The Need for Conceptual Framework - Assignment Example

CONCEPTUAL FRAMEWORK OF FINANCIAL REPORTING INTRODUCTION The conceptual framework is a body of statement of interrelated objectives and generally accepted fundamentals of financial reporting. The framework tries to identify the goals and purposes of financial reporting and uses the concepts of theoretical principles that help to achieve these goals. (Foster and Johnson, 2001) These theoretical principles are actually used to develop the new accounting standards or evaluate the existing ones for their relevance. As it is known that the main purpose of the financial reporting process is to provide the necessary information that can be used in the business and economic decision-making process. The general users such as creditors, investors etc use this information for making many crucial decisions. And hence it is important to include the relevant details in the reports. And this process can be facilitated by the use of conceptual framework which will form the basis for determining the events which should be accounted for and how such events be measured and how they should be shown or provided to the user. Thus many experts and accountants have tried to define and develop the conceptual framework in past but there has been no agreements between them. As per Carsberg (1984) – The conceptual framework is a natural endeavor which is taken up experts in all subjects that have supposedly scientific basis. Thus there is a definite need for a common framework or set of principles to be followed by the accountants and financial experts all over the world. (Archer, 1993b) And finally, according to the Financial Accounting Standards Board the conceptual framework can be described as “ a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting statements” (FASB, 1976, p.2). THE NEED FOR CONCEPTUAL FRAMEWORK The need for conceptual framework has been debated for long by experts, and most of them do agree that it is definitely required. Actually the advantages are many. Though some of them do feel that by defining some rules and principles – the rigidity sets in and people are not free to interpret them as sometimes required. But it is a fact, seen on other fields as well, that the credibility of financial reporting is enhanced when objectives and concepts are used to provide reliability and a stamp of authority to financial statements and reports. And since all financial personnel follow the same principles, though there may be some variations depending upon the interpretation, the general results and reports are same and users can take them at their face value. The framework helps by setting up of standards that are not only internally consistent but also consistent with each other. And thus the users as well the makers of financial statements benefit from them and are less prone to individual whims and judgments of accountants. The need for conceptual framework for financial processing has been debated since 1930s. (Archer, 1992) The Financial Accounting Standards Board tried to fulfill this need from 1978 to 2000 by providing seven versions of conceptual framework but still has not been successful in getting an agreement on them. Many experts have criticized the board for their approach. (for example Macve (1997) Power (1993), Gore (1992), Stamp (1981, 1982) , and Ijiri (1983). Many of them have suggested their own approaches such as the use of Rawl’s Theory of Justice as a paradigm (Power, 1993) or the jurisprudential approach by Archer and Stamp (1981). Similarly, Ijiri (1983) votes for an accountability approach. ADVANTAGES AND DISADVANTAGES Let us consider the main advantages of having the conceptual framework: 1. Some countries have developed standards in a haphazard and patchwork basis depending on the need or because of a particular problem having been encountered. When there is an agreed framework, then the standards help to interpret the accounting rules on those agreed upon basic principles. 2. Moreover, since long, the financial reporting process have been subject to interference from interested groups and influential lobbies and political parties. Thus if there is a conceptual framework, the rules will be interpreted based on those and unnecessary pressure to bend the rules cannot be applied. 3. If there is no basic framework, the fundamental principles will also be open to various interpretations leading to contradictions and inconsistencies in basic concepts. Some standards will focus on the income statement whereas some may concentrate on the valuation of net assets and the balance sheet. And thus the basic credibility and reliability of the financial reporting will be lost. Disadvantages: But there are some issues which will need to be discussed and will require deft handling. 1. Financial statements are used by a variety of users, and it is not possible to devise and define a single conceptual framework that will suit everyone. There will be some shortcomings or some users may require extra reports to supplement the ones based on the conceptual framework. 2. There is no certainty that a conceptual framework will make the task of preparing and implementing standards easier than before or all other countries and people will follow them. Thus we see that there may be some problems, but it will be more useful if the conceptual framework is in place. As said before, the main reason of producing financial statements and reports are to satisfy the requirements of external users. And this methodology will be different for different countries because of the social, political, economic or legal pressures which will be particular or dominant to that region. Thus to sort out these differences and to be on the same wavelength at least when talking about standard terms, the Financial Accounting Standards Board or the International Accounting Standards Board are trying o work on this controversial issue and regulate or standardize the regulations governing the accounting standards and their preparation and presentation. The FASB has come up with seven concepts so far between 1978 and 2000. FASB has given some basic objectives (which is to provide a bias free information to make business and economic decisions – this is called the decision-usefulness approach), qualitative characteristics (understandability, relevance, reliability and comparability with sub ingredients of timeliness, verifiability etc.), essential elements of the financial statements (such as assets, liabilities and equity; income and gains; expenses and losses etc.), objectives of financial Reporting by Non business Organizations, recognition and measurement in financial statements, and elements of financial statements of non business organizations of the conceptual framework. (FASB, 2006) DEVELOPMENT OF THE CONCEPTUAL FRAMEWORK There have been different approaches suggested by many experts. As mentioned above, the use of Rawl’s Theory of Justice as a paradigm by Power (1993) or the jurisprudential approach by Archer and Stamp (1981) and an accountability approach by Ijiri (1983). Of late, a principles-based system and a rules based system have been promoted. The principle based system is based on a well defined set of principles while a rules-based system works on the issues as and when they arise. Both of these have their own advantages and disadvantages. The first one ensures that any new standard or rule is based on the previous set and there is no conflict and no ambiguity in the interpretation of the standards. But when there is no reporting framework, a rules-based approach is more useful. This helps to predict and cover every eventuality. But as seen before, it does not necessarily prevent financial irregularities. For example the most famous case of Enron company Thus recent experts are voting for the need to continuously reviewing and updating the framework based on new criterias and situations. The IASB and the FASB are now working to produce a joint conceptual framework which should combine the best of both approach. LIMITATIONS OF A GENERAL CONCEPTUAL FRAMEWORK Actually, it is not possible for any framework to consider all kinds of combinations and permutation required by the users of financial reports. In fact, financial reporting in itself is one of the many sources of information needed by users making investment, credit, and similar resource allocation decisions. Thus the conceptual framework cannot satisfy everyone. Secondly, there will be some limitations of the information as well. Since the financial reports are based on estimates and not exact figures, the framework establishes the concepts that underlie those estimates. So, it is very difficult to take all sorts of economic, financial, legal and social considerations into these reports. Thus the costs and technical feasibility will be an important factor in the correctness of the estimates. And thus in some cases, it will be more useful to continue to accept estimates based more on accounting conventions than on the concepts in the framework. But in the majority vases, the use of conceptual framework should go a long way in improving the information provided to users for making economic and business decisions. References Archer, S., 1993b On the methodology of constructing a conceptual framework for financial accounting. In: Mumford, M.J. and Peasnell, K.V. (Eds.): Philosofical perspectives on accounting. London, Routledge, pp. 62-122. Carsberg, B 1984 ‘The quest for a conceptual framework for financial reporting’, in Carsberg, B. and Dev, S. (eds), External financial Reporting, Prentice-Hall International Financial Accounting Series, PreliminaryViews: Conceptual Framework for Financial Reporting: Objective of Financial Reporting , 2006 , FASB Foster, J and Johnson, T, 2001. Understanding the Issues, Financial Accounting Standards Board: Why Does the FASB Have a Conceptual Framework? Gore, P., 1992 The FASB Conceptual Framework Project 1973-1985. Manchester University Press. Ijiri, Y 1982 ‘On the Accountability-Based Conceptual Framework of Accounting’, Journal of Accounting and Public Policy, 2, pp. 75-81 Power, M K. 1993: ‘On the idea of a conceptual framework for financial reporting. In: Mumford, M.J. and Peasnell, K.V. (Eds.): Philosofical perspectives on accounting. London, Routledge, 1993, pp. 44-61. Stamp, E 1981 ‘Accounting standards and the conceptual framework: a plan for their evolution’, The Accountant’s Magazine, pp. 216-221. Stamp, E 1982 ‘First steps towards a British conceptual framework’, Accountancy, pp. 123-130. Read More