Lesson Objectives:- Importance of conceptual framework
- Explaining the levels of the framework
- The use of accounting principles
- Examples of activities outside of the established constraints
The conceptual framework is essentially the system that defines how transactions are measured, reported, disclosed and presented. This serves as the foundation for dictating the financial decisions that a company makes and what the requirements are for recording information.
Think of the conceptual framework as the backbone of financial accounting, with the ribs representing the various transactions that fit into the different statements such as the retained earnings and income statement.
Now, let's review the three levels of the conceptual framework depicted above:
First, the smallest diamond represents the objectives. Just as a society requires objectives to grow, the business needs objectives to drive their performance. The conceptual framework requires changes in financial performance to be communicated by recording the assets, liabilities and equity.
The next diamond, elements serves as the language in which the business communicates. These are the same 9 elements that we discussed in the previous lesson: assets, liabilities, equity, revenue, expenses, gains, losses, other comprehensive income and dividends.
The largest part of financial accounting is the principles & constraints that are essentially the driving reporting requirements similar to how laws are applied to society.
There are three main concepts of measuring and reporting information: assumptions, principles, and constraints.
The assumption concept contains how unit of measure, separate entity, going concern and time period of the transactions are reported and recorded. The principles concept consists of cost, revenue recognition, matching, and full disclosure of transactions. The concept of exceptions, or constraints, includes cost-benefit, materiality, and industry practices of transactions as compared to other companies in the same type of business. Above is a diagram of the framework and how the pieces relate to each other.
With the conceptual framework of accounting, we are tasked with the objective of recording the assets, liabilities and equity on the balance statement. The elements are the way that transactions are measured and the categories they fall into. The principles and constraints are the most important part of the framework as they help to guide decisions within accounting, defining how each element should be recorded.
To demonstrate the use of the conceptual framework, let's look at an example:
A company plans to purchase 3 properties with cash, each valued at $150,000. They currently own $4,200,000 total in property and equipment. The company has now closed on two of the properties but have yet to complete the transactions for the third property.
The principles and constraints of accounting will define what should be recorded as an asset on the balance statement. The two properties would be recorded as an additional $300,000 in assets, to total $4,500,000. The other $ 150,000 would still be a cash asset until the other property transaction is completed.
We can see in this example that the company would rely on the standardized guidelines for defining an asset and determining when it should be recorded on the financial statement.
Fraudulent practices are not accepted within the conceptual framework. This means that anything that is misreported or overstated does not adhere to the principles and constraints of accounting.
Have you ever heard of the Bernie Madoff Ponzi scheme?
Well, he was responsible for the largest case of fraud in United States history. In this case, Bernie may have been following his own personal objectives but his actions fell outside of the requirements of recording financial transaction.
He promised high returns in a very short period of time which misrepresented the amount of dividends they would expect to receive. This not only fell outside of the conceptual framework, but it violated the law and cheated investors out of billions of dollars.
With this historical example, you can see that the principles and constraints have the most control over the financial accounting decision. Not following the conceptual framework can have costly consequences for a business' financial records.