The conceptual framework of accounting
The Conceptual Framework of Accounting provides the foundation of the application of accounting and financial reporting. As the Financial Accounting Standards Board (FASB) defined that conceptual framework is a "coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements" (FASB, 1976).Regarding how to identify the items for financial reporting, how to recognize and measure these items and how to report them, the conceptual framework sets up specific guidelines. Return to this essay, it has three parts: the first part introduced the development of conceptual framework, and the second one discussed the relationship of the concept and method between current valuation and the economic income. The last part described the conceptual framework's contribution of financial reporting relate to comprehensive income.
From the first mentioning, the Conceptual framework has been developing rapidly for nearly half a century. As early as 1966, the American Accounting Association issued 'A Statement of Basic Accounting Theory' which established four basic standards of accounting information: relevance, verifiability, freedom from bias, and quantifiability. It developed by Charles T. Zlatkovich, the chair of a committee. These standards were the FASB and IASB conceptual framework's precedents of the qualitative characteristics. In 1973, the Financial Accounting Standards Board was set up, after that, it quickly embarked on the project of conceptual framework that has never been taken. This project includes six statements of financial accounting concepts. The first statement was issued in November 1978, which was called 'Objectives of Financial Reporting by Business Organizations'. It is known as the SFAC No.1.However, this statement was only used by the business organizations instead of all types of organizations. Therefore, in August 1977, FASB commissioned Robert Anthory, whom from Harvard University, to commence the non-business organizations added into this project. With the help of Anthory, FASB published the fourth statement of financial accounting concepts in 1980, 'Objectives of Financial Reporting by Nonbusiness Organizations.' In addition, FASB issued another five statements during next 10 years. They are : SFAC No.2: Qualitative Characteristics of Accounting Information (FASB 1980), SFAC No.3: Elements of Financial statements (superseded by SFAC No.6) (FASB 1980), SFAC No.5: Recognition and Measurement in Financial Statements (FASB 1984), SFAC No.6: Elements of Financial Statements (replaces SFAC No.3) (FASB 1985) and SFAC No.7: Using Cash Flow Information and Present Value in Accounting Measurements. (FASB 2000) In December 1976, the FASB published a memorandum as part of the conceptual framework project; it called 'An analysis of issues related to Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement'.
Subsequent to the publication of the FASB's Conceptual Framework, the International Accounting Standards Committee, the Australian Accounting Research Foundation, the New Zealand Society of Accountants, Accountants Canadian Institute of Chartered Accountants and the Accounting Standards Board (UK) began to work on their own conceptual frameworks. For instance, British did numerous attempts on this area, in 1970, 'Statement of Standard Accounting Practice 2 Disclosure of Accounting Policies' issued. Then, five years later, 'The Corporate Report' proposed. It tried to enlarge the target users, described the new statements and attempted to solve the problem of profits. Following to this, Accounting Standards Committee disclosed 'A Conceptual Framework for Financial Accounting and Reporting: The Possibilities for an Agreed Structure' in 1981. And in 1988, the Institute of Chartered Accountants of Scotland reported' Making Corporate Reports Valuable '. ICAEW/ICAS issued in1991'The Future Shape of Financial Reports'. After that, the ASB published the ED of 'Statement of Principles'. In 1999, the final ASB 'statement of Principles' issued.
Recently, the cooperation of the regulatory bodies became much more frequently. In October 2004, the FASB together with IASB, embarked on a joint project to develop a common conceptual framework. The objective of this project is to rebuild a new common framework based on their existing ones about: refining, updating, completing and converging, which can be used by both boards in developing new accounting standards.
As we all known, there are many methods of valuation existed, like: historical cost measurement, replacement cost measurement, net realizable value, value in use and fair value measurement. Among them, some measurements are used seldom, as replacement cost measurement, net realizable value and value in use. In accounting area, historical cost is the original monetary value of an economic item, as it is always based on an assumption about unit. If there is no change of assets and liabilities value, they may be shown at their historical cost. However, the value of the items in the balance sheet may differ from the "true" value. The historical cost valuation has some disadvantages: it can't give the meanings of current values of the assets, and it does not record the older asset's opportunity costs especially for those which may be recorded many years ago, furthermore, historical cost does not concern the loss of value in inflation. Due to these problems, many regulatory bodies propose to use fair value measurement instead of historical cost valuation.
The IASB defined the Fair Value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date". (SFAS157, 5) As fair value is the most relevant measurement for financial instruments and much more transparency than historical cost based measurement, accounting standards setters including the United States, the United Kingdom, Australia, and the European Union, have issued standards requiring measured the changes of income at fair value and recognized balance sheet amounts with the same measurement. According to the concept of fair value, the objective of this measurement is defined the exchange price of assets and liabilities. However, in practice, fair value may not be well estimated and this may happened when there is no active market exists. In this situation, it becomes difficult to calculate the asset or liability's fair value from its value-in-use to the enterprise. Furthermore, the amount of measurement error and source of the estimates may also cause the false of fair value measurement.
Refer to economic income; we first associated with Hicks's theory. John Hicks defined income as "the maximum which an individual can consume during a period, and still remain as well off at the period's end, as he was at the period's beginning." (Hicks, 1939) After that, Alexander adapted this concept to the corporation, describing economic income as "the amount the firm could distribute to shareholders during a period and still remain as well off (have as much residual equity) at the end of the period as it was at the beginning of the period." The economic income includes the recognized income and unrecognized income, and it is measured at fair value; therefore it reflects the true value of the assets. However, although the benefits of economic income are obviously, it still has some weakness, the amount and timing of future cash flows cannot be estimated appropriately. In addition, the discount rate is also hard to estimate.
From the description of economic income and fair value measurement, we can find that the fair value is the best measurement which can figure out the economic income, since the fair value measurement reflect the truly value of assets and liabilities. And the economic income includes the whole income of recognized income and unrecognized income.
With the use of Conceptual framework, we realize that the framework provides the information to help the users estimate the amounts, timing and uncertainty of future net cash flows. It not only reduces the need of other specific standards and but also regulates the use of the financial statements. To see the specific contribution of conceptual framework for financial reporting, for instance, we relate to the 'Comprehensive income'.
The concept of 'Comprehensive income' was first proposed by the United States in 1980. Comprehensive Income is defined by FASB in SFAC No. 6 as 'the change in a firm's net assets (assets minus liabilities) from non-owner sources'. (SFAC No.6) However, the first country to put it into action is not US but UK. In June 1997, in order to resolve the problems of dealing with the derivative financial instruments, the FASB was forced to release the Financial Accounting Standards No. 130 'report comprehensive income'. After that, other countries affected by the impact of the International Accounting Standards Board in 1997 and required enterprises to provide income statement while providing changes in equity. In June 1998, FASB issued ED No.162, it proposed that the items should be presented as 'other comprehensive income' instead of be taken to equity directly and be presented 'in a statement of finance performance'. ED162A says: the items should be presented either at the foot of the income statement so as to give a total for 'comprehensive income' or in a new 'statement of comprehensive income', which would also include 'net income'. (ED162A) At the meantime, the ED complaining about 'potential confusion and volatility', and proposed that 'per share' amount of comprehensive income should be given. In SFAS130, it requires that 'an enterprise shall display comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements and display net income as a component of comprehensive income in that financial statement'. (SFAS130) However, unlike ED162, SFAS suggests three alternatives methods: first, a combined statement of net income and comprehensive income, secondly, a separate statement of comprehensive income, and lastly: within a statement of changes in equity. FASB encouraged the use of one of the first two methods. In January 1998, the G4+1 group issued a paper of' Reporting Financial Performance: Current Developments and Future Directions ', to suggest the single performance statement should include all 'comprehensive income' components, and analyze the 'operating', 'financing' and 'other' account.
Compared with the different opinions of 'comprehensive income', we can sum up three main ideas, first one is uses a combined statement of net income and comprehensive income, the second one is disclosing comprehensive income uses a separate financial statement, and the third method is reporting comprehensive income in the statement of shareholders' equity. To the first approach, the advantage is the measures of the enterprise's performance, net income and comprehensive income are disclosed in a single statement. The primary disadvantage about this approach is that net income can be seen as a part of the income statement and comprehensive income can be thought of as the new bottom line. One advantage of the second approach is that it may not distracting disclosures of comprehensive income to other income statement. Firms that need net income may choose this approach as it does not change the income statement. The main disadvantage of this approach is that it creates another statement; it may disturb the decisions of reporting users. The main benefit of using the third approach is that enterprises can make the form of comprehensive income as a performance measure. The drawback for companies is that demote the statement of stockholders' equity to the footnotes previously.
In conclusion, Conceptual Framework of accounting is similar to a constitution, which objective is guiding the direction of all accounting theory. However, a few aspects of the frameworks are inconsistent and some others are not as clear as they might be. Although the conceptual framework has numerous weaknesses, it provides the guidance in developing and reviewing the accounting standards. In addition, conceptual framework guide accounting standard-setting bodies to develop new accounting standards as the market changes in the economic environment and the users need for plenty of new information. The amendments of conceptual framework still continuing by the regulatory bodies, it will be revised and improved in near future. The new framework will bring the new concepts of financial reporting into harmony with other concepts. What we hoped is as the joint project is developing, the new conceptual framework becomes much more completely and helpful for the investors, creditors and other users.
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