Peeling away financial reporting issues one layer at a time

The New Conceptual Framework: Renewing a License to Produce Lousy Accounting Standards

The IASB and FASB jointly announced the completion of the first stage of their joint conceptual framework project this week. The eight-phase project was begun almost exactly seven years ago, and the first stage has just now been 'finalized.' For the FASB's part, completion of the first phase was marked by the publication of Statement of Financial Accounting Concepts No. 8, to replace Concepts Statements No. 1 and 2. The contents of SFAC No. 8 are to be published as Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information of a single document containing the revised conceptual framework.

This is the first of what I hope will be several posts on the conceptual framework project. In this first post, I'm going to discuss two preliminary matters: "concepts" versus "principles"; and the "purpose and status" of the conceptual framework that is under development. Notwithstanding the fundamental problems I have with the overall approach taken by the Boards, the next post in the series will address two of the "concepts" promulgated by the recent joint publication: the notion of "general purpose" financial statements; and the "primary users" of financial statements prepared in accordance with GAAP/IFRS.

A (Conceptual) Bridge to Nowhere

Why would you renovate the kitchen of a house if you have no plans to live there yourself, you couldn't rent it profitably, or you couldn't possibly recover the costs of the renovation through sale? Sure, the kitchen is antiquated; but that reason, in and of itself, obviously does not justify the costs of replacing it.

Obviously, one should not renovate one's kitchen without planning to use it for something; and likewise, one would think that the Boards must have an intended use for a new conceptual framework. But, if they do, they're not telling anyone just yet. The publication of SFAC No. 8 marks the completion of the first phase of their project, and the next three phases are reported to be "active." However, the phase in which the question of the "purpose and status" of the framework (number six) has not even begun.

I'm tempted to state that this approach taken by the Boards, to defer consideration of purpose and status until the document is essentially complete, is the accounting equivalent of a bridge to nowhere, but my gut tells me that it's more like a bridge to an undisclosed location. I suspect that the destination for the new conceptual framework is the same as the old one: a humongous warehouse of accounting "concepts" that the board members will draw on as they concoct elaborate rationalizations for having allowed The Accounting Establishment to play the tune – instead of investors.

I will concede that the Boards may be reasoning that the contents of the framework would be unaffected by its ultimate "purpose and status," but I simply don't buy it. There is no question that the nature of the discussions and their affect on the final document would be profoundly affected if, for example, the Boards were to state that the provisions of the conceptual framework sat on top of IFRS and GAAP instead of its current location, which within the universe of accounting rules is located somewhere in outer space.

It's a Matter of Principle, Not Concept (with apologies to Abe Briloff)

"Concepts" are ideas at some relatively high order of intellectualization, but "principles" are of a higher order. They are commitments to behave in a certain manner. My sense of the history of the term "generally accepted accounting principles" is that preparers recoiled at being committed to overarching principles, and thus successfully fought off their formal promulgation. That's why, by the way, academics became gradually but inexorably shoved to the side by standards setters – for principles are the quintessential academic topic. It's also why, I believe, that David Mosso, former FASB member, in his new book, which I summarized here, called for academics to set accounting standards. (Hooray for David!)

Kindly allow me to explain how I see the difference between accounting concepts and accounting principles with an analogy. (I sure hope this works.)

We don't need a statute (or even the Ten Commandments) to know that taking a human life violates the most fundamental principle of civil society. But, there are allowed exceptions, which, in order to be as clear as is practicable, are explicitly stated in the law. When it comes to applying this principle, concepts, such as "human life," have a role, e.g., such as when it would be permissible to take a hospital patient off life support. But, the principle is of a higher order than the concept: all civilized persons live by the principle that it is wrong to take a human life, although not everyone accepts the same conceptualization of "human life."

My point with respect to financial reporting is that the question of a framework's purpose and status would be indisputable if it were comprised of principles instead of concepts; it would be at the very top of a GAAP/IFRS hierarchy. A transaction or event could not be reflected in financial statements in a manner that violated the promulgated principles, unless a specific rule permitted a departure from them.

Tellingly, I could not find a single occurrence of "principles" in the new SFAC No. 8 (except for use as part of that antiquated term of art, "generally accepted accounting principles." Instead, the core issues embodied by fundamental principles, are circumnavigated with discourses on specious concepts like the "primary user group" and "general purpose financial statements," along with peripheral considerations such as the re-packaging of the properties that financial statements are considered to possess. (Can anybody tell me the practical difference between "representational faithfulness" and plain ole truth telling?)

Notwithstanding my belief that principles should be the dominant subject of the framework project, I'll have more to say about the specific concepts covered by SFAC No. 8 in a later post. But, for now, I'll conclude with a brief, yet fairly complete, example of principles that could reasonably be placed at the top of a financial reporting hierarchy. I'll be bringing these up again as benchmarks against which I will be evaluating the conceptual framework project:

  1. The purpose of financial statements prepared in accordance with IFRS/GAAP should be to provide information to investors.
  2. Investors should be provided with information relevant to assessing: (1) the amount of wealth available to the reporting entity; (2) claims on wealth; and (3) how wealth has changed over time. However:
    • It is highly unlikely that financial reporting will provide all of the information investors may desire for assessing these items;
    • It is not the goal of GAAP/IFRS to provide all of the information investors may desire for assessing these items.
  3. Financial statements should be prepared from the perspective of the current holders of common stock, or its equivalent (hereafter, common stock). Therefore:
    • The present holders of common stock should be viewed as the primary users of financial statements prepared in accordance with IFRS/GAAP;
    • The claims on wealth should be distinguished by non-owner claims (liabilities) and owner claims (owners' equity).
  4. The needs of non-primary users of financial statements should not be considered when determining policies for the preparation and presentation of the primary financial statements (e.g., balance sheet, income statement, statement of cash flows). However, the informational needs of non-primary users may provide the basis for requiring certain disclosures outside of the financial statements.
  5. The balance sheet should report items of wealth (assets) and claims on wealth (liabilities).
    • An "asset" is an economic resource to the reporting entity that satisfies at least one of the following conditions: (1) the reporting entity holds legal title to the resource; (2) the reporting entity holds the legal right (conditional or unconditional) to receive the resource; or (3) the reporting entities holds the legal right (conditional or unconditional) to use the resource for some purpose (specified or unspecified).
    • Liabilities are legally enforceable obligations (conditional or unconditional) to either: (1) deliver an asset or the common stock of the reporting entity; or (2) permit another party to use an asset. Therefore, all liabilities of a reporting entity are assets of another entity or person.
    • The attribute of an asset to be measured for purposes of financial statement presentation should be the asset's economic utility to the reporting entity. In most cases, this is represented by the asset's replacement cost; however, in some circumstances measurement of utility is best captured by the asset's net realizable value through sale under current business conditions.
    • A balance sheet may not violate the axioms of arithmetic (e.g., unlike measurements may not be summed).
  6. The income statement reports changes in assets and liabilities for a given period resulting from the following: (1) transactions between the reporting entity and persons that were not common shareholders (or not acting in the capacity of common shareholders) during the period; and (2) other events that affect the measurement of assets and liabilities. Such changes should clearly delineate the effects of operating and financing activities.
  7. Providing information about wealth is costly. Financial reporting standards must weigh the aggregate costs an entity will incur in producing information against the benefits of being provided with information. This weighing of costs and benefits, has, among other things, the following implications:
    • Not all assets and liabilities of the reporting entity may be recognized on the balance sheet.
    • The most accurate approach to measurement of some recognized assets and liabilities may not be economically justifiable. Therefore, financial reporting standards may require or permit alternative measures that are less accurate, without sacrificing the objective of wealth measurement.
    • The needs of regulators, managers, or auditors are not directly germane to establishing financial reporting standards, except to the extent that their past and future actions cause the costs of producing information for investors to change.

If the Boards' goal for the conceptual framework project were the establishment of a rock solid foundation for high quality, investor-oriented accounting standards, then their approach would look something like my list — or perhaps one of your own making. We could have a lively discussion on some of the finer points, but what is being passed off as a "framework" for some yet-to-be-determined purpose is a far cry from what investors need and are entitled to. All the Boards have given investors thus far, and after seven years of conceited, quasi-academic deliberation, are a sleep-inducing list of lame excuses for the current sorry state of affairs – and a license to continue with business as usual.




  1. Reply Edith Orenstein October 4, 2010

    One of your most thought-provoking posts, and a lot of deep insight, as usual! Not saying I agree or disagree on ‘opinion’ stuff, but you raise very good questions and provide very good insights.
    Another leg to the stool to consider is auditability of the standards that will result from this framework – as noted in SAG discussion paper recently released in advance of Oct. 14-15 SAG meeting, particularly regarding increase in fair value and certain other estimates.

  2. Reply Steve October 4, 2010

    Hi Tom,
    I agree that the academics should be more involved in the standard setting. But I have no idea what they(professors & phds) are doing these days!
    Flipping through Accounting Review or Accounting Horizons or any other academic journals, I only see atricles full of math fomulas or statistical samplings, the exact oddity that Abe Briloff criticized many years ago.
    So I don’t think it is fair to say that the academics are “shoved to the side by standard setters”. Quite contrary, the academics choose to show off their math skills, instead of debating real accounting issues. They need to wake up to face the real world.

  3. Reply Tom Selling October 4, 2010

    Hi, Steve:
    I agree with your assessment for the most part, but there are plenty of active academics that are capable of joining the debate. The Accounting Establishment has made it clear that they are not welcome, unless they allow themselves to be placed in a controlled environment (like one Board member; or like the members of the FASB Research Initiative). I believe that The Academic Establishment shares some (though not the majority) of the blame.

  4. Reply Tom Selling October 4, 2010

    Hi, Edith:
    As you might imagine, I have rather strong views on how auditors should be involved with fair value measurements. Bottom line: that should be somebody else’s business.
    When I get the time, I’ll explain more in a post. Thanks for adding to the incentives for me to do that — and as always, for your encouraging words.

  5. Reply William Mister October 4, 2010

    The search for principles, as you know, harkens back to Payton and Littleton vs. Sanders, Hatfield & Moore. Then again, Moonitz’s ARS [Accounting Research Study] 1 & 3, versus Grady’s ARS 7. Dozens of other giants contributed to the debate. How many times will we turn the wheel and not go forward?
    Maybe if there was a vehicle for open discourse about the issues progress could be made – a relevant journal? I am probably showing my age in that blogs may be today’s source of open discourse and journals are irrelevant.

  6. Reply Michael Pakaluk October 14, 2010

    I find your comments interesting, and yet I think they miss the mark this time. I think the document is using the word “conceptual” in the sense of “general”, i.e. it is a framework intended generally for any accounting standard and does not itself directly guide practice.
    The document does not wish to state principles, but rather criteria which even principles must satisfy (insofar as principles are regarded as higher order rules), viz. they must be directed at the appropriate goals or objectives, and they need to have characteristics of relevance, faithful representation, etc.
    I really do think that the SEC’s “Study Pursuant to Section 108(d) of Sarbanes Oxley” is one of the best things written on this subject, and I find the new conceptual framework wholly in line with the recommendation there to speak of “objectives-oriented” standards rather than “principles-based”.

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