In my previous post, I committed to providing a statement of my own accounting principles with newer readers of this blog in mind. I am also adding a few observations about what the process of standard setting has come to be without guiding principles – i.e., standard setting at the FASB and IASB.
A Statement of Basic Accounting Principles
(I apologize for the dense formatting, but I couldn't figure out how to (or couldn't be bother) add spaces in lists with html commands.)
- The purpose of financial statements issued by public companies (hereinafter, reporting entity) should be consistent with the SEC's mission to protect investors.
The present holders of the common stock (i.e., using the FASB's terminology from a defunct proposal from five years ago, "basic ownership interests") of the reporting entity should be viewed as the primary users of financial statements. This view of common shareholder primacy has the following implications:
- Claims on reported wealth should be distinguished by non-owner claims (liabilities as defined in #6, below) and owner claims (owners' equity).
- Determination of what constitutes revenues, expenses, gains and losses is from the perspective of the common shareholders.
- The mission of investor protection is best accomplished when financial statements function as an external control over management. This role is sometimes referred to as "stewardship" – ensuring that the company's affairs are conducted for the benefit of the shareholders and within legal and ethical constraints.
- Usage of financial statements for valuation purposes is a subordinate consideration when determining accounting policies.
- This external control (or stewardship) view of financial reporting calls for providing shareholders with information that is relevant for assessing: (a) the amount of wealth under the control of the reporting entity and how it has been invested; (b) claims on wealth; and (c) a detailed summary of how wealth has changed over time. (However, and as discussed below in #8, it is assumed that users of financial statements understand that financial statements will not provide all of the information investors may desire for assessing these items.)
- 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. (A pragmatic justification for this principle is that it is generally taken as a given that the interests of others in the assets of the company (e.g., bondholders) are not sacrificed in any significant manner when common shareholders are viewed as the primary users of financial statements.)
- If the reporting entity "controls", "jointly controls" or can exercise "significant influence" over its counterparty to a contractual arrangement, the reporting entity should consolidate the counterparty on a proportionate basis. (Note: I accept the existing definitions in U.S. GAAP of "control," "joint control" and "significant influence."
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: (a) the reporting entity holds legal title to the resource; (b) the reporting entity holds the legal right (conditional or unconditional) to receive the resource; or (c) 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.
- A balance sheet may not violate the axioms of arithmetic (e.g., unlike measurements may not be summed).
- 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.
- Since all liabilities are assets of another entity, a liability is measured at the replacement cost of the corresponding asset.
- Comparisons of measurements at different points in time require adjustments for changes in price levels.
The income statement reports changes in assets and liabilities for a given period resulting from the following: (a) transactions between the reporting entity and persons that were not common shareholders (or were not acting in the capacity of common shareholders) during the period; and (b) other events that affect the measurement of assets and liabilities.
- The income statement should clearly delineate the effects on reported net income of operating and financing activities.
Providing information about wealth is costly. Financial reporting standards setters must weigh the aggregate costs to be incurred in producing information against the benefits of making the information available. 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, but 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.
The Effect of Standard Setting without a Statement of Principles
I cannot claim that application of these principles will automatically resolve every accounting policy question; however, I do claim that a comprehensive basis of accounting built on these principles – or making incremental changes to an established basis of accounting such as U.S. GAAP – would be much simpler, more transparent, consistent, and germane to the SEC's mission of investor protection.
In stark contrast, the FASB claims that its "conceptual framework" (note the absence of the term "principles") is supposed to serve as a guide to its mission to improve the quality of accounting standards. How has that been working out? IMHO, not very well at all.
If the FASB has no principles, then how do accounting issues get resolved? There is no simple answer to that question, but consider these facts:
- The members of the FASB, are appointed by the Financial Accounting Foundation (FAF) whose members in turn have strong ties with the reporting entities that the FASB is supposed to regulate through the promulgation of accounting standards. These ties can be direct, or indirect through the larger CPA firms with membership on the FAF's board of trustees.
- Board members often receive a salary that is significantly (2 – 3 times?) higher than what they were earning prior to becoming board members. (This was not always the case, by the way.) They are appointed for an initial term of five years, with the possibility of re-appointment by the FAF for a second term.
Given no principles to serve as constraints and the pecuniary value of FASB membership, the process of promulgating a new major accounting standard (e.g., leases, revenue recognition, or loan impairment) has come to look like a public infrastructure project in southern Italy: it goes on for decades, and the prospect of an outcome in the public interest is highly uncertain. Moreover, like the Italian construction workers, it can be argued that Board members take care to preserve their employment at above-market salaries; and like organized crime in Italy, the reporting entities want a big piece of the action – and they get that in exchange for "protection" of the Board and its members. Just to be sure, each FASB member is carefully chosen by a board composed largely of the representatives of the reporting entities and its friends (i.e., the FAF) so as to maximize the likelihood that they will 'play along.'
Don't shoot me! All I am doing is interpreting long-established and recognized economic rationale of "regulatory capture"; and I'm not the first academic accountant to do it. In 1991, Lawrence Revsine observed in an article published in Accounting Horizons (which I wrote about here), that, even though accounting is intended to protect investors, "…managers gradually learned that while events that affect performance often cannot be controlled, the way that people perceive these events can be controlled by distorting economic reality." To be sure, misrepresentations to benefit the regulatees cannot be too comprehensive lest a complete loss in the credibility of financial reporting should occur; hence, the importance of being "selective."
With respect to specific process of regulatory capture of standard setters, Revsine wrote:
"While it regrettably conjures a pejorative image, the phrase "regulatory capture" is not intended to impugn the integrity of standard setters. Instead, the point is that everyone is influenced by their background and becomes comfortable with familiar perspectives and experiences. This is inevitable and natural. Unfortunately, in the regulatory sphere, it is also antithetical to the intended purpose of regulation."
In other words, Revsine would not state in 1991 that standard setters were actually conscious of being captured. But now, more than 20 years later, I wonder if Revsine would continue to be as kind.
I would hope that Revsine would be more pointedly criticial of the FASB, for whatever the culture of the FASB 20 years ago, it is self-evident that regulatory capture of the FASB has devolved to a much more virulent form, and to a point where moneyed interests run roughshod over investor protection.