CHAPTER 5

The Conceptual Framework for Financial Reporting

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

5.1

explain what a conceptual framework is

5.2

understand the history of and recent developments made to the Conceptual Framework for Financial
Reporting

5.3

outline the structure and components of the revised Conceptual Framework and explain the main
changes and improvements

5.4

understand and apply the prudence and recognition criteria from the Conceptual Framework

5.5

explain and evaluate the benefits of conceptual frameworks

5.6

explain and evaluate the problems with and criticisms of the Conceptual Frameworks

5.7

apply concepts from the Conceptual Frameworks to financial reporting issues

5.8
understand conceptual frameworks applicable to other sectors.

From your previous accounting studies, you will already be familiar with some parts of the Conceptual
Framework for Financial Reporting (Conceptual Framework), although you may not have looked in detail
at the Conceptual Framework itself. For example, the definitions of assets and liabilities that are in many
of the accounting standards that you have studied will have come directly from an accounting
conceptual framework. It is important to consider the Conceptual Framework, as influences on and
changes to it significantly impact the accounting standards that are used to direct financial reporting.
Conceptual frameworks have been dominant internationally in theories of accounting for the past 35
years. This chapter considers the conceptual frameworks developed by the International Accounting
Standards Board (IASB) and looks at some of the reasons for having a conceptual framework in
accounting. This chapter also considers some of the criticisms of and problems associated with the
previous Conceptual F ramework and explores the extent to which these issues have been addressed in
the recently revised Conceptual F ramework. The application of Conceptual Framework concepts to
financial reporting issues is also considered, before briefly discussing conceptual frameworks relating to
entities in other (non‐profit) sectors.

5.1 The role of a conceptual framework

LEARNING OBJECTIVE 5.1

Explain what a conceptual framework is.

A conceptual framework is a group of ideas or principles used to plan or decide something. It can be
seen as a set of guiding principles — that is, those ideas or concepts that influence and direct decisions
being made in a particular area.

Conceptual frameworks are not only found in accounting, but are also used in many areas to help
establish specific guidelines, make decisions or solve problems. For example, your lecturers will use a set
of principles relating to the purpose of professional education and the principles of adult learning when
deciding what assignments or other assessment tasks to set for their students.

Before examining the accounting Conceptual Framework in detail, this section looks at a simple example
of how a set of guiding principles can be used to help influence and direct decisions.
Governments and judges need to set rules and make decisions about punishments or penalties to be
applied when people are found guilty of a crime. In this simple example, the guiding principles (the
underlying concepts) may be as follows.

All people should be treated fairly.

The community’s safety must be ensured.

Punishments and penalties should reflect community values and expectations.

Any actual decisions about punishments and penalties to be imposed should be consistent, because they
should follow these guiding principles. Of course, the decisions would not necessarily all be identical.
The guiding principles are very broad. Specific decisions could vary because of different interpretations,
as in the following examples.

Some people may interpret the first principle (that all people should be treated fairly) as saying that all
should be treated identically. So, for example, any person who steals food from a shop should receive the
same penalty or punishment. Others may interpret ‘treat fairly’ as requiring them to take into account
the particular circumstances, so if it were a hungry child who stole the food, the penalty might be less.

Values and expectations will vary from community to community, often because of cultural, religious and
even economic influences. This can be seen in the different types of punishment imposed for the same
crimes in various countries. One community may impose heavier penalties for a behaviour than others
do. Also, community values and expectations may change over time.

Conceptual frameworks being made of broad principles is an advantage, because it means that these
principles can be used as a basis for making decisions across a wide range of situations or circumstances.
However, the principles’ breadth also has disadvantages — it is normal for more specific guidelines
(consistent with the broader principles) to be established to ensure their clearer and more consistent
application in particular circumstances. In accounting, these specific requirements are found in the
accounting standards and interpretations, and the Conceptual Framework contains the guidelines for
accounting standards.

Conceptual framework theory

The Conceptual Framework is a type of normative theory. As discussed in the chapter on theories in
accounting, normative theories provide recommendations about what should happen. They prescribe
what ought to be the case based on a specific goal or objective. The Conceptual Framework prescribes
the basic principles that are to be followed when preparing financial statements. An accounting
conceptual framework can, therefore, be described as a coherent system of concepts, which are
guidelines for the accounting standards used for financial reporting. The IASB describes the purpose of
the Conceptual Framework as a tool to:

1.

develop consistent IFRS Standards (the Standards)

2.

help preparers to develop accounting policies that are consistent when no IFRS Standard is applicable or
when a choice of accounting policy is allowed by a Standard

3.

provide users with the ability to understand and interpret the Standards.1

Normative theories include terms such as ‘should’ and ‘ought to’. The accounting Conceptual Framework
studied here makes statements such as:

The objective of general purpose financial reporting is to . . .

A liability is a present obligation . . .

If financial information is to be useful, it must be relevant and faithfully represent . . .

Although it does not use the terms ‘should’ or ‘ought to’, it outlines the concepts that should be used
when preparing financial statements.

How a conceptual framework differs from an accounting standard

As noted, the principles in the Conceptual Framework are general concepts. These are designed to
provide guidance and apply to a wide range of decisions relating to the preparation of financial reports.
Accounting standards provide specific requirements for a particular area of financial reporting.

The Conceptual Framework defines what an asset is and when it should be included in the financial
statements.

The accounting standard on inventory (e.g. AASB 102/IAS 2 Inventories) outlines the definition of what is
considered inventory and what costs are included and also requires these assets to be measured at the
lower of cost and net realisable value.

You should see that accounting standards apply to a much narrower area of financial reporting (in the
example given, the accounting standard only applies to inventory and not to other assets) and include
more detail, allowing less scope for different interpretations. Furthermore, accounting standards go
beyond areas that the Conceptual Framework has considered. For example, the inventory standard
requires that inventory be measured at the lower of cost and net realisable value, whereas the
Conceptual Framework does not specify the exact measurement basis for particular assets. Another
difference is that, ordinarily, accounting standards must be complied with (this varies between countries
but can be required by the law or professional accounting bodies). The principles in the accounting
conceptual frameworks are not mandatory (although it is often recommended that they are used for
guidance), and, if they conflict with a requirement of an accounting standard, the latter must be
followed.2 Figure 5.1 outlines the basic relationship between the Conceptual Framework and accounting
standards and interpretations.

FIGURE 5.1 The relationship between the Conceptual Framework and accounting standards

5.2 The history of the Conceptual Framework and current developments

LEARNING OBJECTIVE 5.2

Understand the history of and recent developments made to the Conceptual Framework for Financial
Reporting.

The Conceptual Framework was originally issued by the IASB in 2010 as a result of a joint project
between the IASB and the United States Financial Accounting Standards Board (FASB). This Conceptual
Framework contained sections from the Framework for the Preparation and Presentation of Financial
Statements (known as the ‘Framework’) initially issued by the IASC (the predecessor to the IASB) in
1989.

While the initial IASB Framework was issued over 20 years ago, the idea of a set of principles in
accounting has been around for much longer. From as early as the 1920s and 1930s, there were attempts
to draft statements of principles to guide accounting. The need for them was often decided in response
to reporting failures; in particular, the problems in the financial statements of some large companies. As
well as leading to accounting regulation (such as the requirement of audits of particular companies),
these failures often led many to question current accounting practice and argue that, unless accounting
was based on a set of fundamental principles, these reporting failures would continue. Several sets of
principles were proposed in the period; for example, in 1936 the American Accounting Association
issued a Statement of accounting principles. In 1959, the American Institute of Certified Public
Accountants created the Accounting Principles Board to establish, in part, a set of basic principles on
which accounting standards could be based and, in 1962, published A tentative set of broad accounting
principles for business enterprises by Sprouse and Moonitz.

Principles suggested in this period ranged from restating the principles used in current accounting
practice to proposing radical change to current accounting practice, especially in the area of
measurement. The development of more comprehensive and formal conceptual frameworks began in
the 1970s, again following company failures in the 1960s and criticisms of financial reporting, although
work on these was relatively slow and intermittent. In the United States, the FASB published six concept
statements between 1978 and 1989. This first US framework project was influential, and all future
conceptual frameworks have followed it substantially in approach and in some degree of detail.3 During
this period, the United Kingdom, Canada and Australia also worked on developing their own conceptual
frameworks. The IASB’s Conceptual Framework is drawn directly from these previous conceptual
framework projects.

The 1989 Framework was adopted or used as the basis for the conceptual framework in several
countries, including Australia, Hong Kong and Singapore, and is similar to the conceptual frameworks in
the United Kingdom and the United States. The European Union had not formally endorsed the
Framework, but the adoption of the international accounting standards as the basis of its own standards
meant that the Framework was influential, because the international accounting standards were
themselves based on concepts drawn from the Framework. Parts of the Framework were also
incorporated into the Accounting standard for business enterprise: basic standard in China.4

Current developments

As noted, the Conceptual Framework was issued in 2010. This resulted from a joint project begun in
2004 by the IASB and FASB to develop a common conceptual framework, partly arising from the decision
by the FASB to adopt a principles‐based (rather than rules‐based) approach to standard setting but also
because there were problems with the existing Framework. Specifically, in the existing Framework:

(a)

some key areas were not covered

(b)

guidance was not always clear

(c)

some aspects were out of date and no longer reflected current thinking.5

However, progress on this project was slow. The project had initially been scheduled to be completed by
2010 and had eight phases. But, by 2010, only one phase, Phase A, had been completed. Phase A related
to the objectives of financial reporting and qualitative characteristics. In 2011, the IASB undertook a
public consultation of its work program to determine which areas it should prioritise. Many respondents
called for the Conceptual Framework project to resume as a priority. Respondents noted that:

principles‐based standards needed to be based on a sound conceptual framework

a disclosure framework was desirable to ensure the usefulness of information disclosed

•
definitions of assets and liabilities needed to be clarified before a number of reporting issues (such as
intangibles) could be resolved

guidance on measurement needed to be expanded

concepts for performance items (such as profit or loss and other comprehensive income) needed to be
established.6

As a result, in 2012, the IASB restarted the Conceptual Framework project. Subsequently, a discussion
paper was issued in 2013, and an Exposure Draft of an updated framework (referred to as the ‘Proposed
Framework’) was issued in May 2015. The IASB issued a revised conceptual framework — the
Conceptual Framework for Financial Reporting (Conceptual Fr amework) — in March 2018, and this has
been adopted by the AASB, effective for annual reporting periods commencing on or after 1 January
2020.7

5.3 The structure and components of the Conceptual Framework

LEARNING OBJECTIVE 5.3

Outline the structure and components of the revised Conceptual Framework and explain the main
changes and improvements.

The Conceptual Framework can be seen as providing answers to questions that need to be considered
when preparing financial statements.

What is the purpose of financial statements?

Who are they prepared for?

•

Who prepares them?

What are the assumptions to be made when preparing financial statements?

What type of information should be included, and how should information be presented?

What are the elements that make up financial statements?

When should the elements of financial statements be included (recognised)?

How should elements be measured?

The Conceptual Framework is set out in a series of chapters (although these are interrelated and cannot
be considered in isolation). It begins with principles that consider broader questions, such as those
relating to objectives, and moves to more narrow and specific issues. The approach or answers to the
broader (initial) questions provide direction and influence subsequent principles. For example, the
decision about the nature of information included in financial reports (e.g. relevance and faithful
representation) is influenced directly by the prior principle that financial reports are prepared to provide
information for users to assist in decision making. The ‘initial’ principles determine and influence the
principles included in later chapters of the Conceptual Framework, so that all parts are linked in a
hierarchy.

Figure 5.2 provides an overview of the Conceptual Framework issued in 2010 and the equivalent
sections in the revised Conceptual Framework issued in 2018. This text does not provide an extensive
description of either of these frameworks. Further detail and guidance for each of these frameworks are
in the frameworks themselves and provided in explanatory documents (such as the Basis for Conclusions
and various staff papers) available from the IASB website, www.ifrs.org.
FIGURE 5.2 Overview of the previous Conceptual Framework and the equivalent sections in the
revised Conceptual Framework

The objective of financial reporting

2010 Conceptual Framework

Chapter 1

2018 Conceptual Framework

Chapter 1

Notes on changes

What reports are we considering?

Who are the financial reports for?

Why report? What is the purpose of the financial reports?

General purpose financial reports.

For a range of users who may provide resources (including current or potential investors, lenders and
other creditors).

The key objective is to meet the common information needs of the users for decision making.
The revised Framework includes explicit reference to information helping in decisions relating to
stewardship. Hence, stewardship (reporting how well resources have been managed) is given more
prominence. Under paragraph 1.5, capital providers are the primary user group to which general
purpose financial statements (GPFS) are directed. While other parties might find GPFS useful, they are
not primarily directed to these groups.

Qualitative characteristics

Chapter 3

Chapter 2

What type of information should be included?

To be useful to users, information must have the two fundamental qualitative characteristics of:

relevance

faithful representation.

There are also desired enhancing characteristics of:

comparability

verifiability
•

timeliness

understandability.

These are subject to cost constraints.

While the identified characteristics are unchanged:

measurement uncertainty is explicitly identified as a factor that could affect the relevance of
information.

prudence (the exercise of caution) is reintroduced to support the concept of neutrality to provide a
faithful representation.

Financial statements and the reporting entity

Chapter 3

Used the terms ‘financial statements’ and ‘reporting entity’ throughout, but these terms were not
defined.

Going concern is an underlying assumption.

Defines financial statements and their role.

Defines reporting entity and specifics boundaries.

Going concern assumption remains unchanged.

Financial statements consist of statements, including a statement of financial position and statement(s)
of financial performance, as well as notes on the financial statements. (3.6)

Definition of a reporting entity is:

an entity that is required, or chooses, to prepare financial statements. A reporting entity can be a single
entity or a portion of an entity or can comprise more than one entity. A reporting entity is not
necessarily a legal entity.

Discussion on boundaries discusses direct and indirect control, and parent entities and subsidiaries.

The boundary of the reporting entity is driven by the information needs of the primary users of the
reporting entity's financial statements and the financial reporting regulations of the relevant jurisdiction.

Elements

Paragraphs 47–81

Chapter 4

What are the elements that make up financial statements?

An asset is a resource controlled by the entity as a result of past events, and from which future economic
benefits are expected to flow to the entity.

An asset is a present economic resource controlled by the entity as a result of past events.

The reference to ‘flows of economic benefits’ was excluded, as it was considered that this did not
adequately distinguish between the source of the benefits and the benefits derived from the source.

A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.

A liability is a present obligation of the entity to transfer an economic resource as a result of past events.

The definitions include the term ‘economic resource’. This is defined as:

a right that has the potential to produce economic benefits.

The term ‘expected’ has been removed from these definitions to avoid any misinterpretation of this as a
probability threshold.

Equity is the residual interest in the assets of the entity after deducting all of its liabilities.

Income is any increases in assets or decreases in liabilities that result in increases in equity, other than
those relating to contributions from holders of equity claims.

Expenses are any decreases in assets or increases in liabilities that result in decreases in equity, other
than those relating to distributions to holders of equity claims.
These definitions were taken from from the revised framework but are identical in substance to previous
definitions, although more streamlined.

Recognition & derecognition

Paragraphs 4.37–4.49

Chapter 5

When should these elements be recognised (i.e. included in the financial statement)?

Recognise an item meeting the definition if:

it is probable that any future economic benefit will flow to or from the entity.

it has a cost or value that can be measured reliably.

Recognise an item meeting the definition if such recognition provides users with:

(a)

relevant information about the asset or liability and about any income, expenses or changes in equity.

(b)

a faithful representation of the asset or liability and of any income, expenses or changes in equity.
Recognition now directly links back to the objectives of financial reporting, i.e. to provide information for
decision‐making.

Paragraph 5.8 further provides that an asset or liability is recognised if the benefits of recognising and
providing the information to users are likely to justify the costs of providing and using that information.
This serves to avoid inclusion of lots of assets and liabilities for which the probability is so low that
recognising them would not provide relevant information about the entity's financial position.

When should items be removed from financial statements?

No statements on derecognition included.

Derecognition is defined, and the aim is to ensure a faithful representation of the assets and liabilities of
an entity.

For an asset, derecognition normally occurs when the entity loses control of all or part of the recognised
asset or the potential benefits are fully used or expire.

Measurement

Paragraphs 4.54–4.56

Chapter 6

What measurement bases can be used?

What measurement bases should be used?

Notes that different bases are used to measure items (including historical cost, present value, current
cost and realisable value). No particular measurement basis is recommended, and no guidance is
provided on how to choose between alternatives.
Categorises measurement bases into historic cost or current value and details and summarises the
information that measures under each of these categories provide.

Outlines factors to be considered in the selection of a measurement base.

States that, in some cases, more than one measurement basis can be required and/or different bases can
be used to measure asset/liability versus expense/income.

Equity is not measured directly.

Both historical cost and current value can provide useful information; therefore, the Conceptual
Framework does not favour one over the other.

Current value reflects conditions at the measurement date; and includes:

fair value

value in use for assets and fulfilment value for liabilities

current cost.

The factors to be considered in choosing a measurement basis are explicitly linked to the qualitative
characteristics.

In relation to relevance, the characteristics of the asset or liability and how the asset or liability
contributes to future cash flows need to be considered.
In relation to faithful representation, measurement inconsistency and measurement uncertainty need to
be considered.

Comparability, understandability and verifiability also influence the selection of a measurement basis. No
single enhanced qualitative characteristic is determinative in choosing a measurement basis.

Presentation & disclosure

Chapter 7

No equivalent section/s although some paragraphs referred to disclosure and sub‐classification of items,
but specific guidance is minimal.

Outlines the objectives and scope of financial statements.

Provides guidance on how information should be presented and disclosed, including presentation
disclosure objectives and principles.

Provides guidance on reporting financial performance.

The presentation principles explicitly state that balance is needed between flexibility and comparability,
and that entity specific information is more useful than ‘boilerplate’ language.

Entities need to strike a balance between aggregating large volumes of information by adding together
assets, liabilities, equity, income and expenses that have shared characteristics, as well as providing
sufficient detail.
Concepts of capital and capital maintenance

Paragraphs 4.57– 4.65

Chapter 8

It is noted that either a financial or physical capital concept can be used, but none in particular are
recommended.

The recognition and measurement principles underlying Australian accounting standards applicable for
the for-profit sector are consistent with a financial concept of capital.

Source: Information from IASB, Conceptual Framework for Financial Reporting (2010 and 2018).

The Conceptual Framework (2018) is more extensive than previous frameworks (approximately double in
length) and makes significant changes from the previous Conceptual Framework, with some
controversial inclusions. Two aspects of the revised Conceptual Framework will be considered next,
before we turn to considering the various advantages or benefits claimed by having a Conceptual
Framework for Financial Reporting and perceived problems and criticisms of that framework. The two
aspects of the revised Conceptual Framework considered — prudence and the recognition criteria — will
assist in understanding the role of the Conceptual Framework and help illustrate the contentious and
changing nature of accounting.

5.4 Prudence in the Conceptual Framework

LEARNING OBJECTIVE 5.4

Understand and apply the prudence and recognition criteria from the Conceptual Framework.

Chapter 2 of the Conceptual Framework identifies the properties (known as qualitative characteristics)
that financial information must have to be included in the financial reports. The aim is to ensure that the
information provided is of adequate quality to help users make decisions and to meet the objective of
financial reporting. There is a hierarchy of qualitative characteristics.

Fundamental. Information must have both of the fundamental characteristics, which are relevance and
faithful representation, for inclusion in the financial reports.

Enhancing. The enhancing characteristics are not essential but can improve the usefulness of the
information and assist in making choices between information that has the fundamental characteristics.

Faithful representation requires making sure that what is shown in the financial reports corresponds to
the actual events and transactions that are being represented. To achieve this, the depiction needs to be,
as much possible, complete, neutral and free from error.8 The concept of prudence in the Conceptual
Framework is linked to neutrality. Neutrality is the absence of bias in the selection and presentation of
financial information. Neutral information avoids any manipulations that may influence how users
perceive it. The Conceptual Framework states that the exercise of prudence supports neutrality. When
making judgements in uncertain conditions, the exercise of caution is prudence.9

It may seem self‐evident that judgement requires caution. The definition of professional judgement
mentioned in the chapter on contemporary issues in accounting notes that this requires careful
consideration of information, scepticism and objectivity. Surely, a careless judgement would be
imprudent. Yet, the inclusion of prudence was controversial and a key area of interest with almost three‐
quarters of respondents to the Exposure Draft for the proposed Conceptual Framework commenting on
this issue. To understand this interest, we need to consider the history and meaning of prudence in
accounting.

Historically, a cornerstone of accounting was the concept of conservatism. Although the terms
conservatism and prudence are sometimes used interchangeably, the historic concept of conservatism is
generally understood as being, where there was uncertainty, the recognition of liabilities (and expenses)
as soon as possible, but also to recognise assets (and revenues) only when these were certain. In other
words to ‘play it safe’, to ensure assets were not overstated and liabilities were not understated.
Although this approach is often explicitly linked to the stewardship objective of financial reporting, it is
argued that such a conservative approach better protects resource providers such as creditors (from, for
example, excessive dividend payouts) and constrains managers from being overly optimistic in
accounting measures.10 However, this type of conservatism has also been associated with secret
reserves, income smoothing or ‘cookie‐jar’ accounting.11
The IASB’s 1989 Framework included a requirement to exercise prudence, so that assets, income,
liabilities and expenses where not over- or understated.12

However, prudence was removed from the 2010 Conceptual Framework on the basis that it could be
associated with conservatism, in the sense it could be misapplied and could lead to a bias via the
understatement of assets or overstatement of liabilities. This was considered undesirable, as it conflicts
with the concept of neutrality.13 Neutrality, i.e. a lack of bias in the presentation or selection of
information, is required if users are to rely on or trust the information. Despite this, prudence was re‐
included in the 2018 Conceptual Framework. It should be noted that the amendments to the Framework
in 2010 demoted stewardship, emphasising decision‐usefulness as the pre-eminent objective for
financial reporting. The 2018 Conceptual Framework includes an explicit acknowledgement of
stewardship as a key objective of financial reporting alongside decision‐usefulness.

So why the about‐face in relation to prudence? In the Basis of Conclusions for the proposed Conceptual
Framework that accompanied the Exposure Draft, the IASB noted widespread concerns about the
removal of prudence and calls for its re‐inclusion citing a number of reasons. These included the need
for guidance in exercising prudence, as a number of accounting standards do incorporate treatments
that seemingly reflect prudence or conservatism, and that prudence is needed to address a number of
potential financial reporting issues or problems (such as to counteract any managerial optimism bias).14

As noted, in the 2018 Conceptual Framework prudence is defined as ‘the exercise of caution when
making judgements under conditions of uncertainty’.15 However, as is widely acknowledged in the
literature, there seem to be different understandings of what this actually means, i.e.what level of
caution is required. The IASB, in its redeliberations on the Exposure Draft, distinguished between two
types of prudence:

1.

cautious prudence — being equally cautious when making judgements about any items

2.

asymmetric prudence — being more cautious about certain items than others. It distinguishes this from
deliberate under‐ or overstatement of items to influence, whether information is received favourably or
unfavourably.16
The IASB clarified its view of prudence in the 2018 Conceptual Framework (paras 2.16 and 2.17). To
exercise prudence, assets, liabilities, income and expenses are not to be either overstated or
understated; any misstatements of this nature could result in income or expenses being overstated or
understated in future periods. When exercising prudence, there is not necessarily a need for more
persuasive evidence to support income and asset recognition when compared with expenses and
liabilities. However, this may indeed be the case if it is expected by specific accounting standards that
any information presented is true and fair.17

In the discussion later in this chapter on the benefits and criticisms of conceptual frameworks, prudence
will be noted. Contemporary issue 5.1, an extract from a comment letter, considers how the
reintroduction of prudence could affect the financial statements.

CONTEMPORARY ISSUE 5.1

A need for prudence?

The 2015 Invitation to Comment on the Exposure Draft for a revised Conceptual Framework engendered
significant views from the global accounting community, i.e. practitioners, academics and business
representatives. A total of 228 Comment Letters were submitted to the IASB. One issue that gained the
most attention was the proposal to re-include ‘prudence’ in the Conceptual Framework as part of
‘faithful representation’. There were differing views among respondents about whether reintroducing
the concept of prudence was a good idea.

One respondent proposed that the suggestion that deleting prudence from the Framework would mean
that ‘financial statements would be prepared imprudently’ is not true; they also proposed that the
definition of Neutrality, as defined in the 2010 Framework precludes imprudence.18 A second was
concerned that, under conditions of uncertainty, being prudent introduces an element of judgement-
bias that is likely to be counter-cyclical. ‘In good times, management may be more prudent in
understating income and in bad times, less prudent.19

One concern with the use of the term ‘prudence’ is that it has generally been associated with
conservatism. In his Comment Letter, Glenn Rechtschaffen notes that the accounting world has always
slanted its definition towards the asymmetric definition of prudence.20 This view is also presented in a
Comment Letter submitted by the Linde Group, which proposes prudence to be a ‘deviation from
neutrality’ as it leads to the postponement of income to later periods. Their proposition is that reliability
is crucial and should be prioritised and carefully distinguished from prudence.21
In contrast, other respondents supported the re-introduction of prudence as a characteristic in
determining faithful representation. The Australian Council of Auditors-General supports the proposal to
reintroduce the notion of prudence, stating that ‘when more uncertainty is prevalent, then more
prudence is required to be exercised’. They do not, however, support a broader application that could
build a bias into the Framework.22 Furthermore, the Institute of Public Auditors in Germany proposes
that prudence helps to achieve neutrality because it can limit any bias towards optimism.23

The Singapore Accounting Standards Council accepted the IASB’s use of ‘cautious prudence’ and how it
could support neutrality but suggested that there was also a need to identify ‘asymmetric prudence’ as a
characteristic of financial information that is useful. They felt that the IASB did not adequately consider
the potential role that ‘asymmetric prudence’ could play in supporting the fundamental qualitative
characteristic of relevance.24

QUESTIONS

1.

Do you agree or disagree that re‐introducing prudence in the Conceptual Framework is beneficial? Give
reasons for your answers.

2.

What impact would the use of 'asymmetric prudence' have on the quality and usefulness of financial
reports?

Recognition in the 2018 Conceptual Framework

An important question for any conceptual framework in accounting to address is what items should be
included in the financial statements and when. Chapter 4 of the 2018 Conceptual Framework defines the
elements of financial statements, and chapter 5 outlines the conditions that need to be met for an
element to be included in the financial statements. Inclusion of an element in the financial statements is
known as recognition. This should be distinguished from disclosure, which is the inclusion of particular
information about an item either in the financial statements or in notes to these. An item could be
recognised but separate information not disclosed (for example, an immaterial expense would be
included in expenses but would not warrant separate information being provided about this), or an item
may not be recognised but disclosed (for example, where an asset exists but fails to meet the recognition
criteria and so is not included in the financial statements).

For over 25 years, the IASB’s frameworks specified that recognition of an element required a probability
threshold to be met (for example, for assets, it was probable that future economic benefits would be
received), and that there was a cost or value that could be measured reliably (reliability was replaced as
a qualitative characteristic in the 2010 Conceptual Framework with faithful representation, which has
been continued in the 2018 Conceptual Framework). Specific accounting standards can include further
guidance about the probability recognition criteria. For example, paragraph 23 of AASB 137/IAS 37
Provisions, Contingent Liabilities and Contingent Assets states that the probability criteria is met if ‘the
event is more likely than not to occur’. This was generally interpreted as meaning more than a 50%
likelihood of occurrence.

In the 2018 Conceptual Framework, recognition of an item meeting the definition of an element is
directly related to the objectives of financial reporting. Recognition is required if such recognition
provides users, firstly, with relevant information about the element and, secondly, with a faithful
representation of the element. Thus, recognition is explicitly linked to the qualities that ensure the
usefulness of information to users for decision making.25 The 2018 Conceptual Framework also explains
that recognition may not provide relevant information if it is uncertain that an element exists (that is,
there is uncertainty if an item meets the definition), if probability is low or if the level of measurement
uncertainty is too high.26

The probability threshold has been removed. Further, the definitions of assets and liabilities have been
revised to exclude any reference to ‘expected’ inflows/outflows of economic benefits, as there was
concern that the inclusion of ‘expected’ could be interpreted as requiring a probability threshold to be
met before an item would satisfy the definition of an element.27 In the Basis of Conclusions to the
Exposure Draft, the IASB outlined two key reasons for the removal of probability as a recognition criteria.
First, this was inconsistent with thresholds in standards, which include terms such as ‘more likely than
not’, ‘virtually certain’ and ‘reasonably possible’, as well as ‘probable’. Some research also indicated that
the interpretation of such terms in practice is problematic and inconsistent. For example, a study of
Australian and Korean accountants identified that there were at least 35 terms of likelihood used in
existing IFRS standards, and that these were interpreted differently between individual accountants,
across countries and in different contexts.28 It was also argued that a probability threshold could result
in some items (the example of derivatives was noted) not being recognised.

The issue of whether a probability threshold should be explicitly included is contentious. While some
argue that it provides a practical ‘filter’ for relevant information, others argue that such a ‘bright line’
approach can distort accounts. For example, if probable is interpreted as 50% or more, then a small
reassessment of the expected likelihood of the event or a particular outcome occurring (say from 51% to
49%) results in a major change in the financial statements; from recognition to exclusion. Others argue
that not having such a filter could result in more opportunistic accounting treatments being justified or
result in ‘broader, and excessive, recognition of assets and liabilities’.29

Contemporary issue 5.2 illustrates how the application of the accounting definitions and recognition
criteria of items can affect the financial statements.
CONTEMPORARY ISSUE 5.2

New lease accounting to have big impact

Background: In August 2010, the IASB issued an exposure draft proposing changes to the current
standard on leases. This current standard requires a lease to be classified as either a finance or operating
lease. Only finance leases are shown in the balance sheet with an asset (and a liability) to be recognised
if the risks and benefits associated with ownership have been transferred. This approach has long been
criticised as being inconsistent with the Conceptual Framework’s definition of an asset, which does not
require ownership or a comparison to this. The exposure draft proposes that all leases be recognised in
the balance sheet.

The new draft lease accounting standard is an overdue reality check for the corporate world but it also
exposes the fault‐lines in the standard‐setting process.

No one can argue against the value of the standard. The existing rules mean that large amounts of
liabilities are hidden off balance sheets. And that frankly cannot, particularly in a post‐crisis world, be
right. If the general public understood these things they would be shocked, in the same way that people
going to the theatre to see ‘Enron — The Play’ were shocked.

The old rules were written a long time ago when we had very different ways of looking at the world.
Investors now argue that disclosure is not a substitute for good accounting, and that all assets and
liabilities need to be on the balance sheet. Standard‐setters now take a balance sheet view of life. And in
this brave new world where we recognise more and more assets and liabilities on a balance sheet,
including many more intangibles, why would we not be recognising assets for leases that convey the
rights to use the leased assets, and the corresponding liabilities to pay for that use? The proposed new
rules reflect the way that the accounting world is moving and put all lease assets and liabilities on the
balance sheet.

The impact of the proposed standard should not be underestimated. Moving all those liabilities onto the
balance sheet will inevitably have an effect. We will see lower asset turnover ratios, lower return on
capital and an increase in debt‐to‐equity ratios, which could have a knock‐on effect on borrowing capital
or compliance with banking covenants. The figures are vast. Some ball park calculations suggest that we
are talking about an estimated £94 billion of leasing liabilities for the top 50 companies in the UK and a
mammoth $1.3 trillion (£843 billion) for public companies in the US. There will be short‐term pain, but it
will result in long‐term gain as business realities are more clearly expressed in the financial reporting.
Note: The new leasing standard IFRS 6/AASB 16 was subsequently issued in 2016.

Source: Extract from Veronica Poole, ‘No pain, no gain’, Accountancy Age.30

QUESTIONS

1.

Consider the definitions of an asset and liability in the 2018 Conceptual Framework. Would a 5‐year
lease for land meet these definitions?

2.

The extract discusses the fact that these changes reflect the way in which accounting is moving — that is,
towards putting all assets and liabilities on the balance sheet. What reasons could there be for this
move? Is this consistent with the approach in the 2018 Conceptual Framework? Given the identified
impact on key company ratios, do you believe this approach is justified?

5.5 The benefits of a conceptual framework

LEARNING OBJECTIVE 5.5

Explain and evaluate the benefits of conceptual frameworks.

There are a number of benefits that can arise from a conceptual framework in accounting. These can be
arranged into three categories:

technical

political
•

professional.

Technical benefits

When you think of ‘technical’ improvements, you think of changes that make something work or
function better. A key argument for a conceptual framework in accounting relates to technical benefits.
As stated by Rutherford, the principal attraction of a conceptual framework in accounting:

is argued to be the improvement in the quality of standards that would follow, because they would rest
on more solid ground; other less elevated attractions include the contribution it can make to the
technical consistency and speed of development of standards and the effectiveness with which
standards can be defended.31

So, the main benefit of having a conceptual framework is to improve accounting itself, to improve the
practice of accounting and to provide a basis for answers to specific accounting questions and problems.
Such benefits are explicitly identified by the IASB as the rationale for the Conceptual Framework, as
outlined at the start of this chapter.

The role of a conceptual framework in setting accounting standards

For many years, accounting standards were set without a conceptual framework. This was referred to as
a ‘piecemeal’ approach, because of the slowness of the process and because the rules within some
standards were incompatible with those in others.

A conceptual framework provides a set of established and agreed principles. ‘The key measure of the
success of a standard is its acceptance. An important prerequisite for gaining acceptance is a language
common to all parties involved. An agreed upon set of concepts and principles provides this language’.32
Having a conceptual framework means that, when determining the accounting rules or standards for
specific events or transactions, the focus is on deciding how to apply the principles already in the
Conceptual Framework. For example, when deciding on how to account for money spent on creating and
maintaining websites, the issue considered is whether the cost should be recognised as an asset or
expense, given the definitions and recognition criteria in the Conceptual Framework. This approach
restricts the discussion of how to apply the principles in the Conceptual Framework to website costs. It
also helps to ensure that the recognition of any assets, for example, is consistent with the recognition of
assets in other circumstances. As Foster and Johnson state, a conceptual framework:
provides a basic reasoning on which to consider the merits of alternatives. Although it does not provide
all the answers, the framework narrows the range of alternatives by eliminating some that are
inconsistent with it. It thereby contributes to greater efficiency in the standard-setting process by
avoiding the necessity of having to redebate fundamental issues such as ‘what is an asset?’ time and
time again.33

Of course, using a conceptual framework as the basis for setting specific accounting rules does not mean
there is no room for debate or disagreement. There may be different interpretations of the definitions of
assets or expenses in the Conceptual Framework. This problem is considered later in this chapter. Also, in
particular cases, standard setters may deliberately depart from the principles in the Conceptual
Framework for other reasons (such as concerns over abuse of accounting requirements or political
influences).

Benefits to preparers and users

Consider what would happen if you were preparing the financial reports but had a particular case for
which there were no specific standards or rules. How would you decide how to account for it? One way
is to go to the basic principles in the Conceptual Framework and use them as a guide to help you make
your decision. If there is a specific standard, it needs to be recognised that, for various reasons, the
requirements in accounting standards may be inconsistent with the principles in the Conceptual
Framework. As the Conceptual Framework does not override these accounting standards, changes to it
will have little immediate impact on financial reporting if there is an existing accounting standard.

Also, standards based on a conceptual framework should be more easily understood and interpreted by
users. This is because:

users can refer to the principles in the Conceptual Framework to understand the basis for the specific
accounting rules.

the accounting rules should be more consistent, because they are based on the same underlying
principles.

Political benefits

A further benefit of a conceptual framework is to prevent political interference in setting accounting

standards. To understand this benefit, you need to be aware of the political nature of accounting. Many
accounting students view accounting standards as boring and uncontroversial; however, you should
remember that financial reports provide information on which people base their decisions. Therefore, if
the information in these statements changes, it is likely that the decisions based on this information will
also change.

Decisions made by users, such as where to invest or whether to continue to supply goods to a company,
could change. Decisions by the management of the entity could also change. For example, when the
accounting standard was introduced that required an asset and liability for finance leases to be included
in financial statements, some companies stopped using finance leases. In the United States, when the
accounting standard was introduced that required companies to include health benefits to be provided
to employees as a liability, some companies ended these health benefit schemes to employees.34 These
decisions have a real economic impact and affect the wealth and welfare of particular individuals,
entities and industries.

Political pressures, potential economic consequences and political interference

Of course, it is natural for people to try to look after their own interests, and this leads to attempts to
influence accounting requirements. For example, when the international accounting standard setters
proposed that share‐based payments made to employees be included as an expense in the financial
statements, some argued that requiring recognition of these payments would have unfavourable
economic impacts and would discourage entities from introducing or continuing employee share‐based
plans. This would in turn:

disadvantage employees

harm the economy because share option schemes are needed to attract employees

harm young, innovative companies that did not have cash available to offer equivalent alternative
payment

place companies in countries that required these expenses to be recognised at a competitive

disadvantage.
These potential impacts of changes in accounting standards are known as ‘economic consequences’. In
fact, some have argued the decline in the use and dominance of share options in executive pay packages
since the late 1990s is at least in part attributable to the change in accounting rules in 2006, which
required these to be recognised as an expense — a direct economic consequence.35

Political pressure takes the form of individuals or groups trying to influence the standard setters (by a
range of methods including lobbying standard setters directly, as noted, or by lobbying governments; see
Georgiou36 for further examples) to make sure that the resulting accounting standards best meet their
own preferences and do not result in unfavourable economic consequences that would disadvantage
them.

A conceptual framework provides some defence against individual interests and claims of economic
consequences. Standard setters can argue the theoretical correctness of their decisions by referring to
the principles in the Conceptual Framework.

It is more difficult for individuals to argue for their own preferred way of accounting for events if this is
inconsistent with the principles in the Conceptual Framework. As Damant states, ‘Individual standards
cannot be attacked unless the principles on which they are based are attacked’.37

However, a conceptual framework cannot guarantee freedom from political interference. In some cases,
proposed accounting standards have either been either changed or not introduced because of political
pressures.38 In relation to accounting share‐based payments made to employees, it took almost 20
years to issue a standard; the delay was caused by longstanding opposition. The standard was finally
issued, it is argued, not due to an acceptance of the conceptual basis, as there were no significant
changes in underlying conceptual frameworks over this period, but due to social and political changes.
Macve states the following:

. . . there would appear to have been perceived changes in societal expectations of business legitimacy
that made the new convention [expensing share options] now more useful and acceptable to society.
The resulting political forces were probably more important than the conceptual niceties, which had
been insufficient to resolve the controversy during the period leading to the issue of [the standard].39

Some have argued that the re-inclusion of prudence in the Conceptual Framewor k resulted from
political pressures, rather than any theoretical basis.40 Interestingly, one of the reasons cited for the
removal of prudence from the 2010 Conceptual Framework was ‘convergence with US GAAP, which did
not have a definition of prudence’.41
In addition, there is still debate as to whether economic consequences should be considered when
deciding on accounting standards. Some argue that the cost constraint within the Conceptual Framework
itself justifies taking into account the economic consequences when deciding on accounting
requirements.42

Professional benefits

An alternative reason for having a conceptual framework is the benefit it may provide to the accounting
profession itself. The argument here is that conceptual frameworks exist, not to improve accounting
practice, but to protect the professional status of accounting and accountants.

This argument is based on the following lines of reasoning.

Professional status is valuable. People and groups that are members of professions generally have more
influence and status and receive higher rewards (payments) than those who are seen as non‐
professionals do.

A profession has a unique body of knowledge; it has expertise in an area that other groups do not have.

The historical knowledge base of accounting is double‐entry bookkeeping. However, this, at least in a
simple form, is practised widely in the general community. Other problems with accounting’s knowledge
base include the influence of political pressure, accounting failures (e.g. Enron and WorldCom) and
inconsistencies in standards.

Because of the problems with the historical knowledge base of accounting, a conceptual framework has
been developed to establish a unique body of knowledge of accounting.43

According to this line of argument, although the accounting profession may state that the reason for
conceptual frameworks is to improve accounting (i.e. to achieve the technical benefits discussed), the
true reason is to provide the appearance of having a unique body of knowledge so that it can maintain
its status as a profession, and so that its members can gain the benefits of professional status.

However, others have questioned this theory and argue the following.

The professional status of accountants has been developed and maintained through the social actions of
accounting bodies, such as creating barriers for entry to the profession and legislation restricting certain
activities (such as some auditing and taxation functions) to those with specialised qualifications.44

The theory does not explain why some countries in which accounting rules are regulated by the
government (such as China) have, at least in some way, adopted parts of the Conceptual Framework.45

5.6 Problems with and criticisms of the Conceptual Framework

LEARNING OBJECTIVE 5.6

Explain and evaluate the problems with and criticisms of the Conceptual Frameworks.

Although benefits are claimed for having a conceptual framework in accounting, there are also some
problems with and criticisms of the 2010 Conceptual Framework and the 2018 Conceptual Framework.
The criticisms are either:

caused by the nature of a conceptual framework as a set of general guiding principles. These criticisms
would apply to many conceptual frameworks, not only the accounting conceptual framework, or

related to specific parts of the frameworks.

This section considers the following main criticisms or problems related to the Conceptual Framework:
1.

that it is ambiguous and open to interpretation

2.

that it is too descriptive

3.

that the meaning of faithful representation is problematic

4.

that inconsistencies with accounting standards cast doubt upon the efficacy of the framework.

You should remember a key benefit of a conceptual framework is the improvement in the quality of
accounting rules by providing guidance, in the form of general principles, to standard setters and
individuals. This would also help ensure consistency. However, some features of the framework suggests
that these benefits may not occur.

The Conceptual Framework can be ambiguous

The principles in any conceptual framework are intended to provide a common language. However, the
principles and definitions in the Conceptual Framework are broad and individuals may interpret them
differently. For example, the AASB opposed the inclusion of prudence in the proposed 2018 Conceptual
Framework:

The AASB observe[d] that ‘prudence’ has different meanings to different people. This was illustrated in
the varying responses to a Bulletin issued by the EFRAG, ANC, ASCG, OIC and UK FRC, entitled Getting a
Better Framework: Prudence (April 2013). Some respondents to that Bulletin argued, in effect, that
‘prudence’ means caution without a conservative bias, whilst others argued, in effect, [that] it means
conservatism. Therefore, reintroducing ‘prudence’ to the IASB Conceptual Framework could lead to
inconsistent interpretations of that notion.46

Much of the debate about some recent issues in financial reporting relates to the exact meanings of the
definitions or terms in the frameworks. For example, some have argued that share options to employees
did not meet the definition of an expense. Although the international standard setters interpreted these
options as meeting its definition of an expense, it noted:

However, given that some people have arrived at a different interpretation of the Framework’s expense
definition, this suggests that the Framework is not clear.47

A common criticism of conceptual frameworks in general is that the principles are often too vague,
leaving too much room for alternative interpretations. Therefore, the ability to provide practical
guidance and, in particular, consistent application of the principles is limited. For example, research has
shown that ‘possible’ can, in practice, mean from 25% to 65% chance of occurrence.48 Basing
recognition on an assessment of relevance and faithful representation, which are the new recognition
criteria in the 2018 Conceptual Framework, has been argued as providing too much flexibility, ‘providing
room for justification of individual decisions using bits and pieces from the CF, instead of serving as a
solid technical basis resulting in consistent decision making’.49

Balancing the desired attributes of information

Both the 2010 and 2018 Conceptual Frameworks list qualitative characteristics (both fundamental and
enhancing) for information and also identify the cost constraint that affects the ability to provide
information. These qualities and constraints require those deciding on the information to be included in
the financial reports to balance or weight these issues. These frameworks provide no clear guidance on
how to make these decisions, so the decisions will be subjective. Further, materiality, which is an entity‐
specific aspect of relevance (one of the fundamental qualitative characteristics) requires professional
judgement. In the Conceptual Framework, these qualitative characteristics are also the core of the
recognition criteria.

Adjusting for deficiencies in the guidance

A major criticism of the Conceptual Framework was that it did not provide guidance for all of the
important aspects of and decisions relating to financial reports. In particular, the fact that it provides no
definite answers to the question of how to measure the items to be included in financial reports is seen
as a barrier to achieving high‐quality, consistent and comparable financial reports. Measurement is
perhaps one of the most controversial areas in financial reporting. It can be argued that decisions
relating to it can be guided by other principles in the Conceptual Framework (such as considering the
faithful representation and relevance of alternative measures for particular items). Additional discussion
and guidance is provided in relation to measurement in the 2018 Conceptual Framework. However, this
does not provide straightforward or clear direction around what choices should be made for measuring
particular financial statement items. The incompleteness of the Conceptual Framework in this area is
seen by many as a major weakness, particularly given the impact that choice of measurement has on
financial statements.
The Conceptual Framework is descriptive, not prescriptive

As the key role of a conceptual framework is to provide the principles on which to base accounting
standards, many argue that the Conceptual Framework needs to be aspirational and ambitious. As
McCahey & McGregor state:

Conceptual frameworks have traditionally been viewed by standard setters as aspirational documents,
setting the direction for reform of financial reporting while acknowledging that at any point in time the
‘conceptually correct’ approach may not be achievable at a standards level. If financial reporting is to
continue to evolve and meet the needs of the users of financial statements, it is important that this
continues to be the case. There will always be a temptation when standard setters revisit the conceptual
framework to see it as an opportunity to justify previous decisions at a standard setting level that, at the
time, were driven more by compromise and pragmatic solutions than underlying concepts. Such re‐
engineering would undermine the integrity of the conceptual framework both as a vehicle for facilitating
the development of new ideas by the standard setter at a standards level and as [a] vehicle for holding
the standard setter accountable for its decisions.50

There is the accusation that the conceptual frameworks may be seen as simply reflecting and giving
approval to existing accounting principles and practices. In other words, the conceptual frameworks
simply describe accounting principles as currently practised and applied, rather than being prescriptive
(normative) and trying to improve practice. This criticism is often based on two arguments:

1.

The frameworks include many of the concepts used in accounting practice historically or included in
existing accounting standards. This argument sometimes implies that these concepts must be incorrect
or defective. On the contrary, it could be argued that the frameworks may include ‘old’ assumptions and
principles found in the standards because these are the appropriate ones to use in preparing financial
reports. However, a number of critics of the proposed 2018 Conceptual Framework have argued that the
changes may have been made to justify some of the existing, particularly more recently issued,
standards, thus retrofitting the framework to match current practice. Hence, is the role played by the
Conceptual Framework to endorse principles already embodied in standards, rather than guide their
development? This is of particular concern if the view is that some existing standards contain
compromise, as they have been arrived at through a political process and by consensus, rather than
derived from conceptually defensible principles.

2.

People do not agree with the principles included in the frameworks. For example, some argue that
stewardship or accountability is a more appropriate primary objective for financial reports than the
objective of providing information useful for decision making; others argue that prudence is not
appropriate.

The concept of faithful representation is inappropriate

A further criticism made of the 2018 Conceptual Framework relates to the use of faithful representation,
as this concept is considered to misunderstand the nature of accounting.51

Let’s consider the meaning of faithful representation. To represent can be seen as meaning to ‘portray’
or ‘describe’. Faithful can be seen as meaning ‘true’ or ‘accurate’. When thinking of the accuracy, one
thinks of how close one is to the correct answer. Consequently, many interpret the requirement for
financial reports to faithfully represent the transactions and other events to mean that the aim is to
provide as accurate a report or description of the financial position and performance of the entity as
possible. This implies that there is a single correct financial position and performance measure for an
entity. The financial reports that correspond most closely to this correct position or measure will be the
most accurate and, consequently, the most faithful representations.

But is there one ‘correct’ financial position or performance measure in accounting? Take, for example,
the final profit figure for an entity.

The following events and transactions have occurred in the financial year.

The net profit before depreciation is $250 000.

The company has the following noncurrent assets.

Building A cost $600 000 five years ago. It has a fair value of $1 000 000 and a further useful life of
5 years.

−
Building B cost $300 000 20 years ago. It has a fair value of $2 000 000 and a further useful life of 10
years.

In one set of financial reports, the accountant uses the historical vs. cost basis; in another, the fair value
basis is used. Both are acceptable according to the Conceptual Framework and current accounting
standards. The financial performance of the entity under each basis is shown in table 5.1.

TABLE 5.1 Reporting profit using cost basis and fair value basis

View 1

(at historical cost)

View 2

(at fair value)

Net profit before depreciation

250 000

250 000

Depreciation building A

60 000

200 000

Depreciation building B
 10 000

100 000

Final net profit (loss)

180 000

(50 000)

Which profit figure is correct and represents the ‘true’ measure of the entity’s performance? Both are
correct in the sense that they follow generally accepted accounting principles and the alternatives
allowed in accounting standards. But how can this be? One view shows the company making a profit, the
other a loss.

The problem that many argue here is that the concept of faithful representation treats accounting as
similar to a ‘hard’ science. In science, there is generally one correct objective measure. For example,
scientists can measure the distance between the Earth and the moon at a particular point in time. There
would only be one correct distance, and the most accurate measure (the measure closest to the true
distance) would be the one that represents this faithfully. This view of the world as having one single set
of objective facts to be discovered is often referred to as the ‘realist’ perspective. Applying this view to
accounting:

Financial statements . . . are representationally faithful to the extent that they provide an objective
picture of an entity’s resources and obligations — a reality that exists in the physical world.52

An alternative perspective, known as the ‘materialist’ or ‘social constructionist’ view, argues that
accounting cannot be viewed as a science whose aim is to discover objective facts that simply exist in the
world. Although the underlying events and transactions do exist (such as the purchase of a particular
asset or the sale of goods to a customer), the accounting measures that are reported (such as income or
net assets) are created by accountants and do not exist independently of them. If this approach is
accepted, then the concept of faithful representation does not really fit. The question to be decided
when preparing the financial reports is not which view most faithfully represents the events and
transactions (as this qualitative characteristic asks us to do), but how to choose among the possible
views that could be used to represent them. This choice does not only involve considerations of accuracy
(which view is the most ‘correct’), but would need to consider the question of which is the preferred
view to be represented in the financial statements. It is argued that the Pathways Vision Model
(described in the chapter on contemporary issues in accounting) acknowledges the inherent ambiguities
in accounting and the crucial role accountants themselves have in constructing accounting outputs.

This criticism relates to the very nature of accounting. From these arguments, it should be obvious that
the principles in any conceptual framework for accounting are not unchangeable or unchallengeable.
Principles in accounting are not like the laws of science or mathematics (such as the law of gravity or E =
mc2). Principles, such as the definition of an asset, are decided on through debate and agreement. There
will always be alternative views and those who disagree.

Inconsistencies between requirements in accounting standards, the Conceptual Framework and the
‘real’ world

It was noted previously that where there are inconsistencies between the Conceptual Framework and
accounting standards, the requirements in the accounting standards prevail. Given that the key role of
the Conceptual Framework is to provide the basis for deriving accounting standards, then why would
inconsistencies occur, and should they exist?

There are a number of factors that can cause such inconsistencies. One reason is the delays in revising
the Conceptual Framework. As previously discussed, changes to the Conceptual Framework have been
slow. For example, the definition and recognition criteria for the elements remained unchanged for over
25 years. It was noted in the chapter on contemporary issues in accounting that accounting usually lags
behind changes in the business and social world, effectively needing to catch up with developments,
new transactions and innovations that have already occurred. Standard setters acknowledge this and so
develop standards they believe are best practice, even if these contain requirements that may be
inconsistent with the Conceptual Framework at that time.

Second, some standards may have been issued prior to changes being made to the Conceptual
Framework and may have been consistent with the Conceptual Framework at the time the standard was
issued but are inconsistent with a later (revised) Conceptual Framework. Standards are not automatically
reviewed and/or revised if the Conceptual Framework is changed. Since the 2018 Conceptual Framework
was issued, a number of standards have continued to be inconsistent with this.

Third, as discussed previously, setting accounting rules is a political process. This may mean that it can be
difficult to achieve acceptance and agreement without compromise. An example is accounting for leases.
Despite being acknowledged as being conceptually consistent with the asset definition and recognition
criteria in the Conceptual Framework, there was fervent and persistent opposition to capitalising many
leases, for example, leases of land or buildings. It has taken over 20 years for the IASB to issue a new
leasing standard that aligns the treatment of leases with the concepts within the Conceptual Framework.

Fourth, the application of the cost constraint — the need to balance potential benefits and costs — has
led to restrictions being included in accounting standards or particular concepts (such as faithful
representation) being given greater weight than other concepts. This has occurred, in particular, where
there is a perceived risk of opportunistic accounting or potential distortion of information. One example
of this is asymmetric probability thresholds included in standards. Another example is in IAS 37/AASB
137 Provisions, Contingent Liabilities and Contingent Assets, where contingent assets can only be
recognised if they are virtually certain.

However, some have argued that inconsistencies (in particular, restrictions included in the standards)
and the application of concepts within the Conceptual Framework are out of step with the realities of
the current world and, therefore, impugn the usefulness of financial reports. One particular area where
this has been claimed is in relation to certain intangibles, particularly internally generated intangible
assets.

Accounting for intangibles

How to account for intangibles is perhaps one of the most troublesome and controversial issues in
accounting. ‘Intangible’ generally means without physical substance or form. Intangibles are the source
of many of the future benefits and value of business entities. For example trademarks, patents, good
customer relations and an experienced and well‐trained workforce all bring benefits to entities. It is
often argued that times have changed and the reporting systems that were developed to primarily
account for traditional tangible assets are not able to cope with the reality of today. A driver of this is
research showing a growing gap between the book value (the carrying amount of assets recognised in
the financial statements) and the market value of entities.53 Some of this gap would be due to
conventional accounting measuring assets at historic cost. You should recall that the purpose of financial
reporting is to provide information about economic resources, but it does not necessarily try to value the
actual worth of those resources. If this were the aim, the use of historic cost would not be allowed.
However, it is argued that a significant part of this gap is due to the fact that significant assets of entities
(i.e. intangible assets) are left off the balance sheet entirely, despite intangibles making up more than
80% of the total values of many companies.54 This is the reverse of the situation in 1975, when balance
sheets representing tangible assets made up 83% of company values.55 So, if this is the case why don’t
we simply put them on the balance sheet? Surely omitting most of the assets creating value, if not the
most valuable assets, has a negative impact on the usefulness of financial reporting. The answer is that
we sometimes include such assets, for some intangibles, but due to the requirements in accounting
standards, these are largely restricted to intangible assets that have been acquired (where there is a
transaction price/cost).
One of the difficulties with intangible assets is their many different types. In the modern world,
employees and data are some of the most significant intangibles for companies. There is no doubt that
employees provide benefits to an entity. In the new knowledge economy, people are often far more
important than the things we normally consider assets (such as tangible property). As Robert Reich has
stated:

Your most precious possession is not your financial assets. Your most precious possession is the people
you have working there, and what they carry around in their heads, and their ability to work together.

However, in very few cases are employees recognised as assets in financial statements. The most
common rationale for this is that the requirement for control is not met. As outlined in paragraph 15 of
IAS38/AASB 138 Intangible Assets, generally a company won’t have sufficient control over the expected
future economic benefits resulting from a team of skilled employees and from training in order for them
to meet the definition of an intangible asset. Similarly, certain members of management or staff with
specific technical talent are ‘unlikely to meet the definition . . . unless protected by legal rights to use it’.

What about cases where there are contracts with specific employees? In such cases, we may be able to
control the benefits, in the sense that the entity is able to access the benefits of that particular employee
(their services) and other entities cannot. Such contracts are often used for employees who have unique
services (such as sporting stars) and sometimes these contracts (i.e. the right to use the employees) are
sold by entities. An example is the transfer prices of football players. Many soccer clubs, such as
Manchester United and Real Madrid, account for these as assets as:

professional football clubs generally capitalise the cost of acquiring a player’s registration from another
club on the balance sheet under the heading Intangible Fixed Assets. The capitalised amount is then
amortised over the period of the respective player’s contract with the club.56

Because the cost of such player transfers can be measured reliably, ‘human resources’ are often included
in the financial accounts in the United Kingdom and United States.57 However, other employees are
usually not accounted for. It is argued that accounting requirements, including the Conceptual
Framework, cannot adequately address the new sources of value in the modern world. As Gleeson‐
White states:

two new capitals, intellectual capital and human capital, came to the attention of accountants in the
1990s with the dotcom boom. Their invisible presence is best seen when information‐age companies
such as Twitter are listed on stock exchanges: their shares trade for astronomical amounts despite the
fact these companies have nothing on their balance sheets. In traditional financial accounting terms,
they are worthless. But that’s because the value of these companies can’t be seen in traditional financial
reports, which measure only financial and manufactured capital, the tangible assets of the industrial era.
Instead it’s in geeks and their software — or, in accounting terms, in human capital and intellectual
capital, such as software, data, knowledge, networks and patents for new drugs.58

Contemporary issue 5.3 considers the topic of accounting for intangibles.

CONTEMPORARY ISSUE 5.3

Intangible assets hold real value

Adams describes intangible assets as ‘any part of the business you can’t stub your toe on’. They include
content, data, code, patents, brands, domain names and confidential information.

EverEdgeIP’s job is to ‘identify, evaluate, manage and monetise’ intangible assets for clients. He admits
the role of intangibles as drivers of business growth and the creation of wealth is not widely understood
in business. Intellectual property is one intangible asset that is often overlooked. . . .

While there has been much work over the past decade in creating a framework for defining and
measuring intangible assets, under the . . . IFRS 3 Business Combinations only intangible assets that
have been acquired can be separately disclosed on the acquiring company’s consolidated balance sheet.

Declining to recognise intangible assets, unless there has been a transaction to support intangible asset
values in the balance sheet, may be intended as a bulwark against ‘creative accounting’, but David Haigh,
global CEO of London‐based business valuation consultancy Brand Finance, believes it is time for change.

On balance sheet

‘The ban on intangible assets appearing in balance sheets unless there has been a separate purchase for
the asset in question or a fair value allocation of an acquisition purchase price, means that many highly
valuable intangible assets never appear on balance sheets,’ says Haigh, who began his career as a
chartered accountant.
Haigh supports calls for a ‘new approach to financial reporting’ that recognises the value of intangible
assets. ‘Instead of meaningless balance sheet numbers, we want to see living balance sheets,’ he writes
in the annual Global Intangible Financial Tracker (GIFT) report . . .

The 2016 GIFT report analysed the intangible asset value of 57, 000 companies that trade on the world’s
stock markets. ‘In the world’s leading economies, intangible assets, such as brands, people, know‐how,
relationships and other IP now make up a greater proportion of the total value of most businesses than
tangible assets, such as plant, machinery and property,’ the report says.

It found that the total enterprise value of the companies was US$89 trillion of which US$46.8 trillion
represented Net Tangible Assets, US$11.8 trillion Disclosed Intangible Assets and US$30.1 trillion
Undisclosed Value.

Source: Extract from Leo D’angelo Fisher, ‘Intangible assets hold real value’, Acuity.59

QUESTIONS

1.

The extract discusses the ban from including most intangible assets in the balance sheet unless acquired.
Consider whether some, or all, of such ‘banned’ intangibles would meet the definition of an asset and
criteria for recognition in either the 2010 Conceptual Framework or the 2018 Conceptual Framework.

2.

Do you believe the inconsistent treatment between purchased versus internally generated items is
justified?

3.

If the financial statements are ‘leaving out’ most of the important assets, what does this imply for the
usefulness of financial statements for users?

5.7 Applying the Conceptual Framework

LEARNING OBJECTIVE 5.7

Apply concepts from the Conceptual Frameworks to financial reporting issues.

As noted previously, any requirements in accounting standards override prescriptions in any conceptual
framework. In practice, the requirements for the majority of the transactions and events that
accountants will encounter will be found in accounting standards. However, it is important for
accountants to understand and be able to apply the concepts included in any framework, as the
Conceptual Framework is required to be considered if:

there is no specific accounting standard that applies to a particular transaction or event; or

a particular accounting standard allows a choice of accounting policy (for example, IAS 16/AAB 116
Property, Plant and Equipment requires, after acquisition, a choice between the cost and revaluation
models for measurement).

Further, to understand the requirements of the accounting standards, one needs to have an
understanding of the Conceptual Framework, on which the accounting standards are presumably based.
As McCahey and McGregor state:

practitioners needed to be schooled in the framework in order to understand fully the particular
requirements of standards. Moreover, in those countries where the framework was embodied in
standards specifying a hierarchy for determining appropriate accounting policies for matters not
specifically addressed in a standard or an interpretation, practitioners have been required to apply the
framework directly in resolving those practice issues. With the widespread use of IFRSs around the
world, practitioners in most countries are now applying the framework in practice.60

This is reinforced in the IASB’s education initiative. This includes framework‐based teaching materials
that advocate and illustrate a hierarchical approach to the understanding (or teaching) of accounting
standards, where the concepts in the Conceptual Framework relating to particular transactions or events
are considered prior to examining the specific requirements in the applicable accounting standards.
Within this, the IASB also notes the importance of understanding the Conceptual Framework when
exercising professional judgement.61

Hence, even where standards exist, concepts from the Conceptual Framework (such as relevance,
faithful representation and materiality) need to be interpreted and used in applying the standards.
In this chapter, the focus is on the Conceptual Framework rather than on specific accounting standards.
To effectively apply the concepts in the Conceptual Framework to a particular financial reporting issue or
problem requires a systematic approach, where the concepts are applied to the specific
circumstances/case. For example, the question may be whether, under the Conceptual Framework, a
particular item should be recognised as an asset and, if so, how. Figure 5.3 suggests a process to use
following the steps used in a case study outlined in the chapter on contemporary issues in accounting.

FIGURE 5.3 Case study approach applied to the Conceptual Framework for the potential recognition
of an asset.

5.8 Conceptual frameworks for other sectors

LEARNING OBJECTIVE 5.8

Understand conceptual frameworks applicable to other sectors.

Both the 2010 and 2018 Conceptual Framework s apply to for‐profit entities. The initial joint conceptual
framework project begun in 2004 by the IASB and FASB included a Phase G that was to consider the
Conceptual Framework's application for not‐for‐profit and public-sector entities. However, this phase
was never commenced, and, in 2012, the IASB decided to concentrate solely on business entities in the
private sector.

In 2014, the International Public Sector Accounting Standards Board (IPSASB) published the Conceptual
Framework for General Purpose Financial Reporting by Public Sector Entities (IPSASB CFW). In many
areas, this reflects or includes concepts consistent with the IASB’s Proposed Framework (such as the
qualitative characteristics and recognition criteria), although there are adaptations and changes to
accommodate the unique issues or appropriate emphasis given to the public sector context. For
example, the definition of 'assets' in the IASB’s conceptual frameworks focuses on economic benefits and
associated cash flows. If economic benefits are limited to cash flows, then can entities that do not charge
for their services have assets? For many public sector entities, assets are not intended to produce net
positive cash flows.

Heritage assets (for example, national and marine parks, museum collections, historical buildings and
industrial and cultural artefacts) may often result in negative cash flows. Many heritage assets have the
following characteristics:
(a)

their value in cultural, environmental, educational and historical terms is unlikely to be fully reflected in a
financial value based purely on a market price;

(b)

legal and /or statutory obligations may impose prohibition or severe restrictions on disposal by sale;

(c)

they are often irreplaceable, and their value may increase over time even if their physical condition
deteriorates; and

(d)

it may be difficult to estimate their useful lives, which in some cases could be several hundred years.62

The IPSASB CFW encompasses such items as assets by amending the definition of resources to include
‘service potential’ which is defined as:

the capacity to provide services that contribute to achieving an entity’s objectives. Service potential
enables an entity to achieve its objectives without necessarily generating net cash inflows.63

Other areas of difference include:

emphasis [o]n the objectives for reporting on accountability, although decision-usefulness is included as
an objective

users, includ[ing] service recipients, encompassing citizens as well as resource providers

•

an explicit objective for measurement that includes the need to reflect operational capacity; that is, the
ability for the entity to maintain the provisions of services in the future.64

The IPSASB’s pronouncements have been adopted in a number of jurisdictions around the world. Some
countries have, however, taken a different approach. In Australia, the AASB has adopted a sector‐neutral
approach, where the one suite of accounting pronouncements applies to all sectors, although there may
be specific standards that are sector‐specific, for example, AASB 1049 Whole of Government and
General Government Sector Financial Reporting and AASB 1004 Contributions.

As discussed earlier in this chapter, the adoption of the revised Conceptual Framework has introduced a
different reporting entity concept, which necessitates a change in how the two tiers are differentiated,
resulting in amendments to a range of standards, including AASB1053. Following this, the AASB reissued
the Conceptual Framework in 2020 and required that it be applied to certain for-profit entities.65

The AASB has not yet considered the application of the revised Conceptual Framework to not-for-profit
private or public sector entities. The Board, however, has included the development of a not-for-profit
private sector Financial Reporting Framework in its Work Plan, with the aim of developing a 'simple,
proportionate, consistent and transparent financial reporting framework for all not-for-profit (NFP)
private sector entities in Australia'. 66

Accounting for the not‐for‐profit and public sector entities poses some unique challenges. Not only is the
nature of many assets, such as heritage and infrastructure assets, problematic in terms of control and
measurement, but the prevalence of non‐exchange transactions (such as donations, grants and taxes)
gives rise to further complications. It is also posited that the type of information normally included in
general purpose financial reports may not adequately meet the users in these sectors, given that a key
concern of such users will be how well such entities have met their service obligations, which cannot not
be quantified or judged in monetary terms. The IPSASB CFW explicitly acknowledges that for such
entities ‘the financial performance . . . will not be fully or adequately reflected in any measure of
financial results’,67 and, therefore, that other information to assess the effectiveness of service delivery
will be needed.

SUMMARY

5.1

Explain what a conceptual framework is

•
A conceptual framework is a set of guiding principles.

It is a normative theory that sets out the basic principles to be followed in preparing financial
statements.

You should see that it has broad principles, whereas accounting standards relate to a narrow and specific
area of financial reporting.

5.2

Understand the history of and recent developments made to the Conceptual Framework for Financial
Reporting

The Conceptual Framework for Financial Reporting issued by the IASB is derived from conceptual
frameworks developed in several countries over the past 30 years. Limited sections of this were revised
under a joint project by the IASB and the FASB and issued in 2010.

The project was recommenced by the IASB, and the revised Conceptual Framework was finalised and
issued in 2018.

5.3

Outline the structure and components of the revised Conceptual Framework and explain the main
changes and improvements

The Conceptual Frameworks comprise a series of hierarchical concepts. The Conceptual Frameworks
issued in 1989 and 2010 included sections related to the objectives of financial statements, underlying
assumptions, qualitative characteristics and definitions and recognition criteria for the elements that
make up the financial statements.
•

The 2018 Conceptual Framework is more comprehensive and is comprised of eight chapters, including
chapters relating to the reporting entity, measurement and presentation of the financial statements.

5.4

Understand and apply the prudence and recognition criteria from the Conceptual Framework

Prudence is defined in the Conceptual Framework as the exercise of caution when making judgements
under conditions of uncertainty.

The inclusion of prudence int the Conceptual Framework is controversial and is a departure from the
2010 Conceptual Framework.

In the 2018 Conceptual Framework, recognition of an item meeting the definition of an element is
required if such recognition provides users with relevant information about the element and a faithful
representation of the element. This has removed the probability threshold for recognition that has
beenincluded in the Conceptual Framework since 1989. This change could increase the number of
elements that could be recognised in financial statements.

5.5

Explain and evaluate the benefits of conceptual frameworks

There are three potential benefits of a conceptual framework in accounting. These are:

Technical: to improve the quality of financial statements by providing guidance to standard setters and
for users and preparers.
−

Political: to reduce political interference in the setting of accounting requirements.

Professional: to provide a claim over a body of knowledge to ensure the professional status of
‘accountant’ is maintained.

5.6

Explain and evaluate the problems with and criticisms of the Conceptual Frameworks

Four criticisms are discussed.

1.

The conceptual frameworks do not work in practice, because the principles are too unclear to provide
adequate guidance; the guidance in applying the principles is inadequate, and the conceptual
frameworks are incomplete.

2.

The conceptual frameworks describe current practice, so they are mainly descriptive, not normative.

3.

The concept of faithful representation as one of the fundamental qualitative characteristics

misunderstands the nature of accounting.

4.

Inconsistencies with the accounting standards call into question the effectiveness of the conceptual
frameworks.
5.7

Apply concepts from the Conceptual Frameworks to financial reporting issues

Although requirements in accounting standards override concepts within the Conceptual Frameworks,
the ability to apply the concepts in the C onceptual Frameworks is required to:

account for transactions and events where there is no specific accounting standard

exercise professional judgement

understand accounting requirements.

The effective application of the concepts in the Conceptual Frameworks requires a systematic approach.

5.8

Understand conceptual frameworks applicable to other sectors

The Conceptual Frameworks issued by the IASB apply only to for‐profit entities.

The IPSASB has issued a conceptual framework applicable for public sector entities.

•
In some jurisdictions, adaptations have been made to the IASB’s conceptual framework to enable cross‐
sector application.

Financial reporting outside of the for‐profit private sector poses some unique challenges.

KEY TERMS

accounting conceptual framework A coherent system of concepts that underlie financial reporting.

asset A resource controlled by the entity as a result of past events, and from which future economic
benefits are expected to flow to the entity.

conceptual framework A set of broad principles that provide the basis for guiding actions or decisions.

fair value 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.

heritage assets Assets that have a cultural, environmental, historical, natural, scientific, technological or
artistic significance and are held indefinitely for the benefit of present and future generations.

intangible assets Identifiable non‐monetary assets without physical substance.

liability A present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits.

principles‐based standards Standards that contain a substantive accounting principle that focuses on
achieving the accounting objective of the standard. The principle is based on the objective of accounting
in the Conceptual Framework.

REVIEW QUESTIONS

5.1
What is a conceptual framework?LO1

5.2

What is the difference between a conceptual framework and accounting standards?LO1

5.3

Outline the technical benefits of a conceptual framework. What problems could occur if accounting
standards were set without a conceptual framework?LO5

5.4

How can a conceptual framework help users and preparers understand accounting requirements and
financial statements?LO3

5.5

Why do accountants need to use a conceptual framework in the exercise of professional judgement?LO5

5.6

How is the decision-usefulness approach reflected in the 2018 Conceptual Framework? What type of
decisions do users need to make?LO3

5.7

The 2018 Conceptual Framework (paragraph 1.6) states that ‘general purpose financial reports do not
and cannot provide all of the information that existing and potential investors, lenders and other
creditors need’. What information is not provided and why?LO3

5.8

Identify the qualitative characteristics of financial information in the 2018 Conceptual Framework. How
are these related to the objectives of general purpose financial reports?LO3

5.9
Not all relevant and faithfully representative information will be included in financial reports due to the
materiality aspect and cost constraint identified in the 2018 Conceptual Framework. Outline the
materiality aspect and the cost constraint on the provision of information. Can you think of any problems
in applying these?LO4

5.10

Distinguish between ‘cautious’ prudence and ‘asymmetrical’ prudence. Using an example, explain what
is meant by prudence in the 2018 Conceptual Framework.LO4

5.11

What is the difference between recognition and disclosure in accounting?LO4

5.12

Outline and contrast the recognition criteria for items in both the 2010 Conceptual Framework and the
2018 Conceptual Framework.LO4

5.13

Why is accounting said to be ‘political’ in nature? How can a conceptual framework help in the setting of
accounting standards in a political environment?LO5

5.14

It is claimed by some that the reason for conceptual frameworks in accounting is to protect
the accounting profession, rather than to improve accounting practice. Explain the basis for this
claim.LO5

5.15

Some people argue that a conceptual framework is acceptable in theory but in practice it does not work.
Explain possible problems with and criticisms of the 2018 Conceptual Framework. Do you think these
problems exist and the criticisms are valid?LO6

5.16

Explain why some people believe that the concept of faithful representation in the Conceptual
Framework is incorrect.LO7
5.17

Outline the reasons why there may be inconsistencies between the Conceptual Framework and
accounting standards.LO8

5.18

Identify the characteristics of heritage assets. Would these characteristics preclude recognition of them
as assets if applying the definition and recognition criteria in the Conceptual Framework?LO8

APPLICATION QUESTIONS

5.19

As a group, identify two or three general principles to help guide the making of more specific rules in
relation to a particular area, context or task. For example:

it may be that a group of students is planning on sharing accommodation (such as an apartment); or

you may be required to undertake a group assignment.

Once you have agreed on the two or three principles, use these to form more specific rules in relation to
the context or task. Then consider the following questions:

(a)

How easy was it to agree on the basic principles?

(b)

Are all the rules consistent with these principles?

(c)
Have any members interpreted the principles differently?

(d)

How useful were the principles in helping establish more specific rules?

(e)

Were there any problems with using principles as a basis for setting the rules?LO3

5.20

Choose one or two accounting standards to review and then:

(a)

find examples of how parts of the 2018 Conceptual Framework (e.g. the definitions, recognition criteria
or qualitative characteristics) have been included in them.

(b)

identify any inconsistencies between the requirements in accounting standards and the 2018 Conceptual
Framework. Why do you think these have occurred?LO3, 4, 8

5.21

Find the comment letters received on a current exposure draft or proposal. (These can be found from the
websites of most standard‐setting organisations, such as the IASB, AASB or FASB.) Read a sample of
comments from a range of respondents (e.g. from accounting bodies, industry, company or corporate
bodies) and answer the following questions:

(a)

Is there agreement among the various groups?

(b)

If there are any concerns or objections, are they based on conceptual issues, practical issues or potential
economic consequences? Does this vary among groups?
(c)

Have any of the comments letters referred to the Conceptual Framework as a basis to support their
views?

(d)

Do the comments letters suggest that there is support for the Conceptual Framework?LO2

5.22

The following information is provided for two items of property owned by a company.

Property A was purchased five years ago for $400 000. It was intended to be used to build another
factory, but the company has now reorganised its original factory, and it is no longer required. The
company now intends to sell it. The current property market has dropped but is expected to rise when
interest rates fall. If sold now, the property is expected to realise $360 000. Real estate experts have
predicted that if the company waits for the property market to recover, it could realise $450 000.

Property B is the current factory. It was purchased ten years ago for $200 000. If sold now, it would be
expected to realise $380 000 (and $500 000 if the property market recovers). The company has various
estimates about the building's contribution to the profit of the company. Using current interest rates and
various assumptions about future sales and costs, the property is calculated to have a present value (in
terms of future cash flows) of $900 000. It is insured for $600 000, because this is the cost required to
rebuild it.

The company has always recorded property using the historic cost basis. Other companies in the same
industry have traditionally used the same basis, although about 40% now use the fair value basis.

(a)

For each of the properties, identify which cost or value would best meet each of the following qualitative
characteristics (consider each separately):
–

faithful representation

relevance

verifiability

comparability

understandability

(b)

Which of these costs or values do you think would be prudent?

(c)

For each of the properties, choose which cost or value you consider should be stated in the financial
statements. Explain why you have chosen it and how you balanced the qualitative characteristics.

(d)

Do you think everyone would agree with your choices?LO4

5.23

Think of brands or trademarks that you use and that you think would be valuable.
(a)

Find the annual reports for the companies that have these brands and see if the brands are recognised in
the balance sheet as assets and, if they are, how they are valued.

(b)

Identify any differences between the recognition of such assets between companies. Can you think of
reasons why these differences have occurred?

(c)

Do the relative values of tangible assets, as compared to intangible assets, reflect the relative
importance of assets to the companies?

(d)

Go to a brand valuing site (such as Interbrand or BrandZ) and compare the value of the brands to those
reported in the financial statements. Given this comparison, do you think the balance sheets that you
have examined provide useful information to users?LO7, 8

APPLICATION OF DEFINITIONS AND RECOGNITION CRITERIA IN THE CONCEPTUAL FRAMEWORK

The following questions (5.24–5.30) require you to apply the definitions and recognition criteria in the
2018 Conceptual Framework to specific cases. After you have answered these questions, compare your
answers with those of other students. Do your answers differ? How did using the 2018 Conceptual
Framework help you to make your decision?

5.24

A company has a copper mine in South Africa. It purchased the mining rights 10 years ago for $20 million
and has been operating the mine for the past ten years. It is estimated that there are about 8 million
tonnes of copper in the mine. Because of a fall in world copper prices, the company has closed the mine
indefinitely. At current world copper prices, the mine is uneconomic because the costs involved in
extracting the copper are greater than the selling price. As the mine is in a remote and unpopulated
area, there is no alternate use for it, and it cannot be sold. If copper prices rise by more than 25%, the
company has stated that the mine would be reopened. In the foreseeable future (next 10 years or so), it
is estimated there is a 20% probability that copper prices will rise sufficiently for extraction to be
profitable.
Explain whether this mine would meet the definition and recognition criteria of an asset, applying the
principles in the 2018 Conceptual Framework.LO3, 4

5.25

The company is currently growing, and it is expected that, in five years, an additional factory will need to
be built to meet product demand at a cost of $500 000. The directors wish to recognise an expense of
$100 000 and a liability (provision for future expansion) for each of the next five years.

Applying the principles in the 2018 Conceptual Framework, explain whether:

the definition of a liability or expense is met

the recognition criteria for a liability or expense are met. LO3, 4

5.26

The company has recently issued some preference shares. The terms of these shares are:

A fixed dividend of 3% is payable each year. If no profit is available to pay dividends in one year, these
will be back‐paid in future years.

The preference shares will be redeemed (bought back) by the company in three years at their issue price.

Applying the principles in the 2018 Conceptual Framework, explain whether these preference shares
should be considered as an equity or a liability.LO3, 4

5.27
A public museum has an exhibition of 20 rare fossils. A number of these were purchased at a total cost of
$750 000, while six items were donated to the museum. If sold (to other museums and collectors), it is
estimated that the fossils would sell for around $1.5 million, although the donated items (which would
sell for $600 000) were donated on the condition that they would not be sold and are to be returned to
the donors if no longer required by the museum. The museum charges a nominal fee of $2 for entry to
the exhibit and receives on average of $30 000 per annum in fees. It is estimated that it costs around $70
000 per annum to maintain the exhibition.

Applying the definition of and recognition criteria for assets, explain whether the fossils could be
recognised as assets of the museum.LO3, 4

5.28

Company A is suing Company B for $500 000 in relation to a breach of copyright. Company B produced
designer clothes identical to those for which Company A holds legal rights without permission and
without paying Company A for permission to use the designs. Legal experts have advised Company A
that it has a strong case, and that there is a 60% likelihood that Company B will be required to pay
damages, although these are estimated at $400 000.

(a)

Explain whether the potential damages payable to Company A would meet the definition and
recognition criteria of an asset, applying the principles in the 2018 Conceptual Framework.

(b)

Explain whether the potential damages by Company B would meet the definition and recognition criteria
of a liability, applying the principles in the 2018 Conceptual Framework.

(c)

Would your answers to part (a) or (b) change if the likelihood of Company A winning the case was only
40%?

(d)

Under current accounting standards IAS 37/AASB 137, an asset can only be recognised in such cases if it
is virtually certain that income will be realised (paragraph 33), but a liability is recognised if probable. Do
you think this difference in requirements is justified?LO3, 4
5.29

A company in Europe recently purchased a gold mine on a small pacific island for $80 million. Shortly
after beginning operations, there was political unrest, and the mine had to be abandoned as it was
attacked by rioters. The political unrest has now developed into a civil war that is expected to be
prolonged and continue for a number of years. While this is occurring, the company will not be able to
operate the mine. It is expected that, once the civil war ends, the company will be able to reopen the
mine.

(a)

Explain whether this mine would meet the definition and recognition criteria of an asset, applying the
principles in the 2018 Conceptual Framework. Assume further information is provided, as follows.

Three years later, the civil war is nearing an end, and it is expected that elections will be held, and a
government will be established shortly after. However, one of the potential parties for government (this
party has a 30% chance of being elected) has announced that all foreign‐owned businesses (including
mines) will be seized by the government, and no compensation will be paid. A key issue in the civil war
was the ownership of resources by foreign countries. However, the party that is likely to be elected has
ensured all foreign companies that their ownership rights will be formally recognised, and that most
companies will be able to continue operations or will receive compensation if property is seized.

(b)

Explain whether this new information would change your answer in part (a).LO3, 4, 8

5.30

A company has an extensive customer base. Over many years, it has built a detailed customer list, which
includes various data, including demographics, contact details, purchasing history and preferences. It has
spent quite a lot of resources on developing this customer list so that it can effectively target marking
campaigns and manage customer relations. A number of businesses have approached the company to
purchase their customer list and have offered prices from $60, 000 to $210, 000. However, the company
has decided not to sell at this stage.

(a)

Explain whether this customer list would meet the definition and recognition criteria of an asset,
applying the principles in the 2018 Conceptual Framework.
(b)

Requirements of accounting standards currently prohibit the recognition of internally generated

intangibles such as customer lists, and only allow cost basis to be used for any intangible assets
recognised. Do you think these restrictions are justified?LO3, 4

CASE STUDY 5.1

CODE OF ETHICS — IFAC ISSUES REVISED CODE FOR PROFESSIONAL ACCOUNTANTS

IFAC, through the International Ethics Standards Board for Accountants (IESBA), released a new
International Code of Ethics for Professional Accountants in 2018. It was recently updated in 2021.

Besides ethics, IFAC Boards and Committees develop international standards on auditing and assurance
(ISAs), on education and on public sector accounting. Each of the member bodies of IFAC — there are
180 currently, representing 135 countries — undertakes to use its best endeavours, subject to national
laws and regulations, to implement the standards issued by IFAC in each of these fields.

Fundamental principles

The fundamental principles in the new International Code of Ethics are:

Integrity: An accountant should be straightforward and honest in all professional and business
relationships. For example, accountants should not be associated with information which they believe
contains a false or misleading statement.

Objectivity: An accountant should exercise professional or business judgement without being

compromised by bias, conflicts of interest or undue influence of or undue reliance on individuals,
organisations, technology or other factors.

Professional Competence and Due Care: An accountant has to attain and maintain professional
knowledge and skill at the level required to ensure that a client or employing organisation receives
competent professional service, based on current technical and professional standards and relevant
legislation; and act diligently and in accordance with applicable technical standards.

Confidentiality: An accountant should respect the confidentiality of information acquired as a result of

professional and business relationships.

Professional Behaviour: An accountant should:

comply with relevant laws and regulations;

act diligently and in accordance with applicable technical and professional standards; and

avoid any action that the professional accountant knows, or should know, discredits the profession.

Threats

The professional accountant shall identify threats to compliance with the fundamental principles.
Threats identified in the Code are:

Self Interest Threat: The threat that a financial or other interest will inappropriately influence a
professional accountant’s judgement or behaviour.

Self-Review Threat: The threat that a professional accountant will not appropriately evaluate the results
of a previous judgement made or an activity performed by the accountant or by another individual
within the accountant’s firm or employing organisation, on which the accountant will rely when forming
a judgement as part of performing a current activity.

Advocacy Threat: The threat that a professional accountant will promote a client’s or employing
organisation ’s position to the point that the accountant’s objectivity is compromised.

Familiarity Threat: The threat that, due to a long or close relationship with a client or employing
organisation, a professional accountant will be too sympathetic to their interests or too accepting of
their work.

Intimidation Threat: The threat that a professional accountant will be deterred from acting objectively
because of actual or perceived pressures, including attempts to exercise undue influence over the
accountant.

The Code contains many examples of situations that may be faced by accountants and of possible
safeguards that could mitigate the threats. In some cases, the code makes it clear that no safeguard
could adequately address the perceived or actual threat to the fundamental principles — for example,
the threat to objectivity (or independence) if an auditor held shares in his audit client, and, in such cases,
the only options are to walk away, resign or refuse the assignment. However, the Code clearly states that
the examples are not all inclusive, and that the obligation is on the accountant to identify and assess any
threats that might arise in the particular circumstances faced — and then to address them appropriately
in accordance with the framework approach set out in the Code.

Conceptual framework advantages

The advantages of this conceptual framework approach are that:

the principles‐based standards set out in the Code are robust and can be applied to the diverse and
varying circumstances faced by professional accountants;

•
it avoids technical evasion of detailed rules;

it is appropriate for global application; and

it continues to be applicable in a rapidly changing environment.

QUESTIONS

Can you identify any potential problems or criticisms of the principles outlined in the conceptual
framework in the case?

Do you think using these principles would be interpreted and applied consistently between individual
accountants in determining whether an action is ethical?

How effective do you think such a framework is in (a) ensuring accountants act ethically and (b)
enforcing or penalising unethical behaviour?

Would a set of specific rules about what constitutes ethical and unethical behaviours in specific
circumstances be more or less useful than the principles in the code of conduct outlined above?LO3

CASE STUDY 5.2

The concept of prudence and its use, or non‐use, in financial reporting has been the cause of much angst
and the subject of swirling debates in recent years. Outside of accounting and legal circles, prudence, like
so many other words of another era, is a descriptor, if not a concept, on the wane.
It refers to the exercise of good judgement, informed by intelligence and good character. Prudence
requires the consideration of long‐term choices and the implications of decisions and the avoidance of
biases that make us focus on the here and now. For decades, the concept of prudence had been part of
financial reporting frameworks.

It was recognised as part of the qualitative characteristic of ‘reliability’ within the International
Accounting Standards Board’s (IASB) conceptual framework until 2010, when the IASB decided to replace
it with the concept of neutrality.

IS PRUDENCE STILL A VIRTUE?

In order to better understand the IASB’s decision to remove prudence from the Conceptual Framework,
let us first look at its pre‐2010 definition of the word, which was ‘the inclusion of caution in the exercise
of the judgements needed in making the estimates required under conditions of uncertainty, such that
assets or income are not overstated, and liabilities or expenses are not understated’.

Prudence requires an open‐mindedness that is a necessary trait for accountants. While some argue that
there is nothing wrong with this definition, in practice there have been some real issues with
interpretation, particularly as it can cause a bias towards conservatism in financial reporting.

Or worse, as the IASB chairman put it in a 2012 speech: ‘Many felt that, in practice, the concept of
prudence was often used as a pretext for cookie jar accounting’.

As professionals, we strive to remove bias from our everyday actions — why should financial reporting
be any different? Prudence causes bias in financial reporting [by] introducing a degree of conservatism
that diverges from the presentation of unbiased or neutral financial reports.

There is no doubt that prudence and conservatism were perhaps more important concepts in a time
when the accounting standards and frameworks were less well developed, to encourage the exercise of
caution by financial report preparers when there was no clear guidance or requirement set out to tackle
a particular financial reporting issue.

However, in more recent times, accounting standards and frameworks have become much more well
developed, obviating the need for the concept. As an interesting aside, support for the concept of
prudence appears to be stronger in jurisdictions where the financial reporting function has links to the
‘capital maintenance concept’ and the protection of creditors.

The International Financial Reporting Standards promulgated by the IASB, with their focus on the
provision of information related to financial performance to allow investors to make appropriate
economic decisions, do not have the same objectives. Whilst the meanings and interpretations of the
concept of prudence within financial reporting may have become too warped over time to redefine and
reintroduce, there is no doubt a place for its true meaning in other everyday actions of an accounting
professional.

Prudence requires an open‐mindedness that is a necessary trait for accountants. As accountants, we

need to be able to perceive possibilities as strategic thinkers and as creators and assurers of information.

We need to actively seek information that contradicts our preconceptions and seeks to promote the
common good, the public interest.

Let us look at the development of the framework for Integrated Reporting (IR), for example, an initiative
that I ardently support and seek to foster.

In the last two decades, there have been instances where the Annual Report has been used as a tool to
promote an entity’s brand, often a brazen marketing initiative.

IR seeks to bring discipline into the preparation of annual reports, introducing an emphasis on the
discussion of the business model, the risks a business faces, value creation and value depletion, all in a
structured manner. One might argue that the introduction of such a discipline is synonymous with the
exercise of prudence.

So, I think we should not exclude prudence from our toolkit of virtues, but understand it and embrace it
for what it really is — not bias or conservatism in financial reporting that it was previously associated
with, but unbiased long‐term intelligent thinking.

Source: Alex Malley, ‘Is prudence still a virtue?’, INTHEBLACK.68

QUESTIONS
1

The article claims that, although accountants need to use prudence, the concept need no longer be
included as standards and frameworks are now more developed. Do you agree with this?

The UK Financial Reporting Council has argued that the essence of prudence is ‘asymmetric’ prudence; a
lower threshold for the recognition of liabilities and losses than for assets and gains and so the definition
of prudence in the revised Conceptual Framework is incorrect. How would you interpret prudence? Do
you agree that it should include ‘asymmetric’ prudence.

The IASB acknowledged that asymmetric prudence is (and will likely be) incorporated into some
accounting standards, but that asymmetric prudence is not a necessary characteristics of information, so
should not be included in the Conceptual Framework, and that its use should be on an exceptional basis.
Others have argued that this guidance about when it is appropriate to use asymmetric prudence should
be included in the Conceptual Framework.

(a)

Can you think of situations where asymmetric prudence would be justified?

(b)

If the IASB expect to use asymmetric prudence in some accounting standards, do you believe that
guidance should be provided in the C onceptual F ramework?