difficult for users of financial statements to make informed decisions about a private entity’s performance and cash flows. The SME standard has the potential to improve comparability of information and the quality of communication with stakeholders, thus facilitating better investment decision making. 2. Acquisitions, partnerships and cooperation agreements The SME standard can assist with cross-border acquisition and partnerships or agreements with foreign entities. It may simplify the sale of an entity because the financial statements, which are fundamental in evaluating an acquisition and purchase price, are more transparent and comparable. Evaluation of each entity is simpler and agreement is more likely. The negotiation process is assisted by the use of common standards. Time and expense involved in restating financial information is avoided and post-integration financial reporting costs are lower. 3. Building relationships with overseas customers The SME standard can assist private entities that are buying and selling goods across national boundaries and those that seek to build new customer relationships. The IFRS for SMEs can be used to promote a good image of the company i.e. that the company has high quality financial reporting, and that it provides relevant information to assist customers’ decision making. Financial statements are regularly demanded as part of the supplier selection and evaluation process for a range of reasons, including assisting an assessment of solvency. Companies that offer only national GAAP statements may be disadvantaged if their statements are seen as less transparent and comparable than those of entities using IFRS. 4. Dealing with finance providers Another positive effect from using IFRS is that the company may be in a better negotiating position and be able to achieve a lower cost of borrowing. The positive image of IFRS (high quality standards, that promote comparable and transparent information) may have a positive effect on credit ratings. The more comprehensive disclosures in IFRS may assist lenders in making a more accurate risk assessment, leading to a lower risk premium for the company. Use of IFRS may mean that the company can obtain new sources of equity finance because of the greater transparency and comparability of information. Overall, we can see that a range of parties may benefit from the adoption of IFRS for SMEs by private entities. They include capital providers (investors and financiers) because they may receive better quality information (more comparable, more transparent, more detailed) to use in their decision making. Company managers can also benefit. They produce better quality information which assists them in communicating will all outside stakeholders. The IFRS reports assist them in a range of business operations. If the standards are useful for capital raising and for operations then the business benefits and so too do managers, employees and shareholders. Of course, there are costs in adopting IFRS for SMEs. Companies incur costs of adopting the new set of standards and in adjusting their accounting systems. Personnel must be trained in use of IFRS. IFRS requirements are not necessarily straightforward, even within the IFRS for SMEs standard. There may be confusion generated if accountants try to understand simplified IFRS without reference to full IFRS. Staff will need to learn requirements and keep up to date. The standards may require disclosures that the company has not previously made, raising issues about proprietory information and the costs of disclosure. The benefits of transparency and comparability can only be achieved if companies interpret IFRS the same way and comply with all IFRS requirements (in the IFRS for SMEs). Private companies may be subject to less rigorous auditing than large listed companies, thus they may have more leeway in how they interpret and apply IFRS leading to differences between companies. Private companies are subject to less oversight by enforcement bodies, so the level of comparability may not be as high as for public companies that are closely scrutinised by external regulators. Auditors are also faced with challenges. It is not yet clear the extent to which they will be able to audit just to the SME standard and ignore requirements of full IFRS. Case Study 4.2: Usefulness of accounting information – Public sector and not-for-profit entities We examine the importance of accounting information for public sector and not-for-profit entities. Unlike for-profit organizations, these entities have different goals and stakeholders, which influence the use and importance of accounting information. 1. Stakeholder Information: In the public sector and not-for-profit entities, stakeholders include citizens, donors, government agencies, and regulatory bodies. Accounting information is crucial for these stakeholders to understand how resources are being utilized and managed. 2. Budgeting and Resource Allocation: Accounting information helps in budgeting and allocating resources effectively. It provides insights into the financial health of the entity, enabling better decision-making regarding resource allocation. 3. Transparency and Accountability: Public sector and not-for-profit entities are accountable to their stakeholders. Accounting information enhances transparency by providing a clear view of financial transactions and operations, ensuring accountability. 4. Grant Compliance: Many not-for-profit entities rely on grants and donations. Accounting information helps in ensuring compliance with grant requirements and reporting obligations. 5. Strategic Planning: Accounting information aids in strategic planning by providing data on financial performance, trends, and potential risks. This information is crucial for long-term sustainability and growth. 6. Performance Evaluation: Accounting information is used to evaluate the performance of public sector and not-for-profit entities. It helps in assessing the efficiency and effectiveness of operations and programs. Overall, accounting information plays a vital role in the management and governance of public sector and not-for-profit entities. It provides stakeholders with the necessary information to make informed decisions, ensures transparency and accountability, and supports strategic planning and performance evaluation. Case Study 4.3 Revisiting the conceptual framework 1. Explain why principles-based standards require a conceptual framework. The aim of principles-based standards is to build on previously agreed upon principles, which do not have to debated each time when a standard is being developed. For example, if definitions of elements are agreed upon, they can be used in standards and not debated again. This approach aims to increase consistency among standards and to reduce time taken in their formulation. Principle based standards rely on the existence of underlying principles which can be used so that detailed rules do not have to be provided. The conceptual framework provides a source of principles which can be used in accounting standards. For example, if the conceptual framework provided an agreed approach to measurement e.g. measure all assets and liabilities at fair value, then it would provide a principle which could be applied in standards. The existence of a principle would make it easier and quicker to develop standards. 2. Why is it important that the IASB and FASB share a common conceptual framework? A study by the SEC has recommended that US standards be more principles based (see discussion Chapter 4). Therefore, additional work on the principles underpinning the standards, that is, the principles contained in the conceptual framework, is needed. The IASB/FASB convergence project has created a need to converge the bodies’ conceptual frameworks. Since standards are based on underlying conceptual frameworks, it is necessary to converge the frameworks to achieve convergence of standards. 3. It is suggested that several parties can benefit from a conceptual framework. Do you consider that a conceptual framework is more important for some parties than others? Explain your reasoning. Standard setters are the major beneficiary of a sound conceptual framework. It allows them to develop their standards based on agreed upon principles. The article states that the IASB and FASB base their accounting standards to a large part on the foundations of objectives, characteristics, definitions, and criteria set forth in their respective conceptual frameworks. Further, it states that principles-based standards must be rooted in fundamental concepts that constitute a framework which is ‘sound, comprehensive and internally consistent’. Thus the conceptual framework is important to achieving the goals of setting high quality accounting standards and converging US GAAP and IFRS. However, the conceptual framework can also be of assistance to preparers of financial statements. It can provide guidance in relation to the interpretation of existing financial statements and on matters which are not covered by existing standards. Auditors can also benefit from the guidance in the framework in forming their opinions. Finally, the Framework may assist users in interpreting the financial information provided. 4. What is meant by a ‘cross-cutting’ issue? Suggest some possible examples of cross-cutting issues. Cross cutting issues are those which relate to more than one standard. That is, the issue comes up when various standards are being considered. Examples are the definition and recognition criteria for assets, liabilities and equity. Revenue recognition matters and financial instruments are other examples. In addition, measurement is a problem area. For example, standard setters have not found an obvious way to decide when to value items at historical cost and when fair or market value should be used. QUESTIONS 1. How do conceptual frameworks of accounting attempt to create a theory of accounting? Describe the components of the IASB Framework and how they contribute to a theory of accounting. Conceptual frameworks (such as those developed in the United States, Australia and at the IASC/IASB) do not employ the term ‘theory’ because of the difficulty of demonstrating logical consistency and in gathering empirical evidence to corroborate the theory. However, by following a structured program of inter-related concepts, accounting regulators aim to use the conceptual framework to achieve consistent accounting standards that will replace ad hoc solutions to specific problems. In this context, the components of the conceptual framework can be viewed as the building blocks of a theory of accounting. The components of the IASB/Australian Framework are: objectives of financial statements; qualitative characteristics of financial information (such as relevance, reliability, comparability, timeliness and understandability); and definitions of the basic elements of accounting reports (such as assets, liabilities, equity, revenue, expenses and profit) and principles and rules of recognition and measurement of the basic elements, and the nature of the information to be displayed in financial reports. 2. Some people argue that there is no need for a general theory of accounting, as established in a conceptual framework. They argue that there is no overall theory of physics, biology, botany or psychology, so there is no need for an overall theory of accounting. Furthermore, attempts to develop an overall theory of accounting are futile and unnecessary, since accounting has not needed a conceptual framework so far. Debate this view. It is true that in the physical sciences, there is no overall theory of a given field of study. There is no theory of chemistry, or biology, etc. Some scientists have attempted to formulate such theories, but have failed. It is generally agreed that such theories would be beneficial because they would provide an integrated explanation of all aspects of the given field of study. At present, different theories in a given discipline — for example, in biology — remain as separate categories, and often the connection of one theory to another is not known. Theories in the sciences are descriptive, but in accounting an overall theory would be normative, telling accountants what ought to be done. This would be very useful if it could be formulated. It would serve as a standard by which to judge practices. Although the probability is slim that in the near future a logically consistent overall theory can be constructed, a theoretical framework such as the conceptual framework can be helpful. It is true that the profession has survived without a general theory, but a theory of some sort has always been in mind. Constant reference to generally accepted accounting principles reveals this. It would be easier to assess accounting practices and to formulate standards consistent with each other if a general theory existed. If a theory is empirically verified, accounting methods for particular purposes would also have empirical evidence to support them. In other words, we would be able to present evidence as to why a certain procedure (for example, FIFO inventory valuation) should be used rather than another method. 3. What does the IASB Framework describe as the basic objective of accounting? What are its implications? Stewardship looks primarily to the past, asking the question: What happened? Decision making looks to consequences in the future, asking the question: What will happen? A decision-making approach sees accounting information as inputs for the decision-making prediction models of users. If so, then we are concerned about what kind of accounting information is relevant to decision makers. Some believe that current value is implied. Also that statement of financial position accounts and their amounts are as important as those in the income statement. Traditional accounting emphasises income. 4. What type of information do you think is useful for shareholders, lenders and creditors? Is this the type of information that is currently provided? Useful information is both relevant and reliable. Presumably, it is also ‘fair’. Adopting a narrow perspective, useful information provides a basis for investors and creditors to assess the amount, timing and uncertainty of future cash flows for themselves based on the expected cash flows of the firm. Such a basis is provided by information concerning the profitability and financial condition of the firm. In turn, this information is presently reported in the statement of financial performance or the statement of financial position, and the statement of changes in financial position. For the latter, many believe a cash flow statement is especially pertinent. Taking a broader view, useful information helps to efficiently allocate capital in the economy. (Question 6 deals with this.) 5. The expressions ‘truth’, ‘justice’ and ‘fairness’ have all been applied to describe desirable characteristics of accounting information. What role do you think they play in practice? Are they included in the IASB Framework? If so, how? If not, why not? Truth, justice and fairness are socially desirable goals. Accountants should be concerned that the information they report is true, just and fair. The audit opinion indicates a concern for the above-stated goals. Useful information is relevant and reliable, and these latter terms encompass the broader ones of truth, justice and fairness. However, we should understand that what is true, just and fair often depends on who is making the judgement. The company may believe that its financial statements meet the criteria of truth, justness and fairness, but the shareholders may not think so. Accountants are often caught in the middle. This is all the more reason why a general theory of accounting, especially one that is supported by evidence, is important to accountants. Students should be asked if the following procedures cause information to be ‘true, just and fair’: LIFO inventory valuation; historical cost of land purchased 20 years ago. 6. Explain the role of accounting in relation to: (a) individuals (b) firms (c) the Australian economy. Accounting information helps to efficiently allocate capital in the economy. The successful operation of a free economy depends, to a large extent, on the good judgements made by individuals about their investment opportunities and the investment opportunities of firms. People need information to decide where to invest or lend, and at what price. In relation to firms, accounting information forms the basis for many contracts, such as debt contracts that include covenants specifying that the firm will not allow its leverage ratio to exceed a certain level, or management compensation plans that provide managers with bonuses based on reported corporate earnings. As such, the firm’s cash flows are tied to accounting numbers. Since the value of the firm is the present value of all future cash flows and those cash flows are tied to accounting numbers, accounting numbers determine the value of the firm. In relation to the economy, accounting information plays a vital role in the equitable allocation of capital, and it contributes to the effective performance of the price system. The effective operation of our economy means that efficient and inefficient companies must be identified, so that resources are channelled to the former and away from the latter in order to have a ‘successful’ economic system. What would happen, after a long period of time, if ‘incorrect’ information is reported? The economic system would become inefficient (because of the existence of many inefficient firms), causing serious economic problems to all. 7. Can accounting ever provide an unbiased map of economic reality? Why or why not? Yes. Criticisms of neutrality or freedom from bias take two forms. First, some argue it is a state of mind that is not attainable, because all of us are affected by personal values that have been shaped by our particular beliefs, traditions, environment, background and personality. Granted that this is true, it is still meaningful to speak of neutrality or freedom from bias. We recognise the existence of these influences on our perceptions. The idea is to control them within an acceptable range. Second, some contend that neutrality or freedom from bias is not operational, because we cannot be expected to read other people’s minds. However, it is possible to translate neutrality or freedom from bias into operational terms by establishing specific control devices that are external and subject to examination. Control devices are the means by which the notion of objectivity receives operational meaning. Control devices have to do with making public or external what is essentially internal or introspective. Rules and procedures under the heading of disclosure, consistency, comparability, and materiality as well as GAAP are practical control devices. In the accounting literature, practical control devices under the heading of objectivity have taken the following three forms: to make specific and precise the concepts and procedures of accounting, and to obtain general agreement on them to determine a consensus of the measure among a number of experts to improve the standards of competence and ethics of the profession. Accountants must construct unbiased or neutral financial maps of economic reality. Otherwise, as Solomons warns, ‘If it ever became accepted that accounting might be used to achieve other than purely measurement ends, faith in it would be destroyed’. 8. Some argue that the development of a conceptual framework is inappropriate because accountants constantly deal with specific issues that will not be envisaged by an overall, general conceptual framework. In particular, a conceptual framework makes no allowance for differences in the social contexts where accounting is applied. They also argue that it would be preferable to develop case-specific solutions to accounting issues, based on case study research, and bearing in mind the social contexts of all accounting decisions. Discuss this view, presenting arguments for and against it. Determining ‘best’ accounting methods for situation-specific problems can be accomplished in a more systematic and consistent manner if there exists an underlying theory to guide solutions to problems. In the absence of an overall theory, the results of a micro or case study approach cannot be generalised to other situations. There is also the possibility that the same or a similar problem might be solved in an entirely different and contradictory manner if there is no overall theory or set of generally accepted principles to restrict the ad hoc subjectivity of the decision maker. The results of case studies can, however, be used as empirical evidence in constructing a theory of accounting. 9. What is the difference between art and science? Is accounting an art or a science? Does it matter? Why or why not? Whether accounting is an art or a science has long been debated by accounting academics without coming to an agreement. One position in the middle of the two extremes is that accounting theory is a science whereas accounting practice is an art. According to Sterling, there is nothing inherently unscientific in accounting. In fact it is the approach adopted by the researchers in a discipline that makes the discipline scientific or otherwise. Accountants who believe in the scientific approach seek empirical evidence to support accounting practices so that practitioners can recommend the most appropriate methods for given situations based on the evidence. The scientific approach in accounting is not an attempt to make scientists of practitioners, nor is it an attempt to discuss ‘absolute truths’, since there are no absolute truths in science. Looking at the research in accounting, particularly during the last 30 years, one can see a great deal of analytical as well as empirical research; both being integral parts of a scientific theory. It is therefore inappropriate to claim that accounting is in the pre-science stage. 10. ‘The development of a SME standard by the IASB will defeat the purpose of international harmonisation.’ Explain why you agree or disagree with this statement. The rationale for international harmonisation of accounting is as follows: If companies use the same set of accounting standards, there will be greater transparency and comparability between financial reporting from companies from different countries, thus assisting international investors in efficient allocation of resources and leading to a reduced cost of capital for companies. In addition, companies will not be forced to meet the cost of using more than one set of national GAAP. These advantages are important for many companies in different countries, hence the global support for international harmonisation. However, they are not important for all companies. For example, smaller less international companies may find the arguments less persuasive. Smaller companies may not have international activities and investors, and therefore do not benefit from the use of international standards. Smaller companies may argue that they do not need to use the full IASB standards because they do not have users who are dependent on the financial statements for information, or who need internationally comparable information. The use of an SME standard does mean that all companies are not complying with full IASB standards, so comparability is reduced. However, if SME companies do not have international operations and investors, it is not a disadvantage that they do not comply with the full set of international standards. Thus an SME standard does not defeat the purpose of international harmonisation. 11. In Australia, the conceptual framework did not proceed to SAC 5 concerning measurement. (a) Why do you think that is the case? (b) Do you think that accounting standards have been moving towards a particular measurement method? If so, what is that method? (c) How can standards lead the development of a formalised conceptual framework? (a) SAC 4 was highly controversial. SAC 5, dealing with measurement, would be even more controversial. As such, it is fair to say that at the time the AASB felt that the business community was not ready to accept a standard prescribing measurement methods. Furthermore, while the majority of the AASB might agree on a particular general approach to measurement (for example, current market values) it is likely that the AASB would have great difficulty obtaining agreement on more specific issues (such as how to treat transactions costs, discounts, etc.). It was deemed prudent to defer development of SAC 5 until the community was more supporting. Following adoption of IFRS, standards on measurement come from the IASB. Increasingly, accounting standards have been requiring use of net market values, which are current market selling prices less transactions costs. Some regard this as a ‘back-door’ way of introducing fair value measurement requirements. Standards can contribute to the development of a formalised conceptual framework. If they introduce concepts or methods that become more accepted once they are prescribed in an accounting standard, this provides a lead-in to a more general document such as a Statement of Accounting Concepts for the conceptual framework. For example, the more standards require measurement at net market value or disclosures of net market values, the more acceptable the method becomes, and the easier it is likely to be to gain general acceptance of a Statement of Accounting Concepts that requires measurement at net market values. 12. Give reasons for your answers to the following questions. (a) How important is it that standard setters agree on objectives, concepts and definitions before they develop a conceptual framework of accounting? (b) How important is it that the conceptual framework is generally accepted by the business community before it is applied to develop accounting standards? Although it is important that prior agreement be reached on concepts and definitions in the conceptual framework programs so that there is no confusion in understanding the subject matter, one must remember that substantive knowledge comes from investigation of the subject matter, not from prior agreement on definitions. We should take care that statements we make should never depend on the meaning of our terms. Unfortunately, this is not the approach of the conceptual framework projects. For example, when the standard setters define ‘assets’, ‘liabilities’ and so on, they intend that the valuation decisions should depend on the definitions. Similarly, prior agreement on the objective of financial reporting may be biased towards a particular valuation system. (c) Why do the FASB and IASB require a common conceptual framework. See discussion in the chapter. The FASB and IASB have embarked on a convergence project, to remove differences between their respective standards and to align their work agendas. The standards produced by both bodies should reflect the underlying principles contained in their conceptual frameworks. For example, the financial statements elements (assets, liabilities, equity, income and expenses) are defined in conceptual framework and these definitions are used in standards. If the IASB and FASB have differences in their frameworks, they could flow through to differences in their standards. Thus, agreement about fundamental matters such as definitions and recognition criteria can help the boards to produce harmonised standards. 13. Explain the advantages and disadvantages of principle-based and rule-based standards. The focus of principle based standards is on an underlying principle or principles. They require that the principle be interpreted by financial statement preparers and auditors. They do not set out what preparers are to do in a step by step manner. Rather, they provide guidance to be interpreted and applied in an appropriate manner. They are more flexible, as they allow companies to apply the principles in a way that is appropriate for their situation and business, in order to convey useful information for decision making. Rule-based standards include detailed directions about actions required by preparers. They are more specific than principle-based standards, and may include ‘bright line’ thresholds such as “greater than 50%”. Rule based standards tend to be longer and more complicated, with more amendments, as standard setters try to cover all situations in which the rules apply. Specific rules are easier to follow and enforce so are favoured by some preparers, auditors and regulators. However, one problem with rule based standards is that rules can be “worked around” to give a result which is technically in compliance with the rules but does not meet the overarching objective of the standard (the substance over form debate). It is possible to comply with the substance of a rule based standard while not complying with its form. For example, leases which are in substance finance leases are structured to meet the tests for operating leases so that they can be shown as operating rather than financial leases in the financial statements. 14. Why has the FASB been directed to produce more principle based standards? Do you consider this to be a realistic standard setting objective? Some corporate collapses in the United States have involved the abuse of accounting standards. For example, the collapse of Enron in 2001 showed how the company’s managers and auditors created special purpose entities which would not have to be consolidated under existing accounting standards. The managers and auditors were working around the rules contained in US GAAP. Their actions breached the underlying principle consolidation, that is, that entities under control of a parent entity be included in the consolidated financial statements. The abuse of accounting standards in this way, that is, specifically working around the rules, brought attention to the rule-based nature of US GAAP. As a way of improving financial reporting and preventing events like Enron in the future, it was recommended that US GAAP be more principles-based. The idea is that principles are more difficult to work around than rules and will therefore be less open to exploitation. The SEC has recommended and the FASB has accepted that it should pursue a more principles-based approach (described as objectives based) because of the extent of financial havoc following Enron. In theory, the objective of producing principles based standards is a reasonable one. It is the approach taken by the IASB. Because of the advantages of principles-based standards, it is a reasonable objective. In practice however, producing principles-based standards is complicated by two issues. First, if principles are unacceptable e.g. measure all financial instruments at market value, then the principle may get reduced by the application of specific rules e.g. measure available-for-sale securities at market value. Second, preparers seek guidance in the form of rules to assist them to comply with standards. In cases where these issues are affecting the standard setting process, it may be impossible for the standard setter to produce standards without rules. However, the changed focus in US standard setting should result in more use of principles and less use of rules in standards. 15. Discuss whether the IASB Framework is merely a policy document based on professional values and self-interest, without scientific foundation. In your discussion, state your opinion on whether the conceptual framework should serve as a policy document in this manner. This question covers the last part of the chapter under the heading ‘Professional values and self-preservation’. Students can expand on the following major points: Accountants have a special status in the society. In Australia this is witnessed by the Royal Charter endowed on the Institute of Chartered Accountants, the profile associated with the CPA program of CPA Australia and the professional monopoly by the major accounting bodies. The ability of the accounting profession to retain legitimacy as a profession will be judged by society, in terms of the apparent coherence and theoretical defensibility of the profession’s body of knowledge; hence the need for a conceptual framework (Hines, 1989). The conceptual framework plays a vital political role in maintaining self-regulation and in lobbying against increased regulation by government bodies. A conceptual framework program alleviates the criticism of the diversity of accounting standards — a major threat to the profession’s loss of control of the standard-setting process. The conceptual framework project is not about setting rules for accounting practice; rather, it is about legitimising the process of accounting practice. 16. Assume that you have been contracted by the Australian Accounting Standards Board to develop a proposal regarding whether to issue an accounting standard on accounting for the costs of environmental damage. Draft a proposal of 1500 words or less outlining why you think it is appropriate, or inappropriate, to develop an accounting standard on this issue. Also outline the key issues that would need to be covered by the standard and how the conceptual framework can contribute to resolution of those issues. The purpose of this question is that the students should be able to apply what they have learnt from the conceptual framework project and other readings to the general issue of standard setting. The best way to approach the question is to address the following key points: alternative approaches to standard setting the scope of the proposed standard reference to academic accounting research potential benefits or drawbacks of the standard. Students could begin with a classification of various approaches to an accounting theory: empirical inductive approach the deductive approach (true income, user needs, information economics) new empiricism. They could then discuss the implications of these approaches for the standard setting bodies — for example, problems (or impossibility) of measuring true income; economic consequences of accounting standards; and the political nature of the standard setting process. This should then lead into a discussion of the topic itself: What is meant by the ‘costs of pollution’? What type of pollution are we talking about: air, water, noise? Does costs mean costs actually incurred by the company to avoid polluting the environment, or is it a valuation of the pollution costs to the company/society through the company’s operations? How can one measure these costs? The subject matter is important as it has clear implications for the scope of the proposed standard. Is it to be a valuation standard (requiring auditors to check the company’s valuation of pollution costs) or is it a disclosure standard (requiring the company to disclose fines or reports by inspectors, etc.)? Students should include some comments on the past success of the standard-setting bodies on inflation accounting, research and development expenditure and other relevant issues. This will eventually follow into a discussion about the political nature of the accounting standard-setting process. Does the standard-setting body have enough power to set such a standard? Will the powerful lobby groups frustrate any change? What is the benefit of loosely worded, vague and subjective standards? Would the standard achieve anything or is it just an exercise to show that something is being done so that the accounting profession’s self-regulation is not threatened? 17. Write a report of 1500 words or less to the chairpersons of the Financial Reporting Council and the Australian Accounting Standards Board, commenting on the following argument: Attempts to bring about radical change through the introduction of a conceptual framework have failed. When it appeared as though SAC 4 would require firms to report a greater number of liabilities, lobbying began in earnest and business ensured that any innovation was quashed. As such, the best that can be hoped for from a conceptual framework is that it legitimises current practice, maintains existing social and economic status, and staves off public sector attempts to control accounting standard setting. This question covers the whole chapter. In addition to the answer to question 7, students should summarise the scientific criticisms levelled at the conceptual framework projects, and should also cover the material under the heading ‘The conceptual framework as a policy document’. In their answer, students should discuss the following points: The purpose of the conceptual framework was that prior agreement on fundamental terms would minimise inconsistencies. SFAC No. 5 states that concepts are to be developed as the standard-setting process evolves. The question is: How can a conceptual framework guide choices from among alternative principles and rules if the elements of the framework are defined in those very same terms? (Dopuch and Sunder) Definitions are general and vague. Recognition criteria are couched in terms of (subjective) probabilities. The measurement problem is open-ended. Contrary to Popper, the FASB sought for the definitions to bear as much weight as possible (Gerboth). This is true, also, of SAC 4’s role in Australia. Ontological assumption. The conceptual framework adopts an economic realism–measurement approach. According to Hines, ‘we communicate constructed reality’. Hence, can we provide information that is neutral, independent and free from bias? Demski’s impossibility theorem Epistemological assumption: scientific truth has no absolute truth (Feyerabend). accounting researchers believe in a (confused) notion of empirical testability (Chua). Circularity of reasoning — for example, reliable information depends upon recognition and recognition depends upon reliability. Conceptual framework ignores findings from capital market research. Conceptual framework is a policy document. According to Tinker, it is merely an attempt to legitimise an ideological position at the theoretical level. Conceptual frameworks appear to reinforce existing principles. 18. What is business risk auditing? How does it differ from traditional substantive auditing? Why do critics believe it is used to justify selling more consulting services to audit clients? How could business risk auditing be blamed for failures such as Enron? Business risk auditing is a form of auditing that considers client risk as part of the audit evidence process. Traditional substantive testing could be seen (simply) as based in transaction and balance testing. That is, the auditor gathers evidence that transactions have been correctly authorised, processed, and entered into the accounting records. Balances are tested by gathering evidence, for example, on the physical (or legal) existence of the assets and their correct measurement and depreciation allocations. In risk-based auditing auditors focus on high risk areas, and gather evidence on the risk reducing properties of control systems. They need to develop advanced understanding of business environments and strategies. The differences between the two approaches include the focus on the client as essentially a contained system in substantive auditing and an explicit consideration of the external factors in business risk auditing. Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152
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