Financial Accounting - Part 2
Accounting theory and conceptual frameworks After studying this chapter you should be able to: & explain what accounting theory is & describe the main attempts at constructing an accounting theory & appraise current developments in the area & describe and discuss the contents of the IASB Framework & appraise the quality and usefulness of the IASB Framework in the context of its self-declared purposes & describe and discuss the parts of IAS 1 relating to accounting concepts and policies & appraise the overall effect of the Framework and comparable parts of IAS 1.
Introduction This chapter is about to deal with something that many people believe does not exist – a single generally accepted accounting theory - Financial Accounting introduction. There is no generally accepted accounting theory at this time even though many attempts have been made to formulate one. According to Eldon S. Hendriksen in Accounting Theory (1977), Theory as it applies to accounting is the coherent set of hypothetical, conceptual and pragmatic principles forming the general frame of reference for a ? eld of inquiry. Thus accounting theory may be de?
More Essay Examples on Inventory Rubric
ned as logical reasoning in the form of a set of broad principles that 1 Provide a general frame of reference by which accounting practices can be evaluated and 2 Guide the development of new practices and procedures. Accounting theory may also be used to explain existing practices to obtain a better understanding of them. But the most important goal of accounting theory should be to provide a coherent set of logical principles that form the general frame of reference for the evaluation and development of sound accounting practices. IS AN ACCOUNTING THEORY POSSIBLE? 115
Let’s compare this with what many believe is the accounting framework, the IASC Framework for the Preparation and Presentation of Financial Statements. This Framework purports to: 1 assist the board of IASC in the development of standards and review of existing standards 2 provide a basis for reducing the number of permitted alternative accounting treatments 3 assist preparers in dealing with topics that have yet to form the subject of a standard. This certainly sounds like an accounting theory. But if it is, then this theory would clearly determine how we should provide information to users and different practices would not prevail.
The primary purpose of an accounting theory should be to provide a basis for the prediction and explanation of accounting behaviour and events. Is an accounting theory possible? According to both Hendriksen (1977) and McDonald (1972) the development of an accounting theory should be possible. McDonald argues that a theory must have three elements: 1 encoding of phenomena to symbolic representation 2 manipulation or combination according to rules 3 translation back to real-world phenomena. Activity 8. 1 Do the three elements that McDonald states are necessary for a theory exist in accounting?
Activity feedback The ? rst obviously exists as we have the symbols of ‘debits and credits’ and we have also developed accounting terminology e. g. depreciation, accruals, matching, current cost, revaluation etc. all unique to accounting. The second also exists as we have a wealth of rules and regulations for manipulating or combining these debits and credits. Translation is evidenced in how we present these debits and credits to users in the form of ? nancial reports. Approaches to the formulation of accounting theory
If it is possible to develop an accounting theory (Hendriksen and McDonald) then how do we approach its development? Research in this area has centred on traditional approaches, regulatory approaches and what has come to be regarded as new approaches. We will look brie? y at each of these three types. 116 ACCOUNTING THEORY AND CONCEPTUAL FRAMEWORKS Traditional approaches Traditional approaches cover: & & non-theoretical theoretical. Non-theoretical approaches to accounting theory are concerned with developing a theory or accounting techniques and principles that will be useful to users, particularly decision makers.
This approach can be developed in a pragmatic or authoritarian way. In essence this is the approach the accounting profession has used in the past to develop an accounting theory and it is fairly apparent it has not been able to resolve con? ict in accounting practices or principles. Theoretical approaches to the development of an accounting theory are many but Belkaoui, in his text Accounting Theory, categorizes these as: & & & & & & deductive inductive ethical sociological economic eclectic.
Deductive approach This approach involves developing a theory from basic propositions, premises and assumptions which results in accounting principles that are logical conclusions about the subject. The theory is tested by determining whether its results are acceptable in practice. Edwards and Bell (1961) are deductive theorists (Chapter 4) and historical cost accounting was also derived from a deductive approach. Inductive approach For this approach we start with observed phenomena and move towards generalized conclusions. The approach requires empirical testing, i. e.
the theory must be supported by suf? cient instances/observations that support the derived conclusions. Quite often the deductive and inductive approaches are mixed as researchers use their knowledge of accounting practices. As Riahi-Belkaoui states: General propositions are formulated through an inductive process, but the principles and techniques are derived by a deductive approach. He also observes that when an inductive theorist, Littleton (1935), collaborates with a deductive theorist, Paton (1922), a hybrid results showing compromise between the two approaches. Ethical approach Activity 8. 2
Identify concepts that could be at the core of the ethical approach to an accounting theory. APPROACHES TO THE FORMULATION OF ACCOUNTING THEORY 117 Activity feedback Basically, this approach consists of the concepts of ‘true and fair’. These concepts have, of course, been taken on board by the EU in the Fourth Directive. Writers/researchers in this area are D. R. Scott (1941) and Yu (1976). Sociological approach This is actually an ethical approach that centres on social welfare. In other words, accounting principles and techniques are evaluated for acceptance after considering all effects on all groups in society.
Thus within this approach we would need to be able to account for a business entity’s effect on its social environment. We consider this type of reporting in Chapter 10. Economic approach This approach focuses on general economic welfare. Thus accounting principles and techniques are evaluated for acceptance depending on their impact on the national economy. Sweden, in its national GAAP, uses an economic approach to its development. The IASB in developing its standards does tend to take an economic approach into account.
For example, the current discussion on accounting for leases focuses on the effect that a standard requiring the capitalization of all leases, whether ? nance or operating, might have on the economy or business in general. Traditionally, accounting standards have been set without considering economic consequences but lobby pressures from groups who perceive themselves as being affected can be strong. Eclectic approach This is perhaps our current approach where we have a combination of all the approaches already identi? ed appearing in our accounting theory.
This approach has come about more by accident than as a deliberate attempt, due to the interference in the development of accounting theory by professionals, governmental bodies (including the EU) and individuals. This eclectic approach has also led to the development of new approaches to accounting theory. Regulatory approaches Many would regard this as the approach we currently have to accounting theory. They hold this view because to them it does not appear that standards, even those of the IASB, are based on broad, relevant theories but are developed as solutions to current con?
icts that emerge in our attempts to provide useful information to users. Indeed, they might argue that new standards are only developed when a particular user complains about misinformation or non-information. But there are questions to consider if we do adopt this approach to the development of accounting theory. In the main these questions centre on whether we should adopt a freemarket approach to the regulation, a private sector regulatory approach or public sector regulatory approach. This regulatory approach is also one that tends to identify solutions to dif?
culties that have occurred in our reporting rather than providing us with a theory that anticipates the issues. 118 ACCOUNTING THEORY AND CONCEPTUAL FRAMEWORKS New approaches These attempt to use both conceptual and empirical reasoning to formulate and verify an accounting framework (Belkaoui, Accounting Theory, Chapter 10). The approaches are: & & & & & events behavioural human information processing predictive positive. Events approach The events approach was developed in 1969 by George Sorter and was de?
ned as ‘providing information about relevant economic events that might be useful in a variety of decision models’. The events approach leaves the user to aggregate and assign weights and values to the event. The accountant would only provide information on the economic event to the user, he would not assume a decision model. Thus, for example, the event approach income statement would not indicate ? nancial performance in a period but would communicate events that occurred during the period without any attempt to determine a bottom line. Activity 8. 3
Identify advantages and disadvantages of the events approach to the development of an accounting theory. Activity feedback 1 Research has shown that structured/aggregate reports are preferable for high-analytic decision makers but not for low-analytic decision makers. Thus, the success of the events approach is dependent on the analytical skills of the user. 2 Users, in attempting to evaluate all information provided, may reach ‘information overload’. 3 No criteria have yet been developed for the choice of events to be reported. 4 It will probably prove dif? cult to measure all characteristics of an event.
Behavioural approach The behavioural approach attempts to take into account human behaviour as it relates to decision making in accounting. Devine (1960) stated the following: On balance it seems fair to conclude that accountants seem to have waded through their relationships to the intricate psychological network of human activity with a heavy handed crudity that is beyond belief. Some degree of crudity may be excused in a new discipline, but failure to recognise that much of what passes as accounting theory is hopelessly entwined with unsupported behaviour assumptions is unforgiveable.
APPROACHES TO THE FORMULATION OF ACCOUNTING THEORY 119 This to us seems fair comment. Given that ? nancial reporting is about communicating information to users to enable them to make decisions, a lack of consideration of how that information in? uences their behaviour is indeed unforgivable. Studies in this area have tended to concentrate on: & & & & & the adequacy of disclosure usefulness of ? nancial statement data attitudes about corporate reporting practices materiality judgements decision effects of alternative accounting practices.
In one of these areas, materiality, it was discovered that users’ assessment of materiality was individualistic and that the provider of the information was not in the best position to determine materiality for a user. There is much work still to do within the behavioural approach. Human information processing approach This is similar to a behavioural approach in that it focuses on how users interpret and use the information provided. Predictive approach This approach attempts to formulate an accounting theory by focusing on the predictive nature/ability of a particular method of reporting an event that would be of use to the user.
Such approaches are most prevalent in what could be regarded as management accounting. Ef? cient market hypothesis, Beta models, chaos theory are all examples of this approach. Positive approach This can be best explained by quoting Jensen (1976), who called for the: development of a positive theory of accounting which will explain why accounting is what it is, why accountants do what they do, and what effects these phenomena have on people and resource utilisation. The approach is based on the proposition that managers, shareholders and regulators are rational and that they attempt to maximize their utility.
The theory became known as ‘the Rochester school of accounting’. The positive approach is completely opposite to the normative approach and attempts to explain why accounting procedures and policies are as they are, whereas the normative approach attempts to prescribe the accounting procedures and policies to be implemented. The future of theory This section has been very brief and has mainly merely listed the approaches to the development of an accounting theory that exist in the current literature. For an in-depth study of this area we recommend Accounting Theory by Belkaoui.
This does, however, leave us with several questions: & & Can we develop an all-encompassing accounting theory? Would such a theory be useful to users? 120 ACCOUNTING THEORY AND CONCEPTUAL FRAMEWORKS & & Should any theory be global in aspect and take into account behavioural aspects? Do researchers need to take into account their own underlying cultural beliefs and behaviour when developing an accounting theory? As Glen Lehman states in Accounting Forum (2001) in his editorial: Accounting might bene? t by exploring its direction and future.
Accounting must improve ‘community usefulness’ and not just simply expand into other ? elds such as information technology if it is to remain committed to the public interest. The technology of accounting might bene? t through consideration of the relationships between regulation and construction of community virtues. Accountants have been criticised for assuming that if the ‘? gures’ are constructed in line with current mandatory and legislative requirements, then the accounts are true and fair. Yet what is reported often bears little relation to a reasonable view of the true ? nancial health of the enterprise.
Future accounting research might work toward explaining the means through which corporations might be enabled to act in the interests of the communities they serve. This statement is particularly pertinent given the Enron and Worldcom disasters in the USA. The IASB conceptual framework We have already outlined some of the fundamental general concepts of accounting in Chapter 1. We quickly noted that they are not always compatible between themselves and that they do not necessarily provide a prescriptive solution to a given problem. They do not, therefore, provide a rational coherent basis, which can be applied, in a scienti?
c sense, to solve problems in ways which are likely to be themselves consistent and compatible. They are not true ‘theories’ in the sense discussed earlier. A number of attempts have been made since the 1970s to create some form of more coherent conceptual framework. The IASB version, known as the Framework for the Preparation and Presentation of Financial Statements, was issued in 1989. It belongs to the family of conceptual frameworks for ? nancial reporting that have been developed by accounting standard setters in a number of countries where accounting standard setting is carried out by a private sector body.
On one level, such conceptual frameworks may be considered attempts to assemble a body of accounting theory (or interrelated concepts) as a guide to standard-setting, so that standards are (as far as possible) formulated on a consistent basis and not in an ad hoc manner. On another but complementary level, they may be thought of as devices to confer legitimacy and authority on a private sector standard setter that lacks the legal authority of a public body. The IASB, as a private sector standard setter, shares these reasons for developing a conceptual framework.
Conceptual frameworks developed by accounting standard setters are essentially based on identi? cation of ‘good practice’ from which principles are derived inductively. The criteria for identifying ‘good practice’ are related to the assumed objectives of ? nancial reporting. At the same time, attention is paid to conceptual coherence, and the development process typically involves ‘conceptual tidying up’. Conceptual frameworks may be written in a prescriptive style or a descriptive style, or a mixture of the two. In any event, they are essentially normative, since they seek to provide a set of principles as a
THE IASB CONCEPTUAL FRAMEWORK 121 guide to setting and interpreting accounting standards. Such guidance, however, does not necessarily preclude a standard being issued that, for compelling pragmatic reasons, departs from a principle set out in the applicable conceptual framework. The IASB’s Framework is written in a descriptive style (in fact, it is IASB policy to use the word ‘should’ only in Standards) and seeks to avoid being excessively prescriptive. A principal reason for this is that it needs to have broad international applicability.
In the ? nal paragraph of the Framework, the IASB states: This Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the ? nancial statements constructed under the chosen model. At the present time , it is not the intention of the Board of IASB to prescribe a particular model other than in exceptional circumstances, such as . . . a hyperin? ationary economy. The Framework was intended to be separate from the IASs and to avoid binding the IASB to particular accounting treatments in IASs.
It was approved and issued in April 1989 and has not been revised since that time, although the need to update it is now clearly recognized by the new board. However, the Framework has been quite in? uential in the recent development of IASs and in major revisions. For example, its de? nitions (and especially those of assets and liabilities) were highly in? uential in the preparation of IAS 22, Business Combinations; IAS 37, Provisions, Contingent Liabilities and Contingent Assets; IAS 38, Intangible Assets and IAS 39, Financial Instruments: Recognition and Measurement.
The Framework is not an IAS and does not override any speci? c IAS; in case of con? ict between it and an IAS, the requirements of the latter prevail. One may, however, consider the Framework as embodying IAS GAAP in respect of issues that are not dealt with in any IAS. This is apparent from the way in which the purpose and status of the Framework are described (see points 4 and 5 in the following list). For example, in the case of topics that have not yet been the subject of an IAS, the purpose of the Framework is to assist preparers in dealing with such topics.
Moreover, the IASB will be guided by the Framework in the development of future IASs and in reviewing existing ones, so that the number of cases of con? ict between the Framework and IASs are likely to diminish over time. The Framework itself will be subject to revision in the light of experience. A revision can be expected over the next few years as part of the new board’s development programme. The IASB Framework As indicated earlier, the Framework does not have the status of an IAS, does not override any speci? c IAS and, in case of con? ict between the Framework and an IAS, the latter prevails (paras 2–3).
The purpose of the Framework is stated as follows (para. 1): 1 To assist the Board of IASC in the development of future IASs and in its review of existing IASs; 2 To assist the Board of IASC in promoting harmonization of regulations, accounting standards and procedures relating to the presentation of ? nancial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IASs; 3 To assist national standard-setting bodies in developing national standards; 122 ACCOUNTING THEORY AND CONCEPTUAL FRAMEWORKS 4 To assist preparers of ?
nancial statements in applying IASs and in dealing with topics that have yet to form the subject of an IAS; 5 To assist auditors in forming an opinion as to whether ? nancial statements conform with IASs; 6 To assist users of ? nancial statements in interpreting the information contained in ? nancial statements prepared in conformity with IASs; 7 To provide those who are interested in the work of the IASC with information about its approach to the formulation of accounting standards. The overall scope of the document covers: 1 objectives of ?
nancial statements 2 qualitative characteristics that determine the usefulness of ? nancial statement information 3 de? nition, recognition and measurement of ? nancial statement elements 4 concepts of capital and capital maintenance. The Framework is concerned with ‘general purpose ? nancial statements’, including consolidated ? nancial statements. These are described as being prepared and presented at least annually and being directed toward the common information needs of a range of users. They do not include special purpose reports such as prospectuses and tax computations (para.
6). The Framework applies to the ? nancial statements of all commercial, industrial and business reporting enterprises, whether in the private or public sectors (para. 8). The Framework ? rst of all outlines the users of accounting information in a manner broadly similar to our discussion in Chapter 1: & & & & & & Investors. The providers of risk capital and their advisers are concerned with the risk inherent in and return provided by, their investments. They need information to help them determine whether they should buy, hold or sell.
Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends. Employees. Employees and their representative groups are interested in information about the stability and pro? tability of their employers. They are also interested in information which enables them to assess the ability of the enterprise to provide remuneration, retirement bene? ts and employment opportunities. Lenders. Lenders are interested in information that enables them to determine whether their loans, and the interest attaching to them, will be paid when due.
Suppliers and other trade creditors. Suppliers and other creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be interested in an enterprise over a shorter period than lenders unless they are dependent on the continuation of the enterprise as a major customer. Customers. Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise. Governments and their agencies.
Governments and their agencies are interested in the allocation of resources and, therefore, the activities of enterprises. They also require information in order to regulate the activities of enterprises, determine taxation policies and as the basis for national income and similar statistics. THE IASB CONCEPTUAL FRAMEWORK & 123 Public. Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to the local economy in many ways including the number of people they employ and their patronage of local suppliers.
Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities. Para. 10 states the following: While all of the information needs of these users cannot be met by ? nancial statements, there are needs which are common to all users. As investors are providers of risk capital to the enterprise, the provision of ? nancial statements that meet their needs will also meet most of the needs of other users that ? nancial statements can satisfy. Activity 8. 4 Does the last sentence of para.
10 follow logically? Activity feedback As a matter of logic, the answer is de? nitely not. The suggestion that because investors are providers of risk capital, information meeting the needs of investors will also meet most of the needs of, say, employees is clearly nonsense. Nevertheless, as an empirical pragmatic issue, the emphasis on investors, or at least an emphasis on providers of ? nance generally, may have some validity. Either way it is widely accepted in practice. The Framework then goes on to summarize the overall objectives of ? nancial statements. This is pretty standard stuff and can be brie?
y extracted here: 12 The objective of ? nancial statements is to provide information about the ? nancial position, performance and changes in ? nancial position of an enterprise that is useful to a wide range of users in making economic decisions. 13 Financial statements prepared for this purpose meet the common needs of most users. However, ? nancial statements do not provide all the information that users may need to make economic decisions since they largely portray the ? nancial effects of past events and do not necessarily provide non? nancial information. 15 The economic decisions that are taken by users of ?
nancial statements require an evaluation of the ability of an enterprise to generate cash and cash equivalents and of the timing and certainty of their generation. This ability ultimately determines, for example, the capacity of an enterprise to pay its employees and suppliers, meet interest payments, repay loans and make distributions to its owners. Users are better able to evaluate this ability to generate cash and cash equivalents if they are provided with information that focuses on the ? nancial position, performance and changes in ? nancial position of an enterprise. 124 ACCOUNTING THEORY AND CONCEPTUAL FRAMEWORKS 19 Information about ?
nancial position is primarily provided in a balance sheet. Information about performance is primarily provided in an income statement. Information about changes in ? nancial position is provided in the ? nancial statements by means of a separate statement. 20 The component parts of the ? nancial statements interrelate because they re? ect different aspects of the same transactions or other events. Although each statement provides information that is different from the others, none is likely to serve only a single purpose or provide all the information necessary for particular needs of users.
For example, an income statement provides an incomplete picture of performance unless it is used in conjunction with the balance sheet and the statement of changes in ? nancial position. Next the Framework discusses the various ‘assumptions and characteristics’ of accounting statements. These correspond closely to the conventions and characteristics of Chapter 1, but they are arranged in a series of subgroups with various headings and subheadings, which give interesting nuances of degrees of relative signi?
cance and importance. In order to give the full ? avour of this the Framework is quoted here at some length. Underlying assumptions Accrual basis 22 In order to meet their objectives, ? nancial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the ? nancial statements of the periods to which they relate.
Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions. Going concern 23 The ? nancial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future.
Hence it is assumed that the enterprise 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 ? nancial statement may have to be prepared on a different basis and, if so, the basis used is disclosed. Qualitative characteristics of ? nancial statements 24 Qualitative characteristics are the attributes that make the information provided in ? nancial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability.
THE IASB CONCEPTUAL FRAMEWORK Understandability 25 An essential quality of the information provided in ? nancial statements is that is it readily understandable by users. For this purpose, users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence. However, information about complex matters that should be included in the ? nancial statements because of its relevance to the economic decision-making needs of users should not be excluded merely on the grounds that it may be too dif?
cult for certain users to understand. Relevance 26 To be useful, information must be relevant to the decision-making needs of users. Information has the quality of relevance when it in? uences the economic decisions of users by helping them to evaluate past, present or future events or con? rming, or correcting, their past evaluations. 27 The predictive and con? rmatory roles of information are interrelated. For example, information about the current level and structure of asset holdings has value to users when they endeavour to predict the ability of the enterprise to take advantage of opportunities and its ability to react to adverse situations. The same information plays a con? rmatory role in respect of past predictions about, for example, the way in which the enterprise would be structured or the outcome of planned operations. 28 Information about ? nancial position and past performance is frequently used as the basis for predicting future ? nancial position and performance and other matters in which users are directly interested, such as dividend and wage payments, security price movements and the ability of the enterprise to meet its commitments as they fall due.
To have predictive value, information need not be in the form of an explicit forecast. The ability to make predictions from ? nancial statements is enhanced, however, by the manner in which information on past transactions and events is displayed. For example, the predictive value of the income statement is enhanced if unusual, abnormal and infrequent items of income or expense are separately disclosed. Materiality 29 The relevance of information is affected by its nature and materiality. In some cases, the nature of information alone is suf? cient to determine its relevance.
For example, the reporting of a new segment may affect the assessment of the risks and opportunities facing the enterprise irrespective of the materiality of the results achieved by the new segment in the reporting period. In other cases, both the nature and materiality are important, for example, the amounts of inventories held in each of the main categories that are appropriate to the business. 30 Information is material if its omission or misstatement could in? uence the economic decisions of users taken on the basis of the ? nancial statements.
Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a 125 126 ACCOUNTING THEORY AND CONCEPTUAL FRAMEWORKS threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful. Reliability 31 To be useful, information must also be reliable. Information has the quality of reliability when it is free from material error and bias and can be depended on by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.