School of Business

of business due to change in money value may be shown through

preparation of a supplementing statement showing the effects of changes
in money value in the financial statement.

1.2.2. Conceptual Framework

A conceptual framework is like a constitution, it is coherent system of
interrelated objectives and fundamentals that can lead to consistent
standards and that prescribes the nature, functions, and limits of financial
accounting and Financial statements.1 " This framework will guide the
total magnum of activities performed by an accountant starting from the
collection of information as an input and its processing into an output
Conceptual through preparation of financial statement to be communicated to the
framework guides users. The FASB has issued three Statements of Financial Accounting
the total magnum of
Concepts (SFAC) that relate to financial reporting for business
activities performed
by an accountant enterprises. These three statements form the first two levels of
starting from the conceptual framework stating mainly the objectives, nature and the
collection of qualitative characteristics of accounting information. These first two
information as an levels provide the foundation for developing the third level of conceptual
input and its framework, the operational guidelines, that shall help the accountants in
processing into an performing their activities even in a controversial situations. These
output through operational guidelines comprise of (a) Basic Assumptions of
preparation of Accounting, (b) Basic Accounting Principles; and (c) Constraints. These
financial statement guidelines also help the users in understanding the information supplied
to be communicated
by the accountant through financial statements and their some inherent
to the users.
limitations. These operational guidelines are the Generally Accepted
Accounting Principles. The framework is being presented in the diagram
No-3.

1
Conceptual Framework for financial accounting and Reporting : Elements of financial
statements and their measurement." IASB Discussion memorandum (Standard Con:
FASB 1976), p.1.

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Diagram-3:

Objectives
Provide useful First Level:
information: Basic objectives
1. Useful in investment and
credit decisions.
2. Useful in assessing future
cash flows.
3. About enterprise resources,
claims to resources, and
changes in them.

Qualitative Characteristics: Elements: Second Level:

1.Primary qualities 1. Assets Fundamental concepts
A. Relevance 2. Liabilities
1. Predictive value 3. Equity
2.Feed back value 4. Revenues
3.Neutrality 5. Expenses
2. Secondary qualities 6. Gains
A. Comparability 7. Losses
B. Consistency
Third level:
Basic Assumptions Basic Principles Constraints Operational guidelines
1.Economic Entity 1.Historical cost 1.Cost benefit
2.Going concern 2.Revenue Recognition 2.Materiality
3.Monetary unit 3.Matching 3.Industry Practice
4.Periodicity 4.Full Disclosure 4.Conservatism
Source: Kieso & Weygandt : Intermediate Accounting, p. 44.

FIRST LEVEL : BASIC OBJECTIVES : The basic objective of

accounting is to supply information, mainly financial, to different types The basic objective
of users for decision making, control, and evaluation of the operational of accounting is to
performance of business organization in using their financial resources in supply information,
earning profit and thereby to keep the total investments in resources in- mainly financial, to
different types of
tact so that the business can operate at least in its present form in future. users for decision
Decision making in the present day business world has become more making, control, and
evaluation of the
complex. It includes setting of goal, finding alternative ways of operational
accomplishing the goal and deciding which alternative is the best course performance of
of action. So, the accountant must present a clear statement of financial business
alternatives. organization.

Whether the operation of a business is being carried out as per plan or

not, the management regularly wants to monitor it and in case of
deviation, corrective actions must be taken at the right time. So
accountant must supply comparative statements regarding the level of
actual operational performance as against the plan.
Evaluation of operational performance may be made by different groups
of people either directly interested or indirectly interested in the business.
It may be made by owners, creditors or even by trade unions. So the
necessary statements and supplementary information must be supplied in

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this respect by accounting system. In providing information to users of

financial statements, the accountants generally prepare general purpose
financial statements at minimal costs. These statements are being
supplemented by all other necessary reports or schedules.
SECOND LEVEL : Fundamental Concepts:
The first level defines the objectives, why accounting is done and the
third level shows how the work is being done. But in between these two
levels, one user of the information, supplied by the accountants, must
understand the qualitative characteristics of these information and must
know the meaning and nature of different elements that the financial
statements comprise. This level represents the conceptual building
block.
To be useful to the users, the accounting statements must fulfil some
qualitative characteristics. The statements must be understandable to the
users. Understandability is the quality of information presented in an
appropriate form , so that its significance is being perceived by the users.
True and reliable information presented in a complex form may not be
understandable to the users.
To become understandable the accounting information must possess two
primary qualities: Relevance and Reliability.
Relevance - it is potential for accounting information to have the ability
to influence the decisions of the users. Relevant information helps the
users make predictions about the past (confirmatory relevance), present
and future (predictive value). The information to be relevant must be
supplied to the users in time before it loses its capacity to influence the
decision makers. So, to be relevant, an information must have predictive
value and feed back value and it must be supplied in time.
Reliability : It is the quality of information that gives assurance that it is
reasonably free from errors and biases and is a faithful representation.
An information to be reliable, must possess qualities like verifiability,
representational faithfulness, and neutrality. Verifiability refers to
high degree of consensus among independent measures using the same
measurement methods. Representational faithfulness refers to
correspondence or agreement between accounting records and the
source document and the information presented in the statements.
Moreover, for information to be reliable, it must be neutral, i.e., free
from bias. It should not be presented in such a form so that it can
influence the decision makers in a predetermined way. To be neutral, an
accounting information needs to be objective. Reliable information will
be prudent in nature and must be complete, as omissions can mislead a
decision maker.
Secondary qualities of accounting information : The accounting
information supplied through financial statements and reports should
possess the qualities of comparability and consistency. Information, to
be useful, must be comparable with similar information of other
enterprise or with similar information of the same organization of

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another point of time. To be comparable, information must be measured

Expenses are the
and reported in a similar manner by different organizations. When the scarifies or
measurement and reporting of an event as per accounting principles can obligations for
be made applying different methods, the question of consistency in future scarifies of
applying the same method in accounting treatment of events shall ensure resources for
comparability of information between years, which is essential to earning revenues.
evaluate the enterprises performances over years.
In the second level another most important aspect of accounting
information in the elements or definitions is being stated. Understanding
of financial statements depends on the clear knowledge about the
elements or items through which these statements are being presented.
The primary elements of accounting are:
Assets - Probable future benefits obtained or controlled by a particular
entity as a result of past transactions or events. These assets indicate the
financial strength of the enterprise which shall yield future revenues to
the enterprise.
Liabilities - A business entity is an artificial one created by an agreement
or law or statute . So the assets must be supplied by one . The claims of Assets are probable
the supplier of assets over the entity's resources are termed as liability. future benefits
These are the probable future sacrifices of economic benefits arising obtained or
from present obligations of a particular entity to transfer assets or controlled by a
particular entity as a
provide services to other entities in the future as a result past result of past
transactions or events. Liabilities are contractual debts of the entity transactions or
which are recognized by law. They have rights over owners inter events.
distribution of assets.
Owner's Equity : It is the residual interest in the assets of an entity that The claims of the
remains after the deducting its liabilities. Equity is the owner's claim or supplier of assets
interest in the business. Owner's equity is comprised of two elements in, over the entity's
the capital invested by the owner plus the earnings retained in the resources are termed
as liability.
business. Equity can be stated as : Assets - Liabilities = Owner's
equity.
Revenues : Revenues are inflows or other enhancements of assets of Owners' equity is the
an entity or settlement of its liabilities (or a combination of both) during residual interest in
a period from major operations of the entity which may be delivering or the assets of an
producing goods, rendering of services etc. Revenues are reflected by an entity that remains
increase in owner's equity. All inflows or enhancement of assets may after the deducting
not be a result of a revenue. Such as increase in cash balance due to its liabilities.
borrowing from bank is not a source of revenue. Liabilities are not
generally affected by revenues.
Expenses : Expenses are the scarifies or obligations for future scarifies Revenues are
of resources for earning revenues. These are the outflows of assets or in reflected by an
currencies of liabilities (or a combination of both) during a particular increase in owners'
equity.
period from delivering or producing goods, rendering services, or
carrying out other activities that constitute major operations of the
organization.

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Gains : Increases in equity (net assets) from peripheral and incidental

activities of an entity other than normal operations.
Losses : Decreases in equity (net assets) from peripheral or incidental
transactions of an entity other than normal operations.
Third Level : Operational Guidelines:
Accounting is defined as an information system that measures, processes
and communicates financial information. Now the question arises as to
what information is to be measured and processed? That means what
shall be the input of accounting? The operational guidelines give
answers to all these questions like what is to be recorded in books of
accounts. What should be the value at which the event should be
recorded? When should the information be recorded? How is it to be
recorded? etc.
This level has been sub-divided into three categories: (1) Basic
Assumptions (2) Basic Principles and (3) Constraints. All these three
together gives answers to the above questions relating to accounting
process starting from identification of input to output of accounting ie.,
supply of financial information through statements and reports.
1. Basic Assumptions:
The assumptions provide a foundation for the accounting process. The
assumptions helps to understand what is being recorded and how the
events have been recorded. There are four basic assumptions.
(i) Economic Entity Assumption :
For accounting purpose, a business is treated as a separate entity. As per
this assumption, all events that changes the financial position of the
entity are recorded in the books of accounts. The entity concept assumes
that the business is separate not only from creditors and customers but
The entity concept also from its owners. The owner is treated as a creditor for to the extent
assumes that the of his capital. Capital is thus a liability to the business and an owner is a
business is not only creditor of the business. Under this assumption, all records and reports
separate from are developed from the view point of the particular entity.
creditors and
customers, but also (ii) Money Measurement Assumption :
equally separate
from its owners. As per this assumption, the events or transactions, that are capable of
being measured or expressed in terms of money shall be recorded into
books of account. Thus events, may be very important to business entity,
The events or that cannot be objectively translated into money shall not be recorded
transactions, that into the books of account. For example, if all the efficient managers
are capable of being resign at a time from the business, this information will be not be
measured or recorded in the books as its effect cannot be objectively translated into
expressed in terms of money. Under this assumption, monetary unit is considered to be
money shall be sufficiently constant over time, which might even be considered as a
recorded into books limitation of accounting information. Thus this assumption ignores the
of account. qualitative aspect of things; and the impact of inflationary changes is not
adjusted in financial statements due to this assumption.

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(iii) Going Concern Assumption :

Revenue is
This assumption is frequently called continuity assumption and assumes considered to be
that a business entity generally shall continue for an unlimited period of earned on the date
time to carry out its objectives. Though there are some business failures on which it is
each year, normally a business is established with an objective to realized.
carryout its operations for quite a longer period of time. With this aim in
view the business used to invest a huge amount of money in fixed assets
with a considerable long life. These assets only be used in the business Going concern
assumption assumes
to earn profit, as such these are shown at historical cost. Proportionate
that a business entity
cost of these assets is charged against revenue to find out the profit
generally shall
earned. So, under this assumption, continuity of activity is assumed and continue for an
accounting reports are fashioned as a going concern, just as against unlimited period of
liquidation. time to carry out its
(iv) Periodicity Assumption : objectives.

This assumption, in a way, contradicts the going concern assumption.

Here the unlimited life of the business is artificially sub-divided into time Periodicity
periods which is generally a calendar year. According to this assumption, assumption
determination of yearly income is made, though actual business income emphasises the need
can exactly be determined on liquidation only. This becomes essential of accruals and
for distribution of income to the investors, who invested into the business deferrals basis of
to earn, to pay the loan providers interest, to give income tax on yearly accounting from
basis to government and also to provide data on production, value cash basis
addition, cost, and distribution of values for compilation of national accounting.
income and production statistics. This assumption emphasises the need
of accruals and deferrals basis of accounting than cash basis accounting.
If the demand for frequent interval reports does not arise during the life
span of a business, accruals and deferrals of revenues and expenses could
not be essential.
2. Basic Principles :
The basic principles guide how business events and transactions should
be recorded into books of account and reported. The principles are based
on the above mentioned basic assumptions. These principles give answer
as to at what value and when the transactions should be recorded. The
principles comprise of :
(i) Historical Cost Principle : This principle asserts that the assets Historical cost
should be recorded in the books of account and shown in the balance principle asserts that
sheet at their original costs, which is nothing but the resources sacrified the assets should be
or under obligation to sacrifice in the future period for their acquisition. recorded in the
Cost is both relevant and reliable. Cost is reliable as objectively books of account
measured. It tends to be a matter of demonstrable fact. It is relevant and shown in the
because it represents the assets scarified. Sometimes current value tends balance sheet at
to be more relevant and acceptable, but as it is a matter of opinion, the their original cost.
accountant prefers objectivity.
(ii) Revenue Recognition Principle : This principle determines the
point of time at which revenue should be treated as having been earned.
Revenues should be recognized in the accounting period in which it is
earned. In practice it might sometime become difficult to apply specially
when goods are sold on credit. The question arises as to when the
revenue is to be recognized and recorded: When the order is received

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from the customer or when the goods pass to the customer or when the
customer pays for the goods. Generally as per this principle revenue is
considered as being earned on the date on which it is i.e. the date on
which the ownership on the goods and services are transferred to
customers either for cash or for credit. In case of credit sale it is
recognized when the goods is passed to the customer without giving
emphasis of actual cash payment. This principle is important as it prevent
business firms from, inflating their profits by recording sale and income
that are likely to accrue.

Materiality refers to (iii) Matching Principle: In accounting expenses are recognized always
an item's impact on in reference to revenue. The period in which a revenue is recognized and
the overall financial recorded, the sacrifies made or obligation to make in future should be
position and recognized and recorded as expenses in that period. This concept of
operations. recognizing expense in reference to revenue is called matching principle.
Expenses are thus the expired costs, i.e., that part of the cost which has
already been sacrified for earning revenue. The part of the cost which has
not yet been sacrified for earning revenue or shall be used up in future
for earning revenue is called unexpired cost, and is shown as asset. For
example, purchase of merchandise for sale is the cost of acquisition. But
only that part of purchased merchandise which has been sold out is
called cost of goods sold and is treated as expense against sales revenue.
Expenses are The unsold part is unexpired cost which is shown as inventory in the
recognized always balance sheet. Thus fixed assets are unexpired costs and depreciation is
in reference to the expired cost and treated as expense.
revenue.
(iv) Full Disclosure Principle : This principle dictates that the necessary
information with regard to a particular element in the financial statement
must be supplied to make it self explanatory for decision making
purpose. Financial statements and their accompanying footnotes or other
explanatory materials should contain all of the pertinent data believed
essential to the readers' understanding. In compliance to this principle
additional data, explanation, schedules etc. are attached as supplementary
information for the users for making decisions. For example, significant
loan agreements against an asset as a mortgage, accounting methods
employed, changes in accounting methods, events subsequent to date of
statements all should be disclosed. Though it is difficult to decide how
Full disclosure much disclosure is enough, it is to be judged by the cost-benefit analysis,
principle dictates i.e., the cost of providing such information through statements should be
that the necessary compared with the benefits that shall be accruing to the users.
information with
regard to a 3. Constraints : Constraints in accounting refers to the exceptions/or
particular element in relaxation in the use of accounting principles in special circumstances.
the financial
statement must be The two main constraints are (1) Materiality and (2) Conservatism. The
supplied to make it other dominants constraints are Industry practice and cost-benefit
self explanatory for relationship.
decision making
purpose. (i) Materiality : It refers to an item’s impact on the overall financial
position and operations. An item is material when it influences the
decision of informed investor and immaterial when it has no impact on
that. Materiality in its essence is of relative significance. In the serve that
some of the unimportant items are either left out or included with other
items. For example, a business organization purchased some long-lived

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assets but of very negligible value. In this case this event may be treated
as expense rather than assets, as this treatment either as asset or as
expense does not affect the operational result or financial position of the
business. The determination of what is material and what is unimportant
requires the exercise of judgment, precise criteria cannot be applied.
(ii) Conservatism : This constraints refers to situations when two
methods are otherwise equally appropriate, the choice should be made
for the one that will least likely to overstate assets and income. In
accounting, as per this constraints, all probable/expected losses are
accounted for whereas the expected income/revenues are not recorded
until earned. The attitude of conservatism was frequently expressed in
the admonition to "anticipate no profits and provide for all losses." A
common application of this constraints is the use of ‘cost or market value
whichever is lower’ in valuing closing inventory, though the basic
principle of valuation of closing stock is cost. Application of this
constraint forbids overstatement of income, not yet been earned ,
accounting treatment of which might cause higher outflows of resources
in the form of dividends and taxes.
Industry practice refers to difference in treatment of an event into
accounts from its usual one due to peculiar nature of some business or Conservatism
industry. Cost-benefit relationship dictates the quantum of information to constraint refers that
be provided to the users by the accounting system. The accounting all probable/
system usually prepares general purpose financial statements, which expected losses are
accounted for
contain all basic financial information in relations to an entity, knowing
whereas the expected
it fully well that different types of users might need specifically different income/revenues are
types of information for taking their respective decisions. But from cost- not recorded until
benefit analysis, it is not feasible to prepare specific purpose financial earned.
statement for specific users. All these guidelines comprising
assumptions, principles and the constraints dictate the operational part of
accounting work.

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