In Chapter 3 we established that accounting theory consti tutes the frame of reference on which the development of accounting techniques is based

In Chapter 3 we established that accounting theory constitutes the frame of reference on which the development of accounting techniques is based. This frame of reference, in turn, is based primarily on the establishment of accounting concepts and principles. Of vital importance to the accounting discipline is that the accounting profession and other interest groups accept these concepts and principles. To ensure such consensus, a statement of the reasons or objectives that motivate the establishment of the concepts and principles must be the first step in the formulation of an accounting theory.

A statement of the objectives of financial statements has always been recognised as urgent and essential if debate over alternative standards and reporting techniques is to be resolved by reason and logic. For example, in 1960, Devine argued that:

... the first order of business in constructing a theoretical system for a service function is to establish the purpose and the objectives of the function. The objectives and purposes may shift through time, but for any period, they must be specified or specifiable.'

Watts and Zimmerman note that financial accounting theory has had little substantive, direct impact on accounting theory and practice, and offer the following explanation:

Often the lack of impact is attributed to basic methodological weaknesses in the research. Or, the prescriptions offered are based on explicit or implicit objectives that frequently differ from writers. Not only are the researchers unable to agree on the objectives of financial statements, but they also disagree over the methods of deriving the prescriptions from the objectives.2

Aware of their importance, the accounting professions in Australia, the United States, the United Kingdom and Canada have made various attempts to formulate the objectives of financial statements. In Australia, the accounting profession has formalised the objectives of financial statements in the release of various discussion papers and in Statements of Accounting Concepts (SACs). Together, the SACs represent the Australian conceptual framework or constitution for financial reporting. In the United States, the importance of the development of financial statements objectives was first expressed by the report of the Study Group on the Objectives of Financial Statements,3 and later in the attempts of the FASB to develop a conceptual framework4 In the United Kingdom, the importance of these objectives was highlighted by the publication of The Corporate Report by the Institute of Chartered Accountants in England and Wales'> In Canada, interest in the subject resulted in the publication of Corporate Reporting: Its Future Evolution.6 Although relatively recent, all of these efforts have been directly influenced by Chapter 4 of APB Statement No.4 'Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises'. 7

In this chapter, we will elaborate on the attempts by the AARF, the AASB and the accounting profession to formulate the objectives of financial statements and to develop a conceptual framework for financial reporting in Australia. Emphasis is also given to the conceptual framework in the United States because developments in this jurisdiction proved influential on the development of the Australian SACs. Furthermore, this chapter considers the development of conceptual framework projects in the United Kingdom and Canada.

5.1 The search for a conceptual framework: historical origins

In its simplest form a conceptual framework is a formal set of interrelated concepts that specify the function, scope and purpose of financial accounting and reporting. A conceptual framework can be descriptive, prescriptive or a mixture of both. A descriptive framework is one that attempts to develop a set of interrelated concepts which serves to codify and explain existing financial reporting practices. A prescriptive framework is one that attempts to develop a conceptual basis for what financial accounting practices should or ought to be. In other words, it seeks to modify or change existing accounting practices. It will be seen that the level of description and prescription applied in various conceptual framework projects tends to vary across different accounting jurisdictions.

Concern with a conceptual framework that would guide company financial reporting practices and accounting standard setting has occupied the attention of professional accountants, academics and regulators for over fifty years. Historically considered, the Wall Street crash in 1929 has had much to do with a professional push for a conceptual framework. The share market crash resulted in an international economic depression and the collapse of numerous companies worldwide. Professional accountants in the United States, and to a lesser extent in the United Kingdom, were criticised and assigned considerable blame for the events of 1929. These criticisms related to a lack of self-regulation on the part of the profession. There was also much criticism of permissive accounting practices adopted by accountants during the 1920s, especially in connection with the notorious asset valuation practices of this period. 8

Nevertheless, around 1953 the Roosevelt administration envisaged a great potential for the accounting profession to participate in national economic recovery. Moreover, it was recognised that professional accountants, by producing reliable company financial reports and adopting consistent accounting practices, could help restore investor confidence in the nation's shattered capital markets.9 The needs of the Roosevelt administration and the aspirations of the accounting profession were well synchronised. Following the events of 1929, the accounting profession in the United States experienced one of the most introspective phases of its history. Prominent leaders within the profession, notably Eric Kohler and George O. May, were conscious of the need to establish the basic principles on which company reports were based, to correct the permissive accounting practices of the 1920s and to reaffirm public and investor confidence in professional accountants. There was a consensus at this time that improved financial reporting by companies and the development of coherent set of accounting principles and concepts was a pivotal factor in creating this confidence, This resulted in the American accounting profession sponsoring a number of research initiatives to identify and codify the accounting principles and concepts underlying financial accounting practices and reports. This was exemplified by the 1936 publication of 'A Tentative Statement of Accounting Principles Affecting Corporate Financial Reports' by the American Accounting Association, largely under the influence of its president, Eric Kohler. This early statement anticipated future research and policy positions of the profession. It also stated a desire on the part of the profession to distance itself from the 'valuation follies' of the 1920s. To some extent the accounting profession achieved this objective by establishing the historical cost principle as the cornerstone of financial accounting practice.

This was expanded further in the classic studies of Sanders, Hatfield and Moore, Paton and Littleton, and further still in Littleton's treatise on accounting principles 'Structure of Accounting Theory'. 10.11,12 Since these formative efforts to develop a coordinated body of accounting concepts and principles, there has been a flurry of research interest devoted to establishing a uniform and internally consistent body of accounting theory to guide the development and implementation of accounting practice and policy.

The first standard-setting body was established in 1936 when the American Institute of Accountants formed a Committee on Accounting Procedure. The Committee published accounting research and terminology bulletins that provided authoritative opinions or recommendations on preferred accounting practices. A less formal standard-setting arrangement was observable in the United Kingdom, where professional debate over preferred or 'best' accounting practices had been in progress since the inception in 1871 of the Institute of Accountants' prestigious journal, The Accountant.

Although the bulletins of the Committee on Accounting Procedure provided recommended solutions to particular financial reporting problems, they did not result in a conceptual framework. This failure on the part of the committee was in fact much criticised, and its authority in accounting matters was diminished.

By the mid-1950s, there was a good deal of academic and professional opinion that stressed the inadequacies of company financial reporting. The discontent arose from two directions. First, the historical cost model, generally accepted in accounting practice at this time, was not being applied consistently, nor were the principles underlying historical cost accounting well understood or properly explained in research writings.

Second, a tradition was developing amongst academics, including some practitioners in the United States, that was against the whole principle of historical cost accounting. For example, the early studies of Sprague and Hatfield were critical of historical cost accounting because the model did not reflect the economic reality of changing price levels.13,14 The accounting profession rook steps in this period to redress these concerns by sponsoring research projects to consider some alternative accounting models or, at the very least, make the historical cost model more logical and internally consistent. On the whole, the accounting profession's early attempts to redress criticism had met with some success. This was partly due to the influence of Littleton's 1953 monograph, which answered concerns about the internal consistency and logical coherence of the historical cost model. In particular, Littleton provided extensive justifications for its continued use. Littleton's study, however, was insufficient to quell widespread concerns that the historical cost model was flawed. It was not until the early 1960s that this controversy would be addressed by the accounting profession. The AICPA established the Accounting Principles Board (APB) in 1959. The objective of the APB was, inter alia, to accelerate the development of a conceptual framework. Specifically, the APB set itself the following tasks:

1 to establish basic postulates;

2 to formulate a set of broad principles;

3 to establish rules to guide the application of principles in specific situations; and 4 to base the entire program on research.

The Accounting Research Division of the AICPA commissioned studies by Moonitz, and Sprouse and Moonirz.l5,'6 It was hoped that these studies would answer some specific problems and concerns on the issue of changing price levels. These studies, intet alia, proposed that the accounting profession adopt some form of current cost accounting.

However, the works met with the same fare as previous current cost studies, including Henry Sweeney's 'Stabilized Accounting' in 1936 and Hatfield's 'Modern Accounting' in 1928. The studies of Moonitz, and Sprouse and Moonitz, were regarded as too radical and normative in their approach. Subsequently, the APB recommended that the objectives of accounting be defined in more descriptive terms. In 1963, the APB commissioned Paul Grady to develop this more descriptive framework. This approach was reflected in APB Statement No.4, 'Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises', which was based on Grady's study and served to codify existing accounting practices. Although Statement No.4 was basically descriptive, which diminished its chances of providing the first accounting conceptual framework, it did influence Australian attempts to formulate the objectives of financial statements and to develop a basic conceptual framework for the field of accounting. Chapter 4 of APB Statement No.4 classifies objectives as particular, general and qualitative, and places them under a set of constraints.

The particular objectives of financial statements are to present fairly and in conformity with generally accepted accounting principles, financial position, results of operations and other changes in financial position.

2 The general objectives of financial statements are:

a To provide reliable information about the economic resources and obligations of a business enterprise in order to:

i evaluate its strengths and weaknesses; ii show its financing and investments;

iii evaluate its ability to meet its commitments; and iv show its resource base for growth.

b To provide reliable information about changes in net resources resulting from a business enterprise's profit-directed activities in order to:

i show ex peered dividend return to investors;

ii demonstrate the operation's ability to pay creditors and suppliers, provide jobs for employees, pay taxes and generate funds for expansion;

iii provide management with information for planning and control; and iv show its long-term profitability.

C To provide financial information that can be used to estimate the earnings potential of the firm.

d To provide other needed information about changes in economic resources and obligations.

e To disclose other information relevant to statement users' needs. 3 The qualitative objectives of financial accounting are:

a relevance. which means selecting the information most likely to aid users in their economic decisions;

b understandability, which implies not only that selected information must be intelligible, bur also that the users can understand it.;

C verifiability, which implies that the accounting results may be corroborated by independent measures, using the same measurement methods;

d neutrality, which implies that the accounting information is directed toward the common needs of users, rather than the particular needs of specific users;

e timeliness. which implies an early communication of information, to avoid delays in economic decision making;

comparability, which implies that differences should not be the result of different financial accounting treatments; and

9 completeness. which implies that all the information that 'reasonably' fulfils the requirements of the other qualitative objectives should be reported.

The objectives expressed by APB Statement No.4 appear to provide a rationale for the form and content of conventional financial reports. The statement even admits that the particular objectives are stated in terms of accounting principles that are generally accepted at the time the financial statements are prepared. It is noteworthy that the general objectives fail to identify the informational needs of users. The statement implicitly recognises these limitations when it admits that 'the objectives of financial accounting and financial statements are at least partially achieved at present'. Despite these limitations, APB Statement No.4 has been a necessary step toward the development of a more consistent and comprehensive structure of financial accounting and of more useful financial information, both in the United States and elsewhere. In 1973, the APB was replaced by the FASB, which continued and extended the conceptual framework project initiated by the APB.

ill- The Australian conceptual framework: background and issues

In Australia, the development of a conceptual framework followed a similar pattern to that of the United States. The Australian accounting profession also recognised the need to develop a system of coordinated concepts and objectives which would guide the development of consistent and improved accounting practices. The absence of what Paton and Littleton called 'a coherent, coordinated, consistent body of doctrine' within which to develop accounting standards was widely believed to be a cause of perceived inconsistencies and inadequacies in Australian accounting practices, particularly during the 1960s and beyond. 17 When the FASB accelerated work on the development of a conceptual framework, the Australian profession followed suit. However, because the conceptual framework project had already been in motion in the United States for some time, the Australian accounting profession was in a position to evaluate and adapt APB and FASB initiatives for Australian conditions.

In a similar vein to the works of Sprouse and Moonitz, Australian academics such as Mathews and Grant, 18 and Chambers, 19 were also conscious of the problem of changing price levels and proposed that the accounting profession abandon the conventional historical cost system in favor of some form of current cost accounting system. Chambers was particularly forceful in his criticisms of the inconsistencies and conceptual deficiencies underpinning the historical cost mode1.20 Largely as a response to this academic push the accounting profession commissioned John Kenley, the then director of the Accountancy Research Foundation (later reconstituted as the AARF), to adapt the AICPA studies of Paul Grady to Australian conditions. This adaptation by Kenley was followed by a further study by Kenley and Staubus2122 While the study was intended to be an Australian adaptation of APB Statement No.4, the book ended up adopting a largely prescriptive approach to accounting concepts and objectives. The adoption of this more normative or prescriptive approach represented a fundamental departure from the United States model, which has attempted to blend descriptive and prescriptive elements to enhance the operationality and general acceptance of their conceptual framework. In hindsight, the works of Kenley and Kenley and Staubus have proved very influential as the AARF to this day have persisted with the development of a largely prescriptive framework.However, the Australian conceptual framework did not make significant progress until the 1980s. One reason for the tardiness is that during the 1970s standard-setters were preoccupied with the issue of current cost accounting. As we will see in Chapter 12, this was a period when current cost accounting attracted considerable interest and debate among academics, international standard-setting bodies and some practitioners. During the 1970s, standard-setters expended considerable resources to develop comprehensive current cost regulations for Australian companies. However, in the late 1970s and early 1980s, it became apparent that the AARF's current cost initiatives were not welcomed by the industry. This caused the AARF to refocus its attention on a narrower range of topics, including the conceptual framework. The Australian strategy to develop a conceptual framework has been stated by a previous director of the AARF.23 The elements of this strategy included the following:

1 The use of FASB thinking would be maximised.

2 The importance of a conceptual framework would not be over-sold, but unveiled gradually.

3 The first stage of development would be the tentative identification of the building blocks of a workable framework.

4 The second stage would be the selection of certain building blocks to formalise specific projects.

5 The third stage would be the investigation of interrelationships between the building blocks and any consequential redefinition of those blocks.

6 The fourth stage was to be the commissioning of projects for the remaining blocks. 7 Publication of Statements of Accounting Concepts would begin.

The AARF kept to its game plan. In the late 1980s, six exposure drafts were released for public comment. Exposure drafts ED 42A (objectives of financial reporting), ED 42B (qualitative characteristics of financial information), ED 42C (definition and recognition of assets) and ED 42D (definition and recognition of liabilities) were all released simultaneously in December 1987. Exposure drafts ED 46A (definition of the reporting entity) and ED 46B (definition and recognition of expenses) were released together in May 1988. Exposure drafts ED 51A (definition of equity) and ED 51B (definition and recognition of revenues) were released in August 1990. All these exposure drafts were preceded by discussion papers and accounting theory monographs commissioned by the AARF from academics within Australia and overseas. Furthermore, in August 1990, three SACs were released:

~ SAC 1 'Definition of the Reporting Entity'

~ SAC 2 'Objectives of General Purpose Financial Reporting' ~ SAC 3 'Qualitative Characteristics of Financial Information'.

In the early 1990s, the development of a conceptual framework was given greater momentum by certain amendments to Australian corporations law. In addition to developing accounting standards, Section 226(1) of the Corporations Law (1991) specifically charged the AASB with the responsibility of developing a conceptual framework for financial reporting. This gave added authority to the AARF to develop further SACs. The controversial SAC 4, 'Definition and Recognition of Elements of Financial Statements' (which combined exposure drafts ED 42B-D, ED 46B and ED 51A-B), was released in March 1992, but was amended in March 1995. (Both versions of SAC 4 will be discussed in this chapter) SAC 4 specifies the definition of and rules for the recognition of assets, liabilities, equity, revenues and expenses in the financial reports of companies. The first release of SAC 4 in 1992 symbolised the AARF's ideological commitment to a largely prescriptive or

normative conceptual framework. Implicit in the requirements of SAC 4 would be significant departures from conventional accounting practices. (In a later seer ion we will show that Australia's experimentation with a radical prescriptive framework has been vigorously challenged by companies and other interest groups in the past two years.) The corporate backlash to SAC 4 resulted in the mandatory status of the SACs being withdrawn in December 1993, followed by significant amendments to the Statement. The SACs had initially been made mandatory under APS 1 'Conformity with Statements of Accounting Concepts and Standards' and AASB Release 100 'Nature of Approved Accounting Standards and Statements of Accounting Concepts and Criteria for the Evaluation of Proposed Approved Accounting Standards'.

Finally, it should be noted that the Australian conceptual framework is still evolving.

Important aspects of the framework, particularly in the areas of measurement and the scope of financial reporting, are yet to be addressed by the AARF and its Boards.

The nature and goals of a conceptual framework

Standard-setters in Australia, the United States and elsewhere have given explicit justifications fot theit respective conceptual framework projects. For example, in the process of embarking on a conceptual framework project, the FASB (as did the AASB) acknowledged the erosion of the credibility of financial reporting in recent years and specifically criticised the following situations:

t Two or more methods of accounting are accepted for the same facts.

t Less conservative accounting methods are being used rather than the earlier, more conservative methods. t Reserves are used to artificially smooth earning fluctuations.

t Financial statements fail to warn of impending liquidity crunches. t Deferrals are followed by 'big bath' write-offs.

t Unadjusted optimism exists in estimates of recoverability.

t Off balance-sheet financing (that is, disclosure in the notes to the financial statements) is common.

t An unwarranted assertion of immateriality has been used to justify non-disclosure of unfavorable information or departures from standards.

t Form is relevant over substance.24

Standard-setting bodies have attracted particular criticism because they are authorities charged with the primary responsibility for promoting 'best' financial reporting practices. The absence of a coherent and rigorous body of accounting theory to guide accounting practice has been seen as a major factor leading to a de-professionalisation of accounting in different jurisdictions.25 Gerboth notes: 'suffice it to say that accounting is now painfully self-conscious about the intellectual standing of its reasoning process,26

The FASB and the AASB have instituted conceptual framework projects to correct some of these situations and to provide a more rigorous way of setting standards and increasing financial statement users' understanding and confidence in financial reporting. The FASB described a conceptual framework as follows:

A conceptual framework is a constitution, 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. The objectives identity the goals and the purposes of accounting. The fundamentals are the underlying concepts of accounting - concepts that guide the selection of events to be accounted for, the measurement of those events and the means of summarizing and communicating to interested parties. Concepts of that type are fundamental in the sense that other concepts flow from them and repeated references to them will be necessary in establishing, interpreting and applying accounting and reporting standards.27

The conceptual framework, therefore, is intended to act as a constitution for the standard-setting process. The AARF's Guide to Proposed Statements of Accounting Concepts (issued in December 1987 with Series 1 of the proposed Statements of Accounting Concepts), defines the conceptual framework in similar terms: 'a set of inter-related concepts which will define the nature, subject, purpose and broad content of financial reporting. It will be an explicit rendition of the thinking which is governing the decision-making of (standard-setters).'

5.2.1Advantages of a conceptual framework

The AASB and the AARF expect the conceptual framework to have a number of advantages28 The framework is perceived to be particularly useful in the development of more consistent and logical standards and in removing the necessity to re-debate conceptual issues when preparing new accounting standards. Furthermore, the issue of standards 'overload' can be potentially reduced because a conceptual framework can enable resolution of particular accounting problems which avoids the necessity of issuing new accounting standards. A conceptual framework can also lead to better communication among accountants, auditors and users because all parties would be using a common set of definitions and criteria. Another potential benefit of a conceptual framework is that it can potentially reduce the activities of lobbies and interests groups (who may have self-serving motivations) in attempting to influence the standard-setting process. 29 As suggested by Solomons, conflicts between economic interests could be avoided if the theoretical foundations of accounting were more soundly based. 30

A conceptual framework can also lead to specific improvements in accounting practice and financial reporting by companies. For example, comparability in company financial reports can be enhanced by a reduction in the amount of accounting alternatives available to preparers.

The AARF's Guide to Proposed Statements of Accounting Concepts explicitly states the potential benefits of the conceptual framework as follows:

(a) reporting requirements should be more consistent and logical, because they will stem from an orderly set of concepts;

(b) avoidance of reporting requirements will be much more difficult because of the existence of all-embracing provisions;

(c) the Boards which set down the requirements will be more accountable for their actions in that the thinking behind specific requirements will be more explicit, as will any compromises that may be included in particular accounting standards;

(d) the need for specific accounting standards will be reduced to those circumstances in which the appropriate application of concepts is not clear-cut, thus mitigating the risks of over-regulation;

(e) preparers and auditors should be able to better understand the financial reporting requirements they face; and,

(f) the setting of requirements should be more economical because issues should not need to be re-debated from differing viewpoints.

5.2.2 Strategic objectives for a conceptual framework

Political motivations and pressures for a conceptual framework also need to be considered. Literature indicates that conceptual framework projects have been developed as an instrument for the self-preservation of the accounting profession. That is, standard-setters assert their authority and legitimacy in setting accounting standards as a defensive measure against public criticism of the profession. 31 Hines, for instance, asserted that conceptual framework projects are undertaken as a 'strategic manoeuvre to assist in socially constructing the appearance of a coherent differentiated knowledge base for accounting standards, thus legitimising standards and the power, authority and self-regulation of the accounting profession'. 32 One test Hines used to determine whether conceptual framework projects can more appropriately be viewed as technical enterprises or as strategic manoeuvres was to ascertain whether these projects were undertaken at times of threat to their legitimacy (public criticism of accounting standards and/or company financial reporting deficiencies), or at times of competition from other regulators (possible intervention by government, stock exchange regulations). Hines concludes:

A brief study of the countries and circumstances of the conceptual framework projects suggested that the major rationale for undertaking conceptual frameworks was not functional or technical, it was a strategic manoeuvre for providing legitimacy ro standard-setting boards during periods of competition or threatened government intervention33

The same conclusion was forged by Dopuch and Sunder, who argued that disagreements which are centred on diverse accounting standards are always the target of public criticism of the profession and threaten their authority and control over the standard-setting process.''! Solomons noted that ' ... an explicitly theoretical foundation is an indispensable defence against political inrerference,.35 Horngren suggests that: 'The more plausible the assumptions and the more compelling the analysis of the facts, the greater the chance of winning support of diverse interests- and retaining and enhancing the Board's (FASB) power,.36

Finally, although preparers, auditors and external users are expected to gain from the conceptual framework, it appears that standard-setters are likely to be the primary beneficiaries.37 However, whether the conceptual framework can achieve some or all of its stated benefits will depend heavily on the ultimate acceptance of the framework by the Australian business community and other commercial interest groups. Later we will see that some essential features of the Australian conceptual framework have been strongly criticised by commercial interests. Furthermore, the AARF's future position on more contentious issues, notably measurement in the financial statements, will undoubtedly attract opposing positions and viewpoints from within the business community. These issues are important for evaluating the present and future viability of conceptual framework projects.

5.3 Classification and conflicts of interest

Formulating the objectives of accounting depends on resolving the conflicts of interest that exist in the information marker. More specifically, financial statements result from the interaction of three groups: firms, users and the accounting profession38

t Firms comprise the main party engaged in the accounting process. By their operational, financial and extraordinary (that is, non-operational) activities, they justify the production

of financial statements. Their existence and behavior produce financial results that are partly measurable by the accounting process. Firms are also the preparers of accounting information.

t Users comprise the second group. The production of accounting information is influenced by their interests and needs. Although it is not possible ro compile a complete list of users, the list would include investors, financial analysts, bankers, creditors, consumers, employees, suppliers and governmental agencies.

t The accounting profession constitutes the third group that may affect the information to be included in financial statements. Accountants act principally as 'auditors' in charge of verifying that financial statements conform to generally accepted accounting principles.

Following Cyert and Ijiri's analysis, the interaction between these three groups may be

represented by a Venn diagram, as shown in Exhibit 5.1, where circle U represents the interests of the users in the information deemed useful for their economic decision making, circle C represents the set of information that corporations publish and disclose (whether or not it is within the boundaries of generally accepted accounting principles) and circle P represents the set of information that the accounting profession is capable of producing and verifying. The area labelled I represents the set of information that is acceptable to all three groups. In other words, these data are disclosed by the firm, accountants are capable of producing and verifying them and they are perceived as relevant by users. Areas II-VII represent areas of conflicts of interest.

Given these conflicts, Cyert and Ijiri examine three possible approaches to the formulation of accounting objectives. The first approach considers the set of information that the firm is ready to disclose and attempts to find the best means of measuring and verifying it. (In other words, circle C is kept fixed and circles P and U are moved toward it.) The second approach considers the information that the profession is capable of measuring and verifying and attempts to accommodate users and firms through various accounting options. (In other words, circle P is kept fixed and circles C and U are moved toward it.) The third

approach views the set of information deemed relevant by users as central and encourages the profession and the firms to produce and verify that information. (In other words, circle U is kept fixed and circles P and C are moved toward it.)39

Stated simply, the first approach is firm-oriented, the second approach is profession-oriented and the third approach is user-oriented. Needless to say, given the dominance of the political and legislative approaches to the formulation of an accounting theory, as we saw in Chapter 3, the user-oriented approach will prevail when future objectives of financial statements are formulated. In fact, the user-oriented approach is employed by the SACs in Australia, the FASB in the United States and The Corporate Report in the United Kingdom.

The structure of the conceptual framework

Conceptual framework issues

In the process of developing a conceptual framework, the AARF and its Boards have had to resolve and take an explicit position on a number of fundamental conceptual issues that would determine the nature and content of the SACs.' These issues are now discussed.

Issue 1. Balance sheet versus profit and loss account orientation

There are two distinct approaches to determining an entity's income during a reporting period: t the asset/liability view; and t the revenue/expense view.

The asset/liability view, also called the balance-sheet or capital-maintenance view, maintains that revenues and expenses result only from changes in the values of assets and liabilities. Revenues represent increases in assets and decreases in liabilities; expenses are decreases in assets and increases in liabilities. Some increases and decreases in net assets are excluded from the definition of income - namely, capital contributions, capital withdrawals, corrections of income of prior periods and, depending on the concept of capital maintenance adopted, holding gains and losses. The asset/liability view should not be interpreted as an abandonment of the matching principle. In fact, matching revenues and expenses result from clear definitions of assets and liabilities.

The revenue/expense view, also called the profit and loss account or matching view, holds that revenues and expenses result from the need for a proper matching. This view of income is transaction based, as revenues are only recognised when realised through a sales transaction. Income is merely the difference between revenues in a period and the expenses incurred in earning those revenues. Matching, the fundamental measurement process in accounting, comprises two steps: 'Most of these issues had already been given detailed consideration by the FASB in its Discussion Memorandum 'Conceptual Framework for Financial Accountmg and ReportlOg: Elements of Financial Statements and Their Measuremenf (1976).

The FASB also specifically considered a third option - the 'non-articulated' view. For both the asseVliability view and the revenue/expense view, the statement of earnlOgs 'articulates' with the statement of financial position, in the sense that they are both part at the same measurement process. The difference between revenues and expenses is also equivalent to the increase in net capital.

The non-articulated view is based on the beliet that articulation leads to redundancy, 'since all events reported in the profit and loss statement are also reported 10 the balance sheet, although from a different perspective'. According to this view, the definitions of assets and liabilities may be critical In the presentation of flOancial position and the definitions of revenues and expenses may dominate the measurement of earnings. The two financial statements have independent existence and meanings; therefore, different measurement schemes may be used for them. An example of the non-articulated view would be the use of LIFO in the Income statement and of FIFO in the balance sheet. The non-articulated view has gained some ground recently. In facf, the Amencan Accounting AssoCiation's Statement of Basic Accounting Theory criticises articulation:

We find no logical reason why external finanCial reports should be expected to 'balance' or articulate with each other. In fact, we find that forced balancmg and articulation have frequently restricted the presentatIon of relevant Information. The important guide should be the disclosure of all relevant information with measurement procedures that meet the other standards suggesfed in ASOBAT [A statement of Basic Accounting Theory].1 revenue recognition or timing through the realisation principle; 2 expense recognition in three possible ways:

a associating cause and effect, such as for cost of goods sold; b systematic and rational allocation, such as for depreciation;

c immediate recognition, such as for selling and administrative costs.

Thus, contrary to the asset/liability view, the revenue/expense view primarily emphasises measuring the income of the firm and not the increase or decrease in the value of net assets. Assets and liabilities, including deferred charges and credits, are considered residuals that must be carried to future periods in order to ensure proper matching and to avoid distortion of income.

Which view of profit should be adopted as the basis of a conceptual framework for financial accounting and reporting) The choice between these two views rests on which view constitutes the fundamental measurement process. 401 measurement of the attributes of assets and liabilities and changes in them; or 2 the matching process.

If measurement of the attributes of assets and liabilities and changes in them is deemed the fundamental measurement process (as in the asset/liability view), then income is only the consequence and the result of changes in the value of assets and liabilities. On the other hand, if the matching process is deemed the fundamental measurement process (as in the revenue/expense view), then changes in assets and liabilities are merely the consequences and results of revenues and expenses. A major criticism of the revenue/expense orientation is that it has led to the recognition in the statement of financial position of such items as 'deferred charges', 'deferred credits' and 'reserves', which do not represent economic resources and obligations but which are necessary to ensure a proper matching of costs and revenues in the income determination process. Furthermore, the revenue/expense view places much emphasis on the importance of the historical cost and revenue realisation principles. As we will see in Chapters 12-14, this approach has been criticised for undermining the relevance of the balance sheet to users.

The asset/liability view would exclude debit and credit items (as result, for example, in intra-period tax allocation) because they do not constitute economic benefits or resources available to the entity. By rejecting these items in the balance sheet, the asset/liability view faces a major criticism, which concerns its unwillingness to recognise as revenues and expenses anything except current changes in economic resources and obligations to transfer resources, making it incapable of dealing with the complexities of the modern business world.

A choice between these views would provide not only an underlying basis for a conceptual framework for financial accounting and reporting but also definitions of the elements of financial statements.

Issue 2. Definition of assets. liabilities. equity. revenues and expenses

Definitions of each element of financial statements may be provided by both the asset/liability view and the revenue/expense view.

According to the asset/liability view, assets are the economic resources of a firm; they represent future benefits that are expected to result directly or indirectly in a positive net cash inflow. Alternatively, we may exclude from the definition of 'assets' economic resources that do not have the characteristics of exchangeability or severability. In either case, based on

the asset/liability view, assets are restricted to representations of economic resources of the firm. The economic resources of the firm are:

1 productive resources of the enterprise

2 contractual rights to productive resources 3 products

4 money

5 claims to receive money

6 ownership interests in other enterprises. 41

According to the revenue/expense view, assets include not only the assets defined from the asset/liability viewpoint, bur also all items that do not represent economic resources bur are required for proper matching and income determination.

A third view of assets arises from the perception of the balance sheet not as a statement of financial position, bur as 'a statement of the sources and composition of company capital'. According to this view, assets constitute the 'present composition of invested capital,42

If we exclude the problem of the element of 'deferred charges' on the statement of financial position, the definitions of assets presented in these three different views have the following characteristics in common:

1 An asset represents potential cash flow to a firm. 2 Potential benefits are obtainable by the firm.

3 The legal concept of property may affect the accounting definition of assets.

4 The way an asset is acquired may be part of the definitions. It may have been acquired in a past or current transaction or event; the event includes either an exchange transaction, a non-reciprocal transfer from owners or non-owners, or a windfall and may exclude executory contracts.

5 Exchangeability may be an essential characteristic of assets.

Which of these definitions or modifications of these definitions should comprise the substance of a definition of 'assets' for a conceptual framework for financial reporting) What is needed is a definition that lends itself to the generality of application required for a conceptual framework. Such a definition should take into account the following characteristics:

1 An asset represents only economic resources and does not include 'deferred charges'.

2 An asset represents potential cash flows to a firm.

3 Potential benefits are obtainable by the firm.

4 An asset represents the legal binding right to a particular benefit, results from a past or current transaction and includes all commitments, as in wholly executory contracts.

5 Exchangeability is not an essential characteristic of assets except for 'deferred charges', in order to keep most intangibles as assets and exclude 'deferred charges'.

The second element to be defined is liabilities. According to the asset/liability view, liabilities are the obligations of the firm to transfer economic resources to other entities in the future. We may expand this definition to exclude items that do not represent binding obligations to transfer economic resources to other entities in the future.

According to the revenue/expense view, liabilities comprise not only the liabilities defined from the asset/liability viewpoint bur also certain deferred credits and reserves that do not represent obligations to transfer economic resources bur that are required for proper matching and income determination.

A third view of liabilities arises from the perception of the balance sheet as 'a statement of the sources and composition of company capital'. According to this view, liabilities con-

stitute sources of capital and include certain deferred credits and reserves that do nor represent obligations to transfer economic resources.

If we disregard the element of 'deferred credits', the definitions of liabilities presented in these three different views have the following characteristics in common:

1 A liability is a future sacrifice of economic resources.

2 A liability represents an obligation of a particular enterprise. 3 A liability may be restricted to legal debt.

4 A liability results from past or current transactions or events.

Which of these definitions or modifications of these definitions should comprise the substance of a definition of , liabilities' for a conceptual framework) As in the case of assets, what is needed is a definition of liabilities that lends itself to the generality of application required for a conceptual framework.

The third element to be defined is income. According to the asset/liability view, income is the net assets of the firm except for 'capital' changes. According to the revenue/expense view, income results from the marching of revenues and expenses and, perhaps, from the gains and losses. Gains and losses, therefore, may be distinguished from the revenues and expenses, or they may be considered part of them. Each possible component of income (revenues, expenses, gains and losses) may be defined as follows:

1 Revenues and expenses: according to the asset/liability view, revenues, which encompass gains and losses, are defined as increases in the assets or decreases in the liabilities that do nor affect capital. Similarly, expenses, which encompass gains and losses, are defined as decreases in the assets or increases in the liabilities arising from the use of economic resources and services during a given period.

According to the revenue/expense view, revenues, which encompass gains and losses, result from the sale of goods and services and include gains from the sale and exchange of assets other than inventories, interests and dividends earned on investments and other increases in owners' equity during a period ocher than capital contributions and adjustments. Similarly, expenses comprise all of the expired costs that correspond to the revenues of the period. If gains and losses are defined as a separate element of income, however, revenues are defined as measures of an entity's outputs that result from the production or delivery of goods and the rendering of services during a period. Similarly, expenses are the expired costs corresponding to the revenues of the period.

Which of these definitions of income should comprise the substance of 'revenues' and 'expenses' for a conceptual framework) In other words, which definition lends itself to the generality of application needed for a conceptual framework)

The definitions generated by the revenue/expense viewpoint rely on a listing of all items that may be perceived as revenues or expenses. First, such a list is nor necessarily exhaustive and second, the items in the list may change. As a result, the revenue/expense view of income and the ensuing definitions of revenues and expenses may lack the generality of application needed for a conceptual framework.

2 Gains and losses: according to the asset/liability view, gains are defined as increases in net assets other than increases from revenues or from changes in capital. Similarly, losses are defined as decreases in net assets ocher than decreases from expenses or from changes in capital. Thus, gains and losses constitute that part of income nor explained by revenues and expensesAccording to the revenue/expense view, gains are defined as the excess of proceeds over the cost of assets sold, or as windfalls and other benefits obtained at no cost or sacrifice. Similarly, losses are defined as the excess over the related proceeds, if any, of all or an appropriate portion of the costs of assets sold, abandoned, or wholly or partially destroyed by casualty (or otherwise written off), or as costs that expire without producing revenues. Thus, according to the revenue/expense view, gains and losses are independent from the definitions of other elements of financial statements.

Which of these definitions of gains and losses contains the generality of application required for a conceptual framework? According to the revenue/expense view, the definitions are independent of the definitions of the other elements and may, for that reason, be viewed as lacking generality of application. According to the asset/liability view, the definitions are derived from the other definitions and emphasise the incidental nature of gains and losses; they appear to contain the generality of application required for a conceptual framework.

In any case, gains and losses may be either gains and losses from exchanges, 'holding' gains and losses resulting from a change in the value of assets and liabilities held by the firm, or gains and losses from non-reciprocal transfers.

3 Relationships between income and the component of income: three major relationships exist between income and the component of income:

a Income = Revenues - Expenses + Gains - Losses b Income = Revenues - Expenses

c Income = Revenues (including gains) - Expenses (including losses)

In the first relationship, each component is separate and essential to a definition of income. The different sources of income are distinguished, thereby providing greater flexibility in the classification and analysis of a firm's performance.

In the second relationship, gains and losses are not separate and are not essential to the definition of income. All increases and decreases are treated similarly as either revenues or expenses. Such a definition does not fit all the gains and losses from non-reciprocal transfers, windfalls, casualties and holding gains and losses.

In the third relationship, although gains and losses are separate concepts, they are part of revenues and expenses. Such a definition has the same advantages as the first relationship and avoids the disadvantages of the second relationship. The definitions of revenues and expenses, however, must mix different items and may require a complete identification and listing of the items that comprise revenues, expenses, gains and losses.

The first relationship appears to present the least disadvantage according to both the asset/liability view and the revenue/expense view. It allows identification and disclosure of the three kinds of gains and losses: gains and losses from exchanges, holding gains and losses, and gains and losses from non-reciprocal transfers, windfalls and casualties.

4 Accrual accounting: the elements of financial statements are accounted for and included in financial statements through the use of accrual accounting procedures. Accrual accounting measures the effects of transactions (and other events) having cash consequences for an entity as they are incurred, not simply as cash is received or paid - they are recorded in accounting records and reported in the financial statements of the reporting period to which they relate. Naturally, the acquisition of resources used to provide goods and services and the provision of goods and services by an entity during a period usually do not coincide with the cash receipts and payments of the period. Hence, accrual accounting

reflects credit and barter transactions and changes in the forms of assets and liabilities resulting from relevant internal and external events, in addition to an entity's cash transactions. Accrual accounting provides information about all of an entity's assets, liabilities (and consequently residual equity), revenues, expenses and the changes in them that cannot be obtained by accounting only for cash receipt and outlays or modified systems of accrual accounting.

Accrual accounting tests on the concepts of accrual, deferral, allocation, amortisation, realistrion and recognition.

The FASB opted for the following definitions of these concepts:

Accrual is the accounting process of recognizing non-cash events and circumstances as they occur; specifically, accrual entails recognizing revenues and related increases in assets and expenses and related increases in liabilities for amounts expected to be received or paid, usually in cash, in the future ...

Deferral is the accounting process of recognizing a liability for a current cash receipt or an asset for a current cash payment (or current incurrence of a liability) with an expected future impact on revenues and expenses ...

Allocation is the accounting process of assigning or distributing an amount according to a plan or a formula. It is a broader term than 'amortisation'; that is, amortisation is an allocation process ...

Amortisation is the accounting process of systematically reducing an amount by periodic payments, or write-downs ...

Realisation is the process of converting non-cash resources and rights into money; it is most precisely used in accounting and financial reporting to refer to sales of assets for cash or claims of cash. The related terms, 'realised' and 'unrealised', therefore identify revenues or gains and losses on assets sold and unsold, respectively ....

Recognition is the process of formally recording or incorporating an item in the accounts and financial statements of an enterprise. Thus, an element may be recognized (recorded) or unrecognised (unrecorded). 'Realisation' and 'recognition' are nor used synonymously, as they sometimes are in the accounting and financiallirerarure,43

Issue 3. Concepts of capital maintenance

The concept of capital maintenance allows us to make a distinction between the return on capital, or income, and the return of capital, or cost recovery. Income follows from recovery or maintenance of capital. Two concepts of capital maintenance exist: the financial capital concept and the physical capital concept. Both concepts use measurements in terms of units of money or units of the same general purchasing power, resulting in four possible concepts of capital maintenance:

1 financial capital measured in units of money;

2 financial capital measured in units of the same general purchasing power; 3 physical capital measured in units of money; and

4 physical capital measured in units of the same general purchasing power.

We will examine the conceptual and operational differences among these concepts in Chapters 12-14. Note, however, that the comprehensive income is a return on financial capital, as distinguished from a return on physical capital. The essential difference between the two concepts is that 'holding gains and losses' are included in income under the financial capital concept, bur are treated as 'capital maintenance adjustments' under the physical capital concept.

Issue 4. Which measurement method should be adopted ?The issue of measurement method concerns the determination of both the unit of measure and the attribute to be measured. As far as the unit of measure is concerned, the choice is between actual dollars and general purchasing power adjusted dollars. As far as the particular attribute to be measured is concerned, we basically have five options:

1 historical cost method

2 current cost

3 current exit value

4 expected exit value

5 present value of ex peered cash flows.

These different measurement bases will be explored in depth in Chapters 12-14.

Issue 5. Applicability of the conceptual framework to the public sector

For financial reporting purposes, Australian standard-setters have nor maintained a strong distinction between the private sector, the public sector and not-for-profit entities in the private sector. Indeed, Australia is one of the few countries in the world that has made its conceptual framework equally applicable to all entities, including public sector entities.~

Standard-setters have paid more than just lip service to this policy stance. Accrual accounting principles and professional accounting standards (AASs) are applicable to all nor-for-profit entities in the private and public sectors. The relevance of accrual accounting to nor-for-profit entities has also been emphasised by some authoritative pronouncements in the United States. For example, the Statement of Po sir ion 78-10 'Accounting Principles and Reporting Practices for Certain Non-profit Organisations states:

The accrual basis of accounting is widely accepted as providing a more appropriate record of all an entity's transactions over a given period of time than the cash basis of accounting. The cash basis or any basis of accounting other than the accrual basis does not result in the presentation of financial information in conformity with generally accepted accounting principles (pagel0, paragraph 11).

In the United States, Statement of Financial Accounting Concepts No.4 'Objectives of Financial Reporting by Nonbusiness Organisations', recommends adoption of accrual accounting principles for non-business entities in the private sector. However, the Governmental Accounting Standards Board, which oversees the development of accounting standards and concepts statements for government entities in the United States, only recommends the use of modified accrual systems for the public sector. In contrast to Australia, standard-setters in the United States have tended to maintain greater distinctions between profit-seeking and nor-for-profit entities (in both the private and public sectors). For example, Anthony strcsses that resource providers to not-for-profit entities (both in the private and public sectors) do not expect to receive repayment or economic benefits proportionate to resources provided, nor do they possess rights to a residual interest in the net assets of the entity in the event of liquidarion.44 As a result, resource providers are nor assumed to be overly concerned with the financial status and performance of the entity. Presumably these users are more concerned that contributed funds have been used

in accordance with the objectives of the entity and within the confines of any imposed resource restrictions.

Australia has adopted a different view. Comprehensive accrual accounting has been progressively introduced into the public sector. Recent accounting standards now requite the adoption of comprehensive accrual accounting for all local government authorities and government departments throughout Australia. For example, AAS 29 'Financial Reporting by Government Departments' requires all government departments in Australia to prepare an annual balance sheet, operating statement and statement of cash flows consistent with all relevant private sector accounting standards. Furthermore, government departments are required to disclose all assets, liabilities, revenues and expenses that meet the definition and recognition criteria of SAC 4. AAS 29 asserts that accrual accounting better reflects the performance, financing and investing activities, financial position and compliance of government departments than cash or modified accrual systems. Implicit in AAS 29 requirements for accrual accounting is the presumption that private and public sector entities have a number of economic and operating characteristics in common. Many of these arguments have been explicitly and implicitly stated in AAS 29. According to AAS 29, government departments would have the following similarities to private sector entities:

Similarities in the economic environment. Government departments achieve their operating objectives by providing goods and services to consumers and/or recipients. In so doing, these entities must use scarce economic resources. Government departments must obtain scarce resources from external resource providers and, therefore, are accountable to providers of resources or their representatives in how resources have been used consistent with the objectives of the entity. These entities must also control assets and incur liabilities in carrying out their operating objectives. Furthermore, they must be financially viable by having sufficient resources available to meet their operating objectives and must meet their operating objectives under conditions of economic uncertainty.

2 Similarities in user needs for information. The most fundamental presumption of AAS 29 (paragraphs 18-23) is that government departments constitute reporting entities - that is, it can reasonably be expected that there exist external users dependent on the general purpose financial reports of these entities. AAS 29 identifies these users to include parliament, regulators, other government departments, media and special-interest groups, consumers, taxpayers and resource provers (paragraph 21). These users are assumed to have common information needs and to be interested in, inter alia, (a) how effectively and efficiently resources have been used to meet operating objectives, (b) the extent to which costs have been recovered from revenues, (c) a government department's capacity to provide goods and services into the future, and (d) its present and future funding requirements.

3 Similarities in the objectives of the financial statements. In a similar vein to private sector standards, AAS 29 states that the primary objective of the financial statements of government departments is to serve the information needs of a potentially wide range of users (paragraph 18). With respect to economic decision making, AAA 29 (paragraph 5) asserts that general purpose financial reports will be particularly relevant to users for assessing (a) performance, (b) financial position, (c) financing and Investing activities, and (d) compliance of government departments.

5.4.2 Building blocks of the conceptual frameworkThe structure of the Australian conceptual framework is shown by the tentative building blocks displayed in Exhibit 5.2

As you can see, the conceptual framework can be divided into six levels. At its highest level the conceptual framework defines the scope of financial reporting. The scope of financial reporting deals with the type of information that should be included in general purpose financial reports (GPFRs). The next two levels of the framework define the concept of the

reporting entity and the objectives of GPFRs. The reporting entity concept was developed as a guide for determining the types of entities that should be required to prepare GPFRs and comply with Accounting Standards and associated Statements of Accounting Concepts. Level 4 deals with the qualitative characteristics that financial information should possess before inclusion in GPFRs. It also covets the definition of basic elements of financial reports - the assets, liabilities, equity, revenues and expenses of an entity. Level 5 deals explicitly with how these elements are to be recognised and measured. Lower levels of the framework deal with the display (disclosure) of information, standard-setting policy and policy enforcement procedures.

The following provides a more detailed description of the different levels of the framework.

Part 1. Definition of financial reporting

This part of the conceptual framework deals with the type of information that should be included within the scope of financial reporting, and how the scope of company financial reporting is, or should be, determined. The scope of company financial reports has changed greatly over the years. In the nineteenth century, the primary financial statement disclosed by companies was a balance sheet. In the early decades of the twentieth century, it became common for companies to disclose additional information in the form of a profit and loss account45 By the 1940s and 1950s many companies also disclosed funds statements. Today, the scope of financial reporting has extended to cash flow statements, including many other forms of information voluntarily disclosed by companies, such as financial summaries, future-orientated information and comparative figures.

A number of factors have affected the scope of financial reporting over the years. One important factor is the incidence of financial crises. Share market crashes and economic depressions have usually resulted in more stringent disclosure regulations imposed on companies by regulators such as the stock exchange, the AARF and legislators. For example, the share market crash of 1987 was an important precursor of new regulations on the cash flow statement46

Demands for information by investors and other users of company financial reports have also influenced the scope of financial reporting over the years."7 Investors need relevant information for making economic decisions. Companies have been willing to provide greater quantities of information to investors on a voluntary basis because companies compete with each other for the capital resources of investors.

Determining the scope of financial reporting

Determination of information to be included in the scope of financial reporting will guide the jurisdiction of accounting standards and standard setting, and associated SACs. However, this part of the conceptual framework remains largely undeveloped. For instance, there is no generally accepted definition of general purpose financial reporting or its scope. However, SAC 2 'Objective of General Purpose Financial Reporting' provides an indication that the scope of financial reporting may extend beyond financial information:

Financial reporting encompasses the provision of financial statements and related financial and other information. (paragraph 10)

Paragraph 10 is more specific when it mentions that GPFRs include:

be read with the financial statements ... However, other information can best be provided, or can only be provided, outside financial reports.

Other passages of paragraph 10 obscure the issue completely:

This Statement does not attempt to draw a clear distinction between financial reports and financial reporting, nor does it attempt to define the boundaries of general purpose financial reporting.

Hence, the scope of financial reporting can be potentially very broad. The absence of clear definitions is troublesome. Determination of the scope of GPFR has important implications for standard setting and other facets of the conceptual framework, particularly in light of the growing incidence of various forms of voluntary disclosure by companies over the years. These disclosures include environmental disclosures, value-added statements, financial summaries, trend data, future-oriented information and non-financial performance indicators. It is important to know whether these types of information should be included within the scope of GPFR in Australia. If they do, they can potentially become the subject of accounting standard setting and statements of accounting concepts.

A critical issue evidently concerns what criteria should be used to determine which information will or will not be included within the scope of financial reporting. To some extent the scope of financial reporting will be determined by reference to other components of the conceptual framework, in particular SAC 2 'Objective of General Purpose Financial Reporting' and SAC 3 'Qualitative Characteristics of Financial Information'. SAC 2 specifies that the overall objective of GPFRs is to provide relevant information for economic decision making by users. SAC 3 specifies the necessary characteristics that information should possess before qualifying for inclusion in GPFRs. In particular, the relevance and reliability of information are emphasised as the primary characteristics. Following this approach, only information that can reliably be determined and is demonstrably relevant for economic decision making would be included in the scope of financial reporting. For example, broad economy-related information might be excluded from the scope of financial reporting because, while this information could be relevant for economic decision making, it cannot be measured reliably. On the other hand, value-added statements might be included within the scope of financial reporting because this information can be more reliably measured.

In conclusion, it is unlikely that a definition of the scope of financial reporting will be accomplished easily. Any definition must take into consideration not only the present financial reporting environment, bur the changing nature of its scope over time.

This part of the conceptual framework deals with the types of entities that should be preparing GPFRs and which entities should be complying with Accounting Standards. Should a local council, a tennis club, a church or a family business be required to prepare financial reports and comply with Accounting Standards'

SAC 1 states that only reporting entities should be required to prepare financial reports and comply with Accounting Standards. The definition of the reporting entity is provided in SAC I 'Definition of the Reporting Entity'. Reporting entities are defined as:

entities (including economic entities) in respect of which it is reasonable to expect the existence of users dependent on GPFRs for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources. (paragraph 40)

These users would include shareholders, investors, creditors, suppliers, employees and other users who need financial reports as a basis for assessing an entity's financial position, profitability and performance. The definition implies that for those entities where major external users are not expected to exist, then these entities should not have to prepare GPFRs or comply with Accounting Standards. For example, private companies, trusts, sole traders and family businesses would nor qualify as reporting entities under SAC 1, because it would be reasonable to assume that there will be no external users.

Because the definition of the reporting entity is linked to the information needs of external users, the existence of a reporting entity will not depend on:

1 the sector (whether public or private sector) within which the entity operates;

2 the purpose for which the entity was created (whether business or not-for-profit); or 3 the manner in which the entity is constituted (whether legal or otherwise).

SAC 1 provides some general guidance in determining whether dependent external users are likely to exist. For many entities it will be readily apparent whether dependent users are likely to exist (paragraph 19). For example, larger companies normally have many creditors, investors, suppliers and employees of different descriptions. However, SAC 1 acknowledges that it will not always be clear whether dependent external users exist. The Statement provides three general guidelines to assist in this determination. These guidelines need to be considered together:

1 Separation of management from economic interests. SAC 1 argues that the greater the spread of ownership/membership and the greater the extent of the separation between management and owners/members (or others with an economic interest in the entity) then the more likely it is that there will be users who are dependent on financial reports for economic decision making.

2 Economic or political importance/influence. SAC 1 further argues that the greater the economic or political importance of an entity, the more likely it is that there will be dependent external users (paragraph 21). These types of entities are most likely to have dominant positions in markets, and those that are concerned with balancing the interests of significant groups, such as employer/employee associations and public sector entities which have regulatory powers.

3 Financial characteristics. SAC 1 argues that financial characteristics are also important.

These include an entity's size (e.g. sales turnover) or indebtedness. The larger the size or the greater the indebtedness of an entity, the more likely it is that there will be external users dependent on GPFRs for economic decision making (paragraph 22).

Some writers have argued that a major limitation of SAC 1 is that it does not provide sufficient guidelines as to what constitutes a reporting entity. In particular, guidelines for identifying dependent users are expressed in qualitative rather than quantitative terms. For example, what constitutes economic political importance or what degree of size or indebtedness must exist before it can safely be assumed that dependent users exist I Because these guidelines are generic and are expressed in qualitative terms, determination of whether a reporting entity exists becomes a largely subjective exercise. A mote critical assumption underlying SAC 1 concerns the existence of external users. The reporting entity concept as enunciated in SAC 1 is underpinned by assumptions about the information needs of users. Some commentators have been concerned about the degree of 'use' that needs to be established before it can be concluded that users make economic decisions based on GPFRs.Would an entity still qualify as a reporting entity if users only made very modest use of the financial reports' Another potential weakness of SAC 1 is that there has been no attempt co rank users, for the purposes of defining a reporting entity, in some order of priority. For example, if it is established that one entity has investors as a major user, and another has employees as a major user, will the entity with employees as the major user be more or less of a reporting entity'

It is clear that the introduction of SAC 1, despite potential limitations, will still have an impact on accounting practice. For example, it will result in some partnerships, crusts, government departments and statutory authorities currently not preparing GPFRs co do so, because they would qualify as reporting entities under SAC 1 (see paragraph 33).

This stage of the conceptual framework deals with the overall objective of GPFRs, the users of these reports and their information needs. Statement of Accounting Concepts o. 2 (SAC 2), 'Objective of General Purpose Financial Reporting' issued in August 1990, deals with this aspect of the framework. SAC 2 states:

General purpose financial reports focuses on providing information co meet the common information needs of users who are unable co command the preparation of reports tailored co their particular information needs. These users must rely on the information communicated co them by the reporting entity.

SAC 2 acknowledges that some users have specialised needs and will possess the authority co obtain the information co meet those needs. Examples are taxation authorities, central banks and grants commissions. The information they seek is called special purpose financial reports. Because these users are able co command the preparation of this information, special purpose financial reports are excluded from general purpose financial reporting, and hence will not become the subject of standard setting.

The grand vision behind SAC 2 is the belief that the provision of relevant financial information by companies co external users will ultimately enhance the efficient allocation of scarce resources throughout the entire economy, thus contributing co national economic growth. Relevant financial information will assist, for example, investors co make informed portfolio decisions concerning the spread of risk and return, and creditors co make informed lending decisions.

Because efficient resource allocation is the ideal, SAC 2 states that the primary objective of GPFRs is co provide relevant information co various external users so that they can make and evaluate decisions about the allocation of scarce resources. SAC 2 outlines a secondary objective of GPFRs. This is co demonstrate the discharge of accountability. SAC 2 states:

Managements and governing bodies are accountable to those who provide resources co the entity for planning and controlling the resources of the entity. In a broader sense, because of the influence reporting entities exert on members of the community at both the microeconomic and macroeconomic levels, they are accountable co the public at large. General purpose financial reporting provides a means by which this responsibility can be discharged.

SAC 2 defines three classes of user: resource providers, recipients of goods and services, and parties performing a review or oversight function (paragraphs 17-19). It also defines the types of information these user groups will need in order co make informed and rational economic decisions. To this extent, SAC 2 stresses that user needs for information will overlap because all users are fundamentally concerned with the ability of an entity co generatefavorable cash flows. SAC 2 provides a discursive breakdown of the information needed by users into four different headings: performance, financial position, finance and investing, and compliance.

1 Performance. Performance implies how effective an entity has been in meeting its objectives, and how efficiently and economically it has used resources in meeting those objectives. Aspects of performance can be measured in both financial and non-financial terms. Included in the financial information needed to assess performance is information typically found in company profit and loss accounts and balance sheets. Disclosure of revenues and expenses, assets, liabilities and equity is envisaged by SAC 2 to be relevant to assessing performance. With this information, users will be able to, inter alia, evaluate the changes in the entity's control over resources by reference to the resources or funds employed in achieving the change. Ostensibly, this information is relevant to users in predicting both the capacity of an entity to generate cash from its existing resource base and the effectiveness by which it would employ additional resources.

2 Financial position. The financial position of an entity involves disclosure of information about its wealth or control over economic resources, financial structure, capacity for adaptation and solvency. Most of the information needed to make these assessments is contained in company balance sheers. Disclosure of information about an entity's control over resources (its assets) is ultimately useful in predicting the ability of an entity to continue to meets its objectives, whether these relate to generation of positive cash flows in the future or the continued provision of goods and services. The financial structure of an entity, at any point in time, is a specified relationship (both in terms of value and amount) between its assets, liabilities and equity. Disclosure of relevant information about the financial structure of an entity relates to the sources, types and time patterns of finance, whether debt or equity and the types of assets used by the entity. This information is useful for predicting the future distribution of cash flows among providers of resources and the ability of an entity to attract resources in the future.

Capacity for adaptation refers to the ability of an entity to change or modify its resource base, whether this is necessitated by changes in economic conditions, new opportunities, or directives from controlling bodies. SAC 2 states that information about the location, realisable value and current state of repair of an entity's assets would be relevant to users in assessing capacity for adaptation.

Solvency concerns the ability of an entity to meet its debts as they fall due. According to SAC 2, relevant information needed to assess solvency would include the liquidity of company's assets and the availability of cash from external sources. This information will be useful for predicting the ability of the entity to meet its obligations as they fall due and, therefore, in predicting the ability of the company to provide goods and services into the future.

3 Financing and investing. Financing and investing relates to an entity's sources and application of funds during the period. This information indicates the way in which an entity has financed its operations and invested its resources during a period.

4 Compliance. SAC 2 states that information about non-compliance with externally imposed regulations is relevant as an input into user assessments about an entity's performance, financial position, and financing and investing. Examples of externally imposed requirements include: conditions imposed by borrowing agreements; conditions imposed by licensing agreements and grant arrangements; spending mandates and borrowing limits; occupational health and safety legislation; and environmental legislation.

Part 4. Fundamentals

This part of the framework, Level 4 of Exhibit 5.2, comprises two building blocks: qualitative characteristics of financial information; and elements of financial statements.

Qualitative characteristics of financial information

SAC 3 'Qualitative Characteristics of Financial Information', issued in August 1990, considers this aspect of the framework. The specification of the qualitative characteristics of financial information will provide criteria for choosing between: (a) alternative accounting and reporting methods; and/or (b) disclosure requirements. Basically, these criteria indicate which information is better (more useful) for decision-making purposes. The characteristics may be viewed as a hierarchy as indicated in Exhibit 5.3.

Relevance and reliability are the two primary qualities, with related ingredients.

Comparability and consistency are presented as secondary and interactive qualities. Finally, the concepts of cost-benefit considerations and materiality are recognised, respectively, as a pervasive constraint and a threshold for recognition. Each of these qualitative characteristics of accounting information will now be examined.

Relevance. Relevance is defined in SAC 3 to mean that quality of financial information that exists when information influences the decisions of users about the allocation of scarce resources. Influencing decisions could mean:

a helping users form predictions about the outcomes of past, present or future events; and/or

b confirming or correcting their past evaluations, which enables users to assess the rendering of accountability by preparers.

Hence, information must materially affect, or have the potential to affect, the decisions of users. The importance of relevance as a qualitative characteristic of financial information is central to financial reporting and has been advocated widely in the accounting litetature.18

I t is noted that SAC 3 emphasises that the predictive and confirmatory roles of financial information ate not mutually exclusive. For example, information about the current level and structure of asset holdings will be relevant to users in assessing (predicting) an entity's ability to take advantage of opportunities in the marketplace. However, this same information can playa confirmatory role in respect of past predictions. Furthermore, to have predictive value information does nor have to be in the form of an explicit forecast. Users are interested in forming assessments (predictions) about the nature, timing and amounts of future cash flows based on the information presented to them in GPFRs.

Financial information can also be judged as relevant by reference to its nature or magnitude. For example, an increase in directors' emoluments or a related party contract may be critical with respect to its nature even though the absolute amounts may be insignificant compared to other costs.

Some authors have argued that a major weakness of the definition of relevance provided in SAC 3 is that 'nature' and 'magnitude' are not defined in operational or quantifiable terms, but in qualitative terms only. This leaves the door open for professional accountants to have legitimate disagreements over whether any particular transaction is significant by virtue of either its nature and/or magnitude to warrant disclosure in GPFRs. Furthermore, it is possible that the predictive and confirmatory roles of financial information emphasised by SAC 3 are too broadly based to provide definite guidelines on different measurement and disclosure alternatives in accounting. For example, many researchers have disputed the relative merits of a current cost accounting system versus a conventional historical cost accounting for economic decision making by users. Because both systems would, in differing degrees and under differing circumstances, play a predictive or confirmatory role in user decision making, the definition of relevance in SAC 3 might nor be sufficiently detailed in testing or assessing whether one measurement system would be more relevant to users than the other.

2 Reliability. Reliability is defined in SAC 3 as 'that quality of financial information which exists when the information can be depended upon to represent faithfully and without bias or undue error, the transactions or events that it either purports to represent or could reasonably be expected to represent'. It is essential that financial information be reliable. i9 If information is relevant, but not reliable, SAC 3 implies that it will not qualify for inclusion in GPFRs. Unreliable information, while relevant, can lead to poor or less than optimal decisions by users. SAC 3 (paragraphs 25-26) is careful to point Out that reliability should not be confused with the accounting convention of conservatism or prudence. That is, accountants should not deliberately understate net income on the basis or conservatism, 'thereby usurping the rights of users to make their own decisions' (paragraph 21).

An important part of reliability is the avoidance of bias. For information to avoid bias, or be presented neutrally, it should not be designed to lead users to the conclusions that

serve particular needs, desires or preconceptions of preparers. Bias can stem from deliberate misstatement or even 'misguided' conservatism. This is not to imply that the preparers of information do not have a purpose in mind when preparing the reports; it only means that the purpose should not influence a predetermined result. SAC 3 (paragraphl9) draws a distinction between faithful representation of transactions and the effective representation of those transactions. For example, measuring an asset at historical cost may be reliable, but not effective in terms of providing relevant information to users. In such situations, SAC 3 does not rank relevance over reliability or vice versa. Both characteristics are seen as primary. In practice, however, there