IASB Conceptual Framework for Financial Reporting - Essay Example

Financial Reporting Introduction The IASB Conceptual Framework for Financial Reporting (the Conceptual Framework) sets out the concepts that underliethe preparation and presentation of financial statements (Ifrs.com, 2014). According to Hines (1991:315), “the ontological assumption underpinning the Conceptual Framework is that the relationship between financial accounting and economic reality is unidirectional, reflecting or faithfully reproducing relationship”, which presupposes that “economic reality exists objectively, intersubjectively, concretely and independently of financial accounting practice”. In that sense, “financial accounting reflects, mirrors, represents, or measures this pre-existent economic reality” (Hines 1991:316). On the other hand, the Conceptual Framework is criticised “for not fulfilling its functional objectives, principally that of providing a basis for guiding standard-setting and resolving accounting controversies” (Hines, 1991:313). The purpose of the essay is to provide a critical overview of the conceptual framework and to analyze why it is criticized for not fulfilling its functional objectives as discussed above. This paper is organized as follows. The remainder of this paper is structured in the following way: Section 2 provides a general overview of the Conceptual Framework and its development; Section 3 provides a critical discussion of the concepts identified in previous section; Section 4 is concluding part of the essay. The Conceptual Framework The Conceptual Framework is a tool which “sets out the concepts that underlie the preparation and presentation of financial statements” (Ifrs.com, 2014, n.p.). This tool is used by the International Accounting Standards Board (IASB) for developing and updating/revising International Financial Reporting Standards (IFRSs) (Ifrs.com, 2014, n.p.). The main objective of the Conceptual Framework is to help users in developing, revising, interpreting and understanding the IFRSs (Hoogervorst, Clark & Knubley, 2014). The Conceptual framework was initially established in the late 1970’s and early 1980’s in the USA (Pike & Chui, 2012). CF served as a foundation for accounting standards with identification of key principles and a set of qualitative characteristics (Pike & Chui, 2012). The first product produced by the CF project was the concepts statement on the objectives of financial reporting (Solomons, 1986). CF was aimed to be a set of prescriptive principles that would guide board members in standards’ setting and practitioners in problem solving processes (Hines, 1991). As it is declared in the CF, the principle objective of financial accounting is provision of: information useful for decision-makers (FASB, 1980 cited in Hines, 1991); relevant and reliable information, whereas reliability was implied to embrace representation faithfulness, verifiability, and neutrality (FASB, 1980 cited in Hines, 1991). Thus, there were derived five key characteristics of accounting information, which are applicable till today: understandability, relevance, reliability, comparability and consistency (Pike & Chui, 2012). Below is presented brief description of each characteristic: 1. Understandability: information must be understandable in order to be useful; 2. Relevance: information must be timely and have feedback value; 3. Reliability: information must be verifiable and neutral; it must have representational faithfulness; 4. Comparability: information must enable users to identify differences between and similarities in two companies; 5. Consistency: Information must conform from period-to period with no changes to procedures and policies (Pike & Chui, 2012: 81). These five qualitative characteristics of accounting information were recognized to make accounting information useful. Criticisms of the FASB’s Conceptual Framework Despite good intentions of providing a backbone for principles-based accounting standards, the Conceptual framework has face significant criticisms of many different authors claiming that it failed to fulfill its functional objectives (Pike & Chui, 2012). These functional objectives were mainly referred to providing a basis for guiding standard-setting and resolving accounting controversies (Hines, 1991:313; Pike & Chui, 2012). Some of the initial criticisms referred to the points where SFAC failed to deal with the treatment of long-term contracts, an analysis of the earnings concept, the recognition of executor contracts, depreciation, and inventory valuation (Solomons, 1986 cited in Hines 1991). Other criticisms of the CF were associated with operational factor of the CF, as many SFAC issues on elements of financial statements were not operational (Hines, 1991). Also, the CF was criticized for internal inconsistency, deficiencies of incompleteness, variety of contradictions, ambiguity, unsubstantial assertions and circular reasoning (Hines 1991). Many authors have criticized the CF for controversies and evolutionary philosophy. While the initial idea was to establish a prescriptive framework, SFAC No.5 has become almost totally prescriptive. Later, Hines (1991) declared that with the issue of the statement No. 5, the aims and philosophy of the CF has been lost. Initially, the purpose of the CF was stated to set out the concepts, while later (in SFAC No.5) is has been stated that concepts were subjects to evolutionary process, where CF should be developed as the standard-setting process evolves (Hines, 1991:315). This evolutionary process could be traced with the issue of updated/revised versions of the Conceptual Framework. Initially, the Conceptual Framework was introduced in 1989, and included the following elements: Objective & QCs; Elements; Measurement; and Recognition. In 2010 there was introduced updated version of the Conceptual Framework, which was comprised of the same elements. By 2013 there was presented a discussion paper with the changes proposed to the existing Conceptual Framework. Based on the exposure draft of CF the following new elements should be included to the Conceptual Framework by 2015: Derecognition, Presentation & Disclosure; and P&L/OCI (Hoogervorst, Clark & Knubley, 2014). In view of such an evolutionary approach of the CF, Solomons (1986:122) has called into question the appropriateness of this approach stating the following: “if all that was needed to improve our accounting model was evolution and the natural selection that results from the development of standards, why was an expensive and protracted conceptual framework project necessary in the first place?”. Another criticism was associated with the shift of accounting standards towards rules-based standards leading to inadequacies in the accounting conceptual framework (Pike & Chui, 2012). Hines (1991) has explored in more details the nature of reasoning of the FASB’s CF, drawing an analogy of Azande’s “poison oracle”. Based on this theory, Hines (1991: 320) claims that the objective world is a presupposition, product, and process of FASB reasoning. Further, Hines (1991:24) challenges the existing approach to “reality” suggesting that a true reality is “real in its consequences”, as it involves human factor. Recently, there was carried out another study aiming to analyze the accounting CF usefulness in providing an adequate basis for standard setting. Pike & Chui (2012) have analyzed the five qualitative characteristics of the accounting information and its relationship to intention of the user to rely on or use financial statements. The results have provided empirical evidence of the criticism related to inadequacy of the framework, as only one of five qualitative characteristics (reliability) affected an individual’s intention to rely on or use financial statements (Pike & Chui, 2012). Further, Pike & Chui (2012) have found that an individual’s intention to rely on or use financial statements is highly correlated and dependent on his/her familiarity with accounting theory. This evidence indicates that the CF fails to be helpful to a broader category of users (Pike & Chui, 2012). This study clearly supports the idea of reality suggested by Hines (1991), whereas the reality laid out in the CF is different from the reality in its consequences. Summary and discussion References: Benston, G.J., Carmichael, D.R., Demski, J.S., Dharan, B.G., Jamal, K., Laux, R., Rajgopal, S. & Vrana, G. 2007, "The FASBs Conceptual Framework for Financial Reporting: A Critical Analysis", Accounting Horizons, vol. 21, no. 2, pp. 229-238. Hines R., 1991, ‘The FASB’s Conceptual Framework, financial accounting and the maintenance of the social world’, vol 16., no 4, pp.313-331. Hoogervorst, H., Clark, P. and Knubley, R. (2014). Conceptual Framework web presentation. Available at http://www.ifrs.org/Meetings/Pages/Conceptual-Framework-Webinar-December-2014.aspx Ifrs.org, (2014). IFRS - Conceptual Framework. [online] Available at: http://www.ifrs.org/current-projects/iasb-projects/conceptual-framework/Pages/Conceptual-Framework-Summary.aspx Pike, B. & Chui, L. 2012, "An Evaluation of the FASB’s Conceptual Framework from a user’s perspective’ , Academy of Accounting and Financial Studies Journal, vol. 16, no. 1, pp. 77-94. Solomons D., ‘The FASB’s Conceptual Framework: An Evaluation’, Journal of Accountancy, 161, 6, pp. 114-124. Read More