Conceptual Framework of Accounting | 1

Conceptual Framework of Accounting

Introduction
The conceptual framework allows for the systematic adaptation of accounting standards to a
changing business environment. The FASB uses the conceptual framework to aid in an
organized and consistent development of new accounting standards. In addition, learning the
FASB’s conceptual framework allows one to understand and, perhaps, anticipate future
standards.
The conceptual framework outlines the objectives of financial reporting and the qualities of
good accounting information, precisely defines commonly used terms such
as asset and revenue, and provides guidance about appropriate recognition, measurement, and
reporting. Recording an item in the accounting records through a journal entry is
called recognition. To be recognized, an item must meet the definition of an element and be
measurable, relevant, and reliable.
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Figure: Conceptual Framework of Accounting

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Objective
Without identifying the goals for financial reporting (e.g., who needs what kind of information
and for what reasons), accountants cannot determine the recognition criteria needed, which
measurements are useful, or how best to report accounting information. The key financial
reporting objectives outlined in the conceptual framework are as follows:
 Usefulness
 Understandability
 Target audience: investors and creditors
 Assessing future cash flows
 Evaluating economic resources
 Financial performance reflected by accrual accounting
Qualitative Characteristics of Useful Information
The conceptual framework identifies fundamental and enhancing qualitative characteristics of
useful information.
The fundamental characteristics are- The enhancing characteristics are-

 Relevance and  Comparability,

 Faithful representation.  Verifiability,
 Timeliness, and
 Understandability.
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Fundamental Characteristics
Relevance means that information is “capable of making a difference in the decisions made by
users”. The definition is further refined to state that information is capable of influencing
decisions if it has predictive value, confirmatory value, or both. Predictive value means that
the information can be used to assist in the process of making predictions about future events,
such as potential investment returns, credit defaults, and other decisions that financial -
statement users need to make. Note that although the information may assist in these decisions,
the information is not in itself a prediction or forecast. An income statement may help an
investor decide to invest in a company this year, and next year’s income statement, when
released, will provide feedback as to whether the investment decision was correct. The
framework also mentions the concept of materiality. A piece of information is considered
material if its omission would affect a user’s decision.
Materiality is a concept used frequently by both internal accountants and auditors in
determining the need to make adjustments for errors identified. Clearly, an item that is not
deemed to be material is not relevant, as it would not affect a user’s decision.
Faithful representation means that the financial information presented represents the true
economic substance or state of the item being reported. This does not mean, however, that the
representation must be 100 percent accurate, as perfection is rarely attainable. Information is
complete if there is sufficient disclosure for the reader to understand the underlying
phenomenon or event. This means that many financial disclosures will require additional
explanations that go beyond a mere reporting of the quantitative values.

Completeness is the motivation behind many of the note disclosures contained in financial
statements. Because financial-statement users are trying to make predictions about future
events, more detail is often needed than simply the balance sheet or income- statement amount.
For example, if an investor wanted to understand a manufacturing company’s requirements for
future replacement of property, plant, and equipment assets, detailed information about the
remaining useful lives of the assets and related depreciation periods and methods would be
needed. Similarly, if a creditor wanted to assess the possible future effect on cash flows of a
lease agreement, detailed information about the term of the lease, the required payments, and
possible renewal options would be needed.

Enhancing Characteristics
The conceptual framework describes four additional qualitative characteristics that should
enhance the usefulness of information that is already determined to be relevant and faithfully
represented. These characteristics are comparability, verifiability, timeliness, and
understandability.
Comparability is the quality that allows readers to compare either results from one entity with
another entity or results from the same entity from one year with another year. This quality is
important because readers such as investors are interested in making decisions whether to
purchase one company’s shares over another’s or to simply divest a share already held. One
key component of the comparability quality is consistency.
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Consistency refers to the use of the same method to account for the same items, either within
the same entity from one period to the next or across different entities for the same accounting
period. Consistency in application of accounting principles can lead to comparability, but
comparability is a broader concept than consistency. Also, comparability must not be confused
with uniformity. Items that are fundamentally different in nature should be accounted for
differently.
The verifiability quality suggests that two or more independent and knowledgeable observers
could come to the same conclusion about the reported amount of a particular financial -
statement item. This does not mean that the observers have to be in complete agreement with
each other. In the case of an estimated amount on the financial statements, such as an allowance
for doubtful accounts, it is possible that two auditors may agree that the amount should fall
within a certain range, but each may have different opinion of which end of the range is more
probable. If they agree on the range, however, we can still say the amount is verifiable.
Verification may be performed by either directly observing the item, such as examining a
purchase invoice issued by a vendor, or indirectly verifying the inputs and calculations of a
model to determine the output, such as reviewing the assumptions and recalculating the amount
of an allowance for doubtful accounts by using data from an aged trial balance of accounts
receivable.
Timeliness is one of the simplest but most important concepts in accounting. Generally,
information needs to be current to be useful. Investors and other users need to know the
economic condition of the business at the present moment, not at some previous period.
However, past information can still be useful for tracking trends and may be especially useful
for evaluating management stewardship.
Understandability is the one characteristic that the accounting profession has often been
accused of disregarding. It is generally assumed that readers of financial statements should
have a reasonable understanding of business issues and basic accounting terminology.
However, many business transactions are inherently complex, and the accountant faces a
challenge in crafting the disclosures in such a way that they completely and concisely describe
the economic nature of the item while still being comprehensible. Financial disclosures should
be reviewed by non-specialist, knowledgeable readers to ensure the accountant has achieved
the quality of understandability.
As mentioned previously, accountants are often faced with trade-offs in preparing financial
disclosures. This is especially true when considering the application of the various qualitative
characteristics. Sometimes, the need for timeliness may result less-than-optimal verifiability,
as verification of some items may require the passage of time. As a result, the accountant is
forced to make estimations in order to ensure the information is available within a reasonable
time. As well, all information has a cost, and companies will carefully consider the cost of
producing the information compared with the benefits that can be obtained from the
information, such as improving relevance or faithful representation. These challenges point to
the conclusion that accounting is an imperfect measurement system that requires judgment in
both the preparation and interpretation of the information.
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Elements of Financial Statements

Before commencing a detailed examination of elements of financial statements, it is important
to understand the key assumption underlying the reporting process. It is normally assumed that
companies are operating as a going concern. This means that the company is expected to
continue operating into the foreseeable future and that there will be no need to liquidate
significant portions of the business or otherwise materially scale back operations. This
assumption is important, because a company that is not a going concern would likely need to
apply a different method of accounting in order not to be misleading. If a company needed to
liquidate equipment at a substantial discount due to bankruptcy or other financial distress, it
would not be appropriate to carry those assets at depreciated cost. In situations of financial
distress, the accountant needs to carefully consider the going-concern assumption in
determining the correct accounting treatment.
Assets
An asset is the first financial-statement element that needs to be considered. In the simplest
sense, an asset is something that a business owns. The CPA Canada Handbook defines an
asset as “a present economic resource controlled by the entity as a result of past events” (CPA
Canada, 2019, 4.3). The definition further states that an economic resource is a right that can
produce economic benefits. The key point in this definition is that economic benefits are
expected to be received at some point in the future as a result of holding the resource. The most
obvious benefit is the future inflow of cash. This can be seen very clearly with an item such as
inventory held by a retail store, as the store expects to sell the items in a short period of time to
generate cash. However, an asset could also be a piece of equipment installed in a factory that
reduces the consumption of electricity by production processes. Although this equipment will
not directly generate a future cash inflow, it does reduce a future cash outflow. This is also
considered an economic benefit.
Many assets have a tangible, or physical, form. However, some assets, such as accounts
receivable or a patent, have no physical form. In the case of an account receivable from a
customer, the future benefit results from the legal right the company holds to enforce payment.
For a patent, the future benefit results from the company’s ability to sell its product while
maintaining some protection from competitors. Cash in a bank account does not have physical
form, but it can be used as a medium of exchange.
It should also be noted that, although we can generally think of assets as something we own,
the actual legal title to the resource does not necessarily need to belong to the company for it
to be considered an asset. A contract, such as a long-term lease that conveys benefits to the
leasing party over a significant portion of the asset’s useful life may be considered an asset in
certain circumstances.
Liabilities
A liability is defined as “a present obligation of the entity to transfer an economic resource as
a result of past events”.
When we prepare a balance sheet, it represents the present moment, so the obligation gets
reported as a liability. This obligation is often a legal obligation, as in the case when goods are
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purchased on account, resulting in an accounts payable entry, or when money is borrowed from
a bank, resulting in a loan payable. As well, this legal obligation can exist even in the absence
of a formal contract. A company still has to report wages payable for any work performed by
an employee but not yet paid, even if that work was performed under the terms of an informal,
casual labor agreement.
Liabilities can also result from common business practice or custom, even if there is no legally
enforceable amount. If a retailer of mobile telephones agrees to replace one broken screen per
customer, then the expected cost of these replacements should be reported as a liability, even
if the damage resulted from the customer’s neglect and there is no legal obligation to pay. This
type of liability is referred to as a constructive obligation. As well, companies may record
liabilities based on equitable principles. If a company significantly reduces its workforce, it
may feel a moral obligation to provide career transition counselling to its laid-off employees,
even though there is no legal obligation to do so. In general, an obligation is considered a duty
or responsibility that an entity has no practical ability to avoid.
The settlement of the liability usually involves the future transfer of cash, but it can also be
settled by transferring other assets. As well, liabilities are sometimes settled through the
provision of services in the future. A health club that requires its members to pay for one year’s
fees in advance has an obligation to make the facilities available to its members for that time.
Less common ways to settle liabilities include replacing the liability with a new liability and
converting the liability into equity of the business. It should be noted that the determination of
the value of the liability to be recorded sometimes requires significant judgment. An example
of this would be the obligation under a pension plan to make future payments to retirees. We
will discuss this estimation problem in more detail in later chapters dealing with liabilities.
Equity
Equity is the owners’ residual interest in the business, representing the remaining amount of
assets available after all liabilities have been settled. Although equity can be thought of as a
balancing figure, it is usually subdivided into various categories when presented on the balance
sheet. Many of these classifications are related to legal requirements regarding the ownership
interest. The usual categories of equity include share capital, which can include common and
preferred shares, retained earnings, and accumulated other comprehensive income (IFRS only).
However, other types of equity can arise on certain types of transactions, such as contributed
surplus, appropriated retained earnings, and other reserves that may be allowed under local
law. The purpose of all these subcategories of equity is to give readers enough information to
understand how and when the owners may be able to receive a distribution of their interests.
For example, restrictions on retained earnings or levels of preferences on shares is sued may
constrain the future payment of dividends to common shareholders. A potential investor would
want to know this before investing in the company.
It should also be noted that the company’s reported equity does not represent its value, either
in a real sense or in the market. The prices that shares trade at in the stock market represent the
cumulative decisions of investors, based on all information that is available. Although financial
statements form part of this total pool of information, there are so many other factors used by
investors to value a company that it is unlikely that the market value of a company would equal
the reported amount of equity on the balance sheet.
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Income
Income is defined as “increases in assets, or decreases in liabilities, that result in in- creases in
equity, other than those relating to contributions from holders of equity claims”. Notice that
the definition is based on presence of changes in assets or liabilities, rather than on the concept
of something being earned. This represents the balance sheet approach used in the conceptual
framework, which considers any measure of performance, such as profit, to simply be a
representation of the change in balance sheet amounts. This perspective is quite different from
some historical views adopted previously in various jurisdictions, which viewed the primary
purpose of accounting to be the measurement of profit (an income-statement approach).

Income can include both revenues and gains. Revenues arise in the course of the normal
activities of the business; gains arise from either the disposal of noncurrent assets (realized
gains) or the revaluation of noncurrent assets (unrealized gains). Unrealized gains on certain
types of assets are usually included in other comprehensive income, a concept that will be
discussed in later chapters.
Expenses
Expenses are defined as “decreases in assets, or increases in liabilities, that result in decreases
in equity, other than those relating to distributions to holders of equity claims”. Note that this
definition is really just the inverse of the definition of income. Similarly, expenses can include
those that are incurred in the regular operation of the business and those that result from losses.
Again, losses can be either realized or unrealized, and the definition is the same it was for gains.

Recognition
Items are recognized in financial statements when they meet the definition of a financial
statement element. However, the Conceptual Framework acknowledges that there may be
circumstances when an item that meets the definition of an element is still not recognized,
because doing so would not provide useful information. In referencing usefulness, the
Framework is acknowledging the fundamental qualitative characteristics of relevance and
faithful representation. If it is uncertain whether an asset or liability exists, or if the probability
of an inflow or outflow of economic benefits is low, it is possible that recognition is not
warranted, since the relevance of the information is questionable. Similarly, if the measurement
uncertainty present in estimated amounts were too great, the element would not be faithfully
represented, and accordingly, should not be recognized. It is also possible that if the costs of
recognition outweigh the benefits to users of the financial statements, the item will not be
recognized.
Recognition means the item is included directly in one of the financial statements and not
simply disclosed in the notes. However, if an item does not meet the criteria for recognition, it
may still be necessary to disclose details in the notes to the financial statements. A pending
lawsuit judgment at the reporting date may not meet the criterion of measurement certainty,
but the possible future impact of the event could still be of interest to readers.
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Measurement Base
The Conceptual Framework also notes that once recognition is affirmed, the appropriate
measurement base needs to be considered. The following measurement bases are identified in
the conceptual framework:
 Historical cost
 Current value, which includes
 Fair value
 Value in use/fulfillment value, and
 Current cost
Historical cost is perhaps the well-entrenched concept in accounting. This simply means that
items are recorded at the actual amount of cash paid or received at the time of the original
transaction. This concept has persisted in accounting thought for so long because of its relative
reliability and verifiability. However, the concept is often criticized because historical cost
information tends to lose relevance as time passes. This can be particularly true for long-lived
assets, such as real estate.
The current value concept results in elements being reported at amounts that reflect current
conditions at the measurement date. This measurement base tries to achieve greater relevance
by using current information, but it may not always be possible to represent this information
faithfully when active markets for the item do not exist. It may be very difficult to find the
current cost of a unique or specialized asset that was purpose built for a company.
Fair value is 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. This amount can
be easily determined when active markets exist. However, if there is no active market for the
item in question, the fair value may still be estimated using a discounted cash flow technique.
Value in use is also a discounted cash flow technique. It differs from fair value in that it uses
entity specific assumptions, rather than market assumptions. In other words, the entity projects
future cash flows based on the specific way it uses the asset in question, rather than cash flows
based on market assumptions about the use of the asset. In many cases, fair value and value in
use may result in the same valuation, but this is not necessarily true in all cases.
Current cost is the cost to acquire an equivalent asset at the measurement date. This cost will
include any transaction costs to acquire the asset, and will take into consideration the age and
condition of the asset, along with other factors. Current cost represents an entry value, while
fair value and value in use represent exit values.
All of the measurement bases identified have both strengths and weaknesses in terms of their
overall decision usefulness for readers. Thus, there are always trade-offs and compromises
evident when accounting standards are set. It is not surprising, then, to see that current
accounting standards are a hybrid, or conglomeration, of these different bases. Historical cost
is still the most common base used, but many accounting standards for specific items will allow
or require other bases as well.
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It should be noted that the Conceptual Framework’s discussion of measurement bases should
be read in conjunction with IFRS 13 – Fair Value Measurement. While the Conceptual
Framework provides a broad overview of possible measurement bases, IFRS 13 provides more
specific guidance on how to determine fair value. Fair value is a concept that is applied to a
number of different accounting transactions under IFRS. IFRS 13 suggests that valuation
techniques should maximize the use of observable inputs and minimize the use of unobservable
inputs. The standard further applies a hierarchy to those inputs to assist the accountant in
assessing the quality of the data used for valuation.
Level 1 of the hierarchy represents unadjusted, quoted prices in active markets for identical
assets or liabilities.
Level 2 inputs are those that are directly or indirectly observable but do not meet the definition
of Level 1. This could include quoted prices from inactive markets or quoted prices for similar
(but not identical) assets.
Level 3 inputs are those that are unobservable. In this case, valuation techniques that require
the use of assumptions and calculations of future cash flows may be required. I
FRS 13 recommends that Level 1 inputs should always be used where possible. Unfortunately,
Level 1 inputs are often unavailable for many assets. The application of fair-value accounting
as described in IFRS 13 will be discussed in more detail in subsequent chapters.

Capital Maintenance
The last section of the conceptual framework deals with the concept of capital maintenance.
This is a broader economic concept that attempts to define the level of capital or operating
capability that investors would want to maintain in a business. This is important for investors
because they ultimately want to earn a return on their invested capital in order to achieve growth
in their overall wealth. However, measuring this growth will depend on how capital is defined.
The conceptual framework identifies two broad approaches to this question. The measurement
of the owners’ wealth can be defined in terms of financial capital or in terms of physical capital.
Financial capital maintenance is measured simply by the changes in equity reported on the
company’s balance sheet. These changes can be measured either in terms of money invested
or in terms of purchasing power. The monetary interpretation is consistent with the approach
used in historical cost accounting, where wealth is measured in nominal units (dollars, euros,
etc.). This is a simple and reasonable approach in the short term, but over longer periods,
monetary values are less relevant due to inflation. A dollar in 1950 could purchase much more
than it could in 2020, so comparisons of capital over longer periods become meaningless. One
way to get around this problem is to apply a constant purchasing power model to capital
maintenance. This attempts to apply a broad- based index, such as the Consumer Price Index,
to equity in order to adjust for the effects of inflation. This should make financial results more
comparable over time. However, it is very difficult to conclude that a broad-based index is
representative of the actual level of inflation experienced by the company, as the company
would be selling and purchasing goods that are different from those included in the index.
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The concept of physical capital maintenance attempts to get around this problem by
measuring productive capacity. If a company can maintain the same level of outputs year after
year, then it can be said that capital is maintained, even if the nominal monetary amounts
change. This approach essentially represents the rationale behind the current cost-measurement
base. The difficulty in using this approach is that current cost information about each specific
asset in the business would be prohibitively expensive to obtain. If, instead, the company tried
to apply a general index of prices for its specific industry, it is unlikely that this index would
accurately match the specific asset composition of the company.

Conclusion
The conceptual framework has been seen in many ways. For example, in Concepts Statement
No. 5, the FASB outlines the need for a statement of comprehensive income that would contain
all of the changes in the value of a company during a period whether those value changes were
created by operations, by changes in market values, by changes in exchange rates, or by any
other source. This statement of comprehensive income is now a required statement (see FASB
ASC Section 220). In addition, the existence of this statement as a place to report changes in
market values of assets has facilitated the adoption of standards that result in more relevant
values in the balance sheet. Examples are the market values of investment securities and the
market values of derivatives. Without the conceptual framework to guide the creation of these
standards, their provisions would have been even more controversial than they were.
Related to the conceptual framework is the push toward more “principles-based” accounting
standards. In theory, principles-based standards would not include any exceptions to general
principles and would not include detailed implementation and interpretation guidance. Instead,
a principles-based standard would have a strong conceptual foundation and be applicable to a
variety of circumstances by a practicing accountant using his or her professional judgment. A
number of accounting standards in the United States, including those dealing with the
accounting for leases and derivatives, are full of exceptions, special cases, and tricky
implementation rules requiring hundreds of pages of detailed interpretation. The cry for an
emphasis on principles-based standards is a reaction to the huge costs of trying to understand
and use these voluminous, detailed standards. The ideal of basing accounting standards on a
strong conceptual foundation is what motivated the FASB’s conceptual framework project in
the first place.
The framework discussed in this chapter will be a reference source throughout the text. In
studying the remaining chapters, we will see many applications and a few exceptions to the
theoretical framework established here. An understanding of the overall theoretical framework
of accounting should make it easier for you to understand specific issues and problems
encountered in practice