The Importance of a Conceptual Framework in Financial Accounting

Discuss about the  Accounting Theory for Expenses, Liabilities and Assets.

A conceptual framework is defined as an evaluation tool comprising of various contexts and variations, leading towards the creation of a uniform set of standards and rules. In relation to financial accounting, these standards and rules set the functions, scope, and nature of financial reporting. All items accommodated in the financial statements of income, expenses, liabilities, and assets are recognized on the basis of the conceptual framework and it assists in assessing current accounting standards or developing new accounting standards as a whole (Graham & Smart, 2012). Furthermore, as per the FASB (Financial Accounting Standards Board) of USA, an effective conceptual framework for financial reporting is always required in a principle-based standard. Moreover, several accountants have argued upon the requirement of an efficient conceptual framework but studies have shown that in the absence of a conceptual framework, development of accounting standards cannot be done, thereby leading towards unwanted and ineffective outcomes.

Since accounting standards could be efficiently developed in the prevalence of a conceptual framework, it is clear of the fact that existing standards would become either ineffective or complex when the conceptual framework is missing. Moreover, in the corporate world, there are infinite transactions that are subject to the complexity and if a conceptual framework is effectively present, these transactions can be easily managed (Parrino et. al, 2012). Furthermore, it is very important to note that users of financial accounting would become more accountable to the standard because conceptual framework assists in informing the users about the various principles that are set out in the standard (Melville, 2013). On a whole, designers can frame relevant principles with the assistance of a conceptual framework that will in turn help in designing the procedure in a prudent way, thereby justifying its strong requirement.

In relation to financial accounting, it is notable that since the principles in IASB and FASB are well established in order to facilitate the proper functioning of relevant accounting standards, a conceptual framework that can serve both the purposes of IASB and FASB is very significant. In simple words, if a conceptual framework can satisfy the purposes of either IASB or FASB, such a framework will not function effectively, thereby leading towards inappropriate outcomes. For instance, evaluation of liabilities and assets of a company and thereafter, appropriate disclosure and exhibition of the same in financial statements. Hence, it is clear that a balanced functioning of both IASB and FASB is required in order to make the conceptual framework more beneficial and effective in terms of information and understandability. Another reason as to why a common principle is very beneficial is that a better scope can be established in the long-run process. Furthermore, the conceptual framework of IASB can easily clench the future course of IFSB. For instance, it is the prime responsibility of the AASB to take into account the IFRS in order to incorporate the same into the ASA (Accounting Standards of Australia). Therefore, the future course of action of the ASA can then be easily influenced by the IASB. Hence, in order to acquire the most effective outcomes, a framework that serves the purposes of both IASB and FASB must be established. Moreover, it is the key duty of a conceptual framework to address the issues properly instead of creating doubts and complexities, because utilization of a framework that does not cater to the requirements of both IASB and FASB will create various confusions (IASB, 2013).

Advantages of a Conceptual Framework

The advantages of a conceptual framework comprise of developments of several concepts in a specific order that can make the financial reporting more effective, logical, enhancement of overall communication, enhancement of the compatibility of standards both nationally and globally with the assistance of developed consistency. Furthermore, the users of financial accounting can acquire several benefits from such interconnection betwixt financial accounting and report (Seilber, 2015). This makes it clear that a conceptual framework enhances and improves the accounting standards, thereby making it more economical and easy for the users.

Furthermore, the principles in IASB and FASB are well established and can be very beneficial in application to situations where significant accounting standards are absent. These principles can be also be applied to policies where there is the prevalence of conflicts of interests but the policies that are backed by an efficient conceptual framework will not have any disadvantages. In simple words, in the absence of a conceptual framework, ambiguous guidelines and rules could facilitate in creating external pressures but a well-defined conceptual framework can make the users more accountable to financial accounting as they can acquire the advantages of flexibility, thereby making the procedure of reporting easier (Tysiac, 2015). Therefore, to conclude, a conceptual framework efficiently contributes towards building public confidence by employing well-established principles for the users. It helps in creating a better impact and leads to a strong presentation.

The problems or complexities that are prevalent in the financial reporting process are termed as cross-cutting issues. Since there are a massive amount of transactions, there might be various kinds of complexities when the financial statements of a company are dealt with. In order to understand and assess different methods of addressing these issues, the Board has suggested that the domination of impact and changes in measurement in the financial statements is highly needed (Williams, 2012). Determination of future expenses must also be done in the period of selection of an accounting method for financial reporting. Besides, the basis of measurement is inclined towards depicting another substitute. In other words, during the selection of a basis of measurement, these cross-cutting issues tend to arise in the accounting process (Northington, 2011). For instance, during the period of analysis of the assets and liabilities of a company, it becomes problematic to ascertain which basis must be opted for, that is whether a single basis or a combined basis. Therefore, it must be noted that proper planning must be done if there is a prevalence of more than one basis of measurement in the accounting process. Moreover, when the basis of measurement is selected, such depiction of alterations must also be done in the income statement of the company in order to facilitate comparability.

IASB and FASB Principles for Financial Reporting

People of the accounting world are already aware of the fact that historic cost is considered as a GAAP (Generally Accepted Accounting Principle) and it requires that every financial statement of a company must be based on original cost. In other words, historical cost is the cost or expense of an item incurred by the company and it is completely distinct from the fair value of the market. Furthermore, in relation to asset acquisition, this historical cost notion suffers from various drawbacks leading towards criticisms because this concept fails to consider the current market value of the asset. In other words, the concept of historical cost only gives due significance to the allocation of costs while it neglects to offer any importance to the value of assets. Another reason why this concept suffers from various criticisms is that offers explanation to the users only about the depreciation and asset acquisition cost in the subsequent years, thereby failing to consider the asset’s current market value that can vary from the offered commendation. Even in relation to the inflation period, this concept is highly criticized by many because it is based on an assumption that the currencies are appropriately balanced, thereby implying that the purchasing power of people is inoperative over the time. However, it is notable that in the period of inflation, the prices of assets are highly influenced because any asset purchased for a particular period will eventually become more expensive in the upcoming period. On a whole, it is clearly observable that the historical cost concept only gives due significance to the assets’ original cost and thereafter utilizes the same throughout the remaining tenure of the asset. Hence, it can be said that the assets portrayed on the company’s financial statements fail to offer a true and fair view of the company’s financial position because these assets consist of an unfeasible value of fixed assets.

This image of accounts primarily gives due consideration to the evolution of financial statements of a company. Financial statements like the income statement of a company must be based upon the system of valuation as it assists in depicting the economic reality that cannot be depicted by the system of historical cost. They key ideology to this notion is that the financial statements of a company must be capable of revealing its entire funds and therefore, each and every liability and economic assets must be taken into due consideration. The second explanation is that the company’s financial statements portray its present value information and therefore, it is vital that economic reality must be clearly depicted. Furthermore, in relation to the present scenario, this image also assists in developing the system of accounting research, which signifies that depiction of economic reality is a vital requirement considering the fact that accounting information accommodated in the financial statements of a company is reliant upon matters that are observable in this economy.  Therefore, this can be regarded as a very significant measurement principle in accounting as it assists in offering extraordinary information to all the users of financial accounting. Moreover, any kinds of information that cannot be intimated in monetary denominations are simply not taken into consideration.

Cross-Cutting Issues in Financial Reporting

Measurement of economic reality is a very vital issue in the given period. Since a long time, companies have been utilizing several methods like Generally Accepted Accounting Principle (GAAP) and Earnings per Share (EPS) in order to measure performance. However, in relation to the present situation, the method of EPS is only being given due consideration. Besides, the method of measurement by EPS is being considered as the most appropriate method but the actual reality differs from the same. This is because the methods that are adopted for the calculation of EPS plays a key role in exiling the prime costs, thereby altering the performance outcomes of a company. With the gradual progress of time, Economic Value-Added (EVA) is replacing the ideology of EPS being the best performance measurement method because it assists in altering the beliefs of people by altering their beliefs on value. Furthermore, it is notable that this method is of immense benefit to the investors and shareholders as they can attain a true and fair view of the company’s performance (William, 2010). Besides, companies that are adopting EVA for measurement of true performance are more likely to gain than other companies because of the fact that EVA can play a very important role in depicting economic reality in a more efficient manner (Laux, 2014). In addition, this concept is also very significant because unless opportunity costs and cost of capital are being covered, companies are incapable of earning further gains.

The reliability concept of accounting implies that any information incorporated in the financial statements of a company must not contain any flaws and must be complete in every aspect, thereby making the information more meaningful, understandable, and reliable to the users. Furthermore, the information must also align with the accounting standards so that the users can take relevant decisions based on such information (Needles & Power, 2013). This concept is very vital in accounting because misstatements in financial statements of a company can deteriorate the reliability or dependence, thereby leading towards topsy-turvy outcomes. When one company sues another one, the economic stability is impacted.

In the system of accounting, the concept of reliability can be efficiently undertaken with the proper assistance of various accounting principles like the concept of prudence, economic entity, etc. Investors will not have a willful desire to invest in a particular company if the prevalence of the concept of reliability is missing because this concept helps in establishing the truthfulness of any information (Seilber, 2015). Furthermore, in the given scenario, the concept of reliability is being given due consideration because the users of financial accounting highly exert their confidence upon that information that can be relied upon, rather than information that lacks reliability.

Historical Cost Concept in Financial Accounting

With time passing by, environmental expenses for the retirement of assets have highly risen because of a consistent increase in the environmental issues. It has been coined in many of the studies because it is vital for the smooth functioning of the company. Therefore, provisions are being made in response to this issue and it has proved to be of major benefit because recognition of such provision can, in turn, assist in framing provisions especially for those retired assets that will possess no utilization in the upcoming period (Landsman et. al, 2014). Furthermore, recognition of such provision can also assist in rebuilding a fresh asset that can prove to be very relevant and beneficial for companies with massive asset base. In addition, companies also become well prepared for situations when their assets have no use in future, thereby assisting in progressing towards development. Moreover, companies capable of ascertaining the fair value of their assets and simultaneously recording the provisions are more likely to operate efficiently than another company is because this indicates that environmental liabilities are well reserved. In simple words, the establishment of a provision assists a company to operate in an efficient way, thereby minimizing different pressures exerted on it (Wagenhofer, 2014). On a whole, this provision highly assists in the easy retirement of assets without interfering with the smooth operations of the company. In addition, the fair value of assets can also be easily determined with the assistance of this provision.

The US companies to defer the identification of a liability utilize various prospects and in relation to this, various steps are being initiated in order to differentiate betwixt the present and proposed obligations. For this purpose, the probable possibilities of future outflows together with their economic advantages are being taken into consideration. Furthermore, obligations that fail to align within the meaning of liability are not taken into account (Landsman et. al, 2014). However, any type of liability that fails to be identified and is incapable of being crystallized into a specific liability is termed as a contingent liability and therefore being deferred. These contingent liabilities fail to form part of the Balance Sheet and are recognized separately in the notes segment as disclosure items. The notes segment in the Balance Sheet that describes the contingent liabilities assists in explaining that such contingent liabilities are conditional upon the satisfaction of various rules and regulations that are portrayed in the environmental regulations segment (IASB, 2011). Moreover, many US companies adopt this procedure so that the recognition of liabilities can be deferred. This makes it clear that under this procedure, observation of contingent liabilities becomes a very vital and appropriate step. For example, after taking into consideration the annual report of Brambles Ltd, it can be noted that the company has clearly recognized its contingent liabilities in the notes section of its Balance Sheet stating about the different rules and regulations that induce it.

Liability recognition is a very important notion as it assists in making the financial statements of a company more concise and clear in the eyes of readers, thereby making it very powerful. Hence, it is through the part of the recognition that a paramount importance is gained. Furthermore, this notion also plays an important role in influencing the present and future year net profits of a company because of various assumptions did by the users of financial accounting relating to clenching and forecasting of present year’s net profit based on the company’s liabilities (Guerard, 2013). Moreover, liabilities must only be recognized as and when they occur or when they happen. Furthermore, the reason behind the impact of future year’s net profits is that the influence of liabilities in the financial statements of a company continues to happen regularly. This is the reason why net profits are impacted by the recognition year and the future year. In addition, the cash flow of present and future year also is influenced because of this notion. When the recognition of a liability is at a minimal phase, a higher cash flow will be generated and when the recognition is at a very high phase, the cash flow generated will be very low (Davies & Crawford, 2012). The key reason behind this notion is that determination of cash flow can be done only after considering the liability recognition as cash is always desired in order to fulfill the upcoming future obligations. Moreover, while the future year’s flow of cash is highly dependent on the recognition of a liability, the present year’s flow of cash can help in satisfying the current liabilities as these already exist on the company’s financial statements.

Recognition of a liability is very relevant for companies because a liability is an obligation that has occurred in the past and the company must discharge the same by spending its resources that possess economic advantages. Furthermore, it is also notable that these obligations must refer to the present scenario but had taken place in the past. Proper identification and depiction of these liabilities on the financial statements are very important as it proves to be of utmost importance to the users. In order to understand this notion more effectively, two different steps must be taken into consideration (Davies & Crawford, 2012). The first test implies that outflow of funds from a company is more likely to occur subsequently and therefore, this proves that liability recognition is rational when the settlement of a company can be completely assured. The second test implies that the expenses of the obligation can determine in a fair manner, thereby proving that the liabilities that are subject to measurement in terms of objectivity can only be identified in the financial statements of a company. Moreover, an obligation that can be regarded as a liability but is incapable of being recognized is termed as a contingent liability. These liabilities are not depicted under liabilities section in the financial statements of a company and instead, are shown in the notes segment of the Balance Sheet (Deegan, 2012). In order to attain a true and fair view of the financial statements of a company, it is very significant to know that disclosure of liabilities is very important especially when it falls in the disclosure zone.

References

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