A Brief Introduction of Conceptual Framework

Category: Accounting

The first time that the terminology of "Conceptual Framework" officially turned up was in the "Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement", December, 1976, a document issued by Financial Accounting Standards Board (FASB), which laid emphasis on the elements of financial statements and measurement rather than objectives of financial accounting.

Various names of the conceptual framework are used across different organizations. For instance, similar framework is called "Statement of Principles for Financial Reporting" under Accounting Standard Board (ASB) and "Framework for The Preparation and Presentation of Financial Statements under International Accounting Standards Board (IASB). However, the key feature of each board is very similar, with most attempts to build up a universal and systematic platform for accounting research and clarify some basic accounting concept in order to guide the accounting practice and form an appropriate rule for evaluating the quality of current accounting standards.

The main building blocks for conceptual framework could be slightly different under different regulatory bodies, with most of them the same. FASB is displayed in this essay for illustration purpose. The existing FASB framework is contained in several Concepts Statements, as follows:

FASB Concepts Statement No.1, Objectives of Financial Reporting by

Business Enterprises (1978).Objectives of financial statements could be facilitating decision making, reducing debate, simplifying detailed standards

FASB Concepts Statement No.2, Qualitative Characteristics of Accounting Information(1980). Qualitative characteristics illustrate what should be good properties for financial reporting, as relevance, reliability. Note, relevance and reliability are regarded as the keystone of financial report by FASB, while understandability and comparability are added by other boards.

FASB Concepts Statement No.5, Recognition and Measurement in Financial Statements of Business Enterprises(1984). Recognition and measurement of accounting factors are defined clearly for reporting certain elements in financial report.

FASB Concepts Statement No.6, Elements of Financial Statements (1985). Main elements of financial statements include asset, liability, income, expense, etc.

FASB Concepts Statement No.7, Using Cash Flow Information and Present Value in Accounting Measurements (2000), which aimed to promote the use of fair value.

In recent years, boards seem to cooperate more frequently as the blossom of multi-nation business. Accounting conventions on the basis of different principles could lead to nasty results in accounting practice and great transaction costs. It's cheerful that regulatory bodies have acknowledged this issue as well. In October 2004, the most two influential boards, FASB and IASB, engaged in a joint project to develop a common conceptual framework. The purpose is to build up a new common framework by refining, updating, completing and converging their current ones, which can be used by both Boards in developing new accounting standards. (Revisiting the Concepts, 2005)

The common goal of the FASB and IASB is to establish a "principles-based" framework, rather than a collection of pratical conventions, thus it should be based on fundamental concepts. "For standards on various issues to result in coherent financial accounting and reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent."(Revisiting the Concepts, 2005)

It's worth mentioning Statement of Principles for Financial Reporting (SP) as it owns two additional characteristics over SFACs. One is an important concept derived in UK, "true and fair" and SP treats it as the "core" concept in dealing with financial report. Basically "true and fair" serves an supreme role in accounting affairs. The other characteristic is that SP appends presentation of financial information and accounting for interests in other entities. (Comparison of conceptual frameworks, Jiashu Ge)

Summarization of Valuation and Economic Income

In accounting theory and practice, income is always in the central position as it is a straightforward indicator for evaluating a company's performance in the perspective of shareholder, creditor, and regulator. Under the IASB/FASB approach, Hicks Number 1 income is introduced to calculate the economic income, which can be expressed as "the maximum value which the company can distribute during the year and still expect to be as well off at the end of the year as it was at the beginning."(Lecture note 1, Economic Income and Wealth, Joanne Horton). Given constant interest level r, income can be addressed as I=rV­0, where V0 is the value of certain financial asset. As a result income I is connected with value V0 by interest rate r.

It is clear from the expression above that different methods of valuation will come to different conclusion about income. So far, historical cost based valuation is widely used from time to time, while fair value is gaining greater popularity in practice. Both of them have inherent advantage and drawback, which will be stated below.

Historical cost accounting is an approach to accounting using asset values based on the actual amount on money term paid for assets. It reflects the cost when acquiring assets and states the amount in the financial statement (http://moneyterms.co.uk/historical-cost). It could be objective as the amount displayed can't be changed in most cases, so manipulation is difficult to realize. The concept of historical cost implies some assumptions, such as stable economic and political environment, continuing operations, no inflation during accounting periods, etc.

However, the advantage mentioned could be the disadvantage as well. Historical cost bases on the spot when obtaining assets and won't change easily in the financial report, thus it is unable to show the whole picture that the difference of the number stated and "true value" of asset due to the macroeconomic environment or management over the assets. Stepping into 21 century, the global economy is fluctuating harder than ever before and inflation is becoming routine in some countries and areas. Taking these factors into account, the shortcoming of historical cost stands out sharply.

Fair value, defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (SFAS157, 5) by IASB, enable itself to draw the complete picture of the assets' value, regardless of variety of influence over the assets, and enters certain accounting standards. It is highly relevant to the enterprise's value, and always up to date. Moreover, the introduction of fair value helps set balance for long-run developing strategy and short-run profit pursuing. In a lot of cases, there would be collision between long-run strategy and short-run behavior. According to statistic, 41 SFASs involve fair value among 55 which issued by FASB from Dec 1990 to Sep 2006. Fair value is enjoying greater potential in accounting practice.

A problem of fair value is that the assumption that the market is efficient and complete doesn't always hold. Deals can't be made if there is no market existing or the market is inactive. Under this circumstance the fair value will be restricted into purely numeric numbers and become useless. Another problem is that the estimate of fair value could sometimes be subjective as there is no real deal made between seller and buyer, and would be based on the account's own opinion, which could be biased. Thus the estimation of fair value is based on empirical issues and the result might be noisy.

Comprehensive Income- another attempt

In June 1998, FASB issued ED No.162, which proposed that the accounting factors should be presented as "other comprehensive income". "Other comprehensive income" are "the change in the balance of unrealized gains on marketable securities, the change in the cumulative foreign currency translation adjustment, and the change in additional minimum pension liability in excess of unrecognized prior service costs" (Is comprehensive income superior to net income as a measure of firm performance? 1999)

In 2006, the FASB issued Statement of Financial Accounting Standards (SFAS 130)-Reporting Comprehensive Income, which outlined a new summary measure of company performance, should be recorded in a company's primary financial statements. Items which are reported previously as adjustments to equity should be recorded as adjustments to income to enter comprehensive income.

Comprehensive income is defined as "the change in equity of an enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners" (SFAS 130). A firm's value could be reflected more clearly as comprehensive income approach is "all-inclusive" and consequently could provide information users more valuable information. Accounting should not only perform a measure system, but also offer information for individuals or companies to make decision.