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Chapter 1

Contemporary Issues
in Accounting

PowerPoint Presentation
by Matthew Tilling
©2012 John Wiley & Sons Australia Ltd
Accounting Theory
• Accounting viewed as a practical discipline
– Rule focussed
– With little use for theory

• However, theory is necessary to


– Understand the world we live in
– Provide a basis for decision making
Accounting Theories
• All accounting is premised on theories
– Concepts of Materiality
– Recognition Criteria
• Relevance
• Faithful Representation
– The Conceptual Framework
– Measurement Bases
Theory Defined
• Theory can mean a lot of different things
• In common usage

– “I have a theory…”

– “In theory…”
Dictionary Definitions
• A belief or principle that guides actions or
behaviour
• An idea or set of ideas that is intended to
explain something
• The set of principles on which a subject is
based or of ideas that are suggested to explain
a fact or event
Accounting Theory
• A description, explanation or a prediction [of
accounting practice] based on observations
and/or logical reasoning

• Logical reasoning in the form of a set of broad


principles that (1) provide a general
framework of reference by which accounting
practice can be evaluated and (2) guide the
development of new practice and procedures
Why Is Theory Needed
• To provide an explanation of what is
happening

• To help us predict what will happen


The Affect Of Theories
• Theories drive many real world situations
• Theory informs decisions about
– Tax
– Interest Rates
– Global Warming
– Education
– Construction
• Almost every aspect of our lives
Different Theories
• Some of these theories explain

• Some of these theories predict

• Some of these theories conflict


Different Accounting Theories
• Some accounting theories
– Describe and explain current practice
• Capital Market Theory
– Predict practice
• Agency Theory
– Provide principles for decision making
– Identify problems and deficiencies and offer
solutions
• The conceptual framework
Types Of Theories
• Theories are often placed into two categories

– positive theories

– normative theories.
Positive Theories
• Positive theories are about the world as it is.
• They
– Describe what is happening
– Explain what is happening
– Make predictions about what will happen
• Based around Hypotheses
• Also called empirical theories
Normative Theories
• Make suggestions about
– What should happen
– What ought to be
• Observations or facts are considered in
development of normative theories
Acceptance of Theories
• A good theory should
– Be logical in its construction
– Be clearly articulated
– Be testable
– Be consistent with observation
• A theory can never be proved true
• A single observation can prove a theory false
Chapter 2
Contemporary Issues
in Accounting

PowerPoint Presentation
by Matthew Tilling
©2012 John Wiley & Sons Australia Ltd
The Role Of A
Conceptual Framework
• A Conceptual framework is a group of ideas
or principles used to plan or decide
something.
– It is a normative theory
– It prescribes the basic principles that are to be
followed in preparing financial statements
– It is a coherent system of concepts, which are
guidelines to the accounting standards used for
financial reporting
Conceptual Framework Versus
Accounting Standard
• The Conceptual Framework is designed to
provide guidance and apply to a wide range of
decisions.
• Accounting standards
– Specific requirements for a particular area
– May go beyond the framework
– Are mandatory
– Sometimes conflict with the framework
The Structure And Components Of
The Conceptual Framework
• The Conceptual Framework can be seen as
providing answers to questions such as:
– What is the purpose of financial statements?
– Who are they prepared for?
– What are the assumptions to be made when
preparing financial statements?
– What type of information should be included?
– What are the elements that make up financial
statements?
– When should the elements of financial statements be
included?
Purpose, Objective And
Underlying Assumption
• The Conceptual Framework states that it is
concerned with general purpose financial
reports.
– These are financial reports intended to meet the
needs of users who are not in a position to require
an entity to prepare reports tailored to their
particular information needs.
• Not special purpose financial reports
Purpose, Objective And
Underlying Assumption
A reporting entity is a circumscribed area of
economic activities whose financial information has
the potential to be useful to existing and potential
equity investors, lenders, and other creditors who
cannot directly obtain the information they need in
making decisions about providing resources to the
entity and in assessing whether the management
and the governing board of that entity have made
efficient and effective use of the resources provided.
Proposed definition of a reporting entity
Purpose, Objective And
Underlying Assumption
• Focus on economic events and transactions,
not legal form
• Designed for ‘for-profit’ entities
• Does not actually set out which entities must
prepare General Purpose Financial Reports
– This is a matter for individual countries to decide
at law
The Objective of
Financial Reporting
The objective of general purpose financial reporting
is to provide financial information about the
reporting entity that is useful to existing and
potential investors, lenders and other creditors in
making decisions about providing resources to the
entity. Those decisions involve buying, selling or
holding equity and debt instruments, and providing
or settling loans and other forms of credit
The Conceptual Framework
The Objective of
Financial Reporting
• Financial statements should provide
information that is useful to users in making
decisions.
– Help predict the future
– Provide feedback on previous decisions
– Accountability and stewardship
The Objective of
Financial Reporting
• The Conceptual Framework identifies the
following users
– Existing and potential investors
– Lenders
– Other creditors.
• Very limited list when compare with previous
framework
Underlying Assumption
The financial statements are normally prepared on
the assumption that an entity is a going concern and
will continue in operation for the foreseeable future
The Conceptual Framework

• Affects recognition and measurement


Qualitative Characteristics Of Useful
Financial Information
• There is a hierarchy of qualitative
characteristics:
– Fundamental
– Enhancing
• To be useful for decision making
– Information must have both of the two
fundamental characteristics
– The enhancing characteristics are not essential
• But can improve the usefulness of the information
Fundamental
Qualitative Characteristics
• Relevance
– Aims to ensure that only useful information is
included
– An important part of this concept is materiality
Fundamental
Qualitative Characteristics
• Faithful Representation
– What is shown corresponds to the actual events
and transactions that are being represented

• Three key elements


– Complete Depiction
– Neutrality
– Freedom for Error
Enhancing
Qualitative Characteristics
• Comparability
– Achieved with consistent measurement and
presentation of items over time and between
entities

• Verifiability
– Information can be supported or confirmed so
that users are confident in relying on it
Enhancing
Qualitative Characteristics
• Timeliness
– Users need information on a timely basis

• Understandability
– Financial reports are prepared for users who
• Have reasonable knowledge of business and economic
activities, and
• will conduct a diligent review and analysis of the
information
Determining the Relative Importance
of Qualitative Characteristics
• Ideally information will have all characteristics
• In reality there are often trade-offs
– Timeliness versus faithful representation
– Relevance versus verifiability
– Relevance versus understandability

• Cost Constraint on Financial Information


– Cost versus benefit
The Elements Of
Financial Statements
• Assets
A resource controlled by the entity as a result of
past events and from which future economic
benefits are expected to flow to the entity.
• Liabilities
A present obligation of the entity arising from past
events, the settlement of which is expected to
result in an outflow from the entity of resources
embodying economic benefits.
The Elements Of
Financial Statements
• Equity
The residual interest in the assets of the entity after
deducting all its liabilities.
• Income
Increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity,
other than those relating to contributions from equity
participants.
• Expenses
Decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or
incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity
participants.
Recognition Criteria
• Recognition is the process of incorporating an
item in the balance sheet or income
statement . . . It involves depiction of the item
in words and by a monetary amount and the
inclusion of that amount in the balance sheet
or income statement totals.
• Two tests for recognition
– Probability
– Measurability
Probability
• An element should be recognised if
(a) it is probable that any future economic
benefit associated with the item will flow to or
from the entity
• Probability criteria is met if ‘the event if more
likely than not to occur’.
Reliable Measurement
• An element should be recognised if
(b) the item has a cost or value that can be
measured with reliability.

• Estimation is acceptable
• Either a cost or a value
The Benefits Of A
Conceptual Framework
• Technical Benefits
– Improve the practice of accounting and to provide
a basis for answers to specific accounting
questions and problems.
– It is stated that the Conceptual Framework does
this in two ways:
• By providing a basis and guidance for those who set the
specific accounting rules.
• By helping individuals involved in preparing or auditing
or using financial statements.
The Benefits Of A
Conceptual Framework
• Political Benefits
– Prevent political interference in setting accounting
standards.
• Accounting information has significant real-world
affects

• Professional Benefits
– Protect the professional status of accounting and
accountants.
Problems & Criticisms Of The
Conceptual Framework
• It is ambiguous
– The principles are too vague
– Too much room for alternative interpretations.

• It is descriptive not prescriptive


– The Conceptual Framework simply describes
current accounting practise.
– Should be prescriptive (normative) and try to
improve practice.
Problems & Criticisms Of The
Conceptual Framework
• The concept of faithful representation is
inappropriate
• Realist view:
Financial statements . . . Are representationally faithful to
the extent that they provide an objective picture of an
entity’s resources and obligations
• Materialist view:
Although the underlying events and transactions do exist
the accounting measures that are reported are created by
accountants and do not exist independently of them.
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