Lesson 11: Conceptual Framework
In this lesson, we will discover the importance of conceptual framework and
study its levels. We will learn the use of accounting principles, and cover
some 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.
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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.
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To demonstrate the use of the conceptual framework, let's look at an example:
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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.
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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.
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Have you ever heard of the Bernie Madoff Ponzi scheme?
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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.
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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.
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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.