After years of trying to work with the FASB on a revised conceptual framework, the IASB finally decided to abandon the goal of a fully converged framework and to finish a document for its own use. A draft is imminent, and on June 29th, IASB Chair Hans Hoogervorst’s spoke to a conference in Paris about his board’s thinking on key decisions — in particular, the status of historic cost and current value measurements.
Let’s just say for now that I don’t think very much of Mr. Hoogervorst’s speech. To get started, we should step back and consider why the IASB and FASB have conceptual frameworks, and projects to revise them.
Why a Conceptual Framework
When done right, a conceptual framework is an important component of a comprehensive basis of accounting. It should express the commitment of standard setters to hew to broadly accepted principles when developing guidance on the accounting for specific transactions and events. For example, the mere existence of a conceptual framework should discourage moneyed special interests from sticking their noses where they don’t belong. And, individual standard setters will come and go, but everyone should be reading from the same bible when trying to figure out what to do next.
A well-reasoned conceptual framework should also be the first source of issuer guidance if they are called upon to fill the gaps in GAAP. It is axiomatic that any authoritative set of rules, no matter how detailed, could not possibly address every transaction, particularly those new transaction structures that “financial engineers” are wont to dream up — often without any other valid business purpose except for producing particular accounting numbers. In a similar vein, a conceptual framework should defend the general public against “industry practices” that conflict with the concepts enunciated in the conceptual framework.
That is the theoretical justification for a conceptual framework in a nutshell. In practice, however, it doesn’t work that way. Not even close.
The biggest reason why the FASB and IASB’s conceptual frameworks don’t work as purportedly intended is that they are both giant sacks of mush. Pressure from those aforementioned moneyed interests while the frameworks were under development ensured that they shouldn’t restrict the boards from doing pretty much anything they wanted.
For example, the definition of an “asset” is like a Costco: it is spacious enough to hold practically anything. Every FASB member, past and present, is acutely aware that the concept of a liability is deeply flawed, but politically it has been easier to keep kicking that can down the road. For guidance on the measurement and reporting of net income, the conceptual framework is like the Wild West.
We can all recite the litany of problems that have occurred despite the existence of a conceptual framework, and can precisely identify who has benefitted while most everyone else has lost: treating stock options granted to employees as if there is no cost to shareholders; not recognizing the implications on pension plans (private and governmental) when assets fail to grow as hoped; or misrepresenting the economics of banks and the loans they make. Trust me, I can think of many more examples.
And as for filling those gaps in GAAP, the conceptual framework is more like chopped liver than glue; it’s merely one of a laundry list of unranked “nonauthoritative” sources that any issuer could invoke without regard to its authorship (see ASC 105-10-05-3).
Hans Hoogervorst’s Hokum
On the one hand, I don’t want to single out the IASB for being particularly miserable in this regard, because the FASB is in a similar situation and is doing just as badly about fixing their problems. But, Mr. Hoogervorst’s speech is the most timely example of a standards setter that is continuing the grand tradition of mush for concepts. The only real development is that from time to time it becomes necessary to modernize the humongous warehouse of bogus rationales to be cited — much as the devil will quote scripture when it suits her — when the European bankers decide to call the tune.
Time and space prevents me from taking apart Mr. Hoogervorst’s speech as much as I would like to. I going to limit my specific criticisms to this excerpt from early in the speech:
“In our Conceptual Framework, we have divided the host of measurement techniques we use in accounting into two basic categories: historical cost on the one hand and current value on the other. Within the current value category, it is fair value accounting that generates most controversy.
So what are the facts? Fair value and historical cost are at the opposite ends of the measurement spectrum, with fair value demanding a full updating of all variables, while historical cost requires only partial and less regular updating.” [underlining supplied]
Fair value as straw man — Fair value (i.e., exit prices) as an accounting concept has many flaws. Three in particular are: (1) profits on manufactured inventory would be recognized before a sale actually takes place; (2) costs of acquiring a financial asset* must be expensed instead of capitalized; and (3) is the problem of illiquid markets. With respect to (3), some assets (financial and non-financial) have economic value despite the fact that they are unsellable during economic downturns or periods of high uncertainty.
Other valuation concepts do not share these limitations. Yet Mr. Hoogervorst has declined to explain why fair value is the scapegoat that taints all concepts of current value. In particular, measuring an asset’s current cost of replacement (as opposed to its cash value in a hypothetical sale) is free from the aforementioned flaws.
Puffing up historic cost — Did you know that an historic cost can be “updated”? What a wonderful non sequitur! Perhaps Lady Macbeth was mistaken when she declared, “What’s done is done.”
A historic cost refers to a cost that was incurred in the past. When an asset originally measured at its historic cost is adjusted, it is not an exercise in updating a valuation, but merely an exercise in subsequent allocation. Using Mr. Hoogervorst’s own example of PP&E less accumulated depreciation, the net carrying amount on the balance sheet of the PP&E looks like a “value” only to a complete moron. The carrying amount of PP&E under the historic convention can only be accurately described by the way it was calculated: the portion of “cost” that has not yet been allocated elsewhere. If Shakespeare had written his play today about accounting instead of murder and power, Lady Macbeth’s line might have been, “it is what it is.” Anything more or less than that about historic cost numbers on the balance sheet is mere puffery.
Even proponents of historic cost conventions at least as far back as Paton and Littleton in 1940 (although Paton at least favored current values over historic costs), recognized that a historic cost balance sheet is not a statement about values. The primary focus of historic cost is on (simplistic) reporting of earnings; and its informativeness depends solely on whether one can regard the one allocation technique adopted by management from among an infinite number of possibilities to be a reasonable depiction of subsequent economic events.
To summarize, allocation and valuation are two completely different accounting concepts. To clinch the idea, I would ask Mr. Hoogervorst this: in his own example, what does the carrying amount of PP&E reported on an historic cost basis have to say about the PP&E itself? Answer: absolutely nothing. And to add insult to injury, the carrying amount under IFRS (and U.S. GAAP) could be higher than a genuine approach to valuation.
Made-up Numbers — It’s depressing enough that the chair of the IASB does not comprehend that comparing historic costs to current values is much like comparing a Diet 7-Up to a Riesling. Yes, my dear, they are both liquids and they both taste sweet. So what?
Yet, it does get worse.
Mr. Hoogervorst’s depicts the range of measurement choices by “anchoring” historic cost at one end of a “spectrum” (I already explained that historic cost is not really measurement), and lumping all manner of current value measures on the other end.
But, what constitutes the middle of the spectrum Mr. Hoogervorst refers to only in passing. That’s because there is only one way to describe these ersatz bases of accounting: they produce made-up numbers, devoid of any meaning beyond the rules that were applied to produce them. The very worst examples of IFRS (and U.S. GAAP) rules are these made-up numbers. That’s because the very worst of IASB (and FASB) standards lie in the truly vast middle of Mr. Hoogervorst’s spectrum.
One could at least hope, if not expect, that a conceptual framework would not comprehend, or it might even repudiate, the production of made-up numbers; but that is clearly not the IASB’s plan. And, the conceptual framework project notwithstanding, it’s not like the IASB plans to clean up their act anytime soon. Even as I write this, they are enthusiastically peddling some very important made-up numbers:
Loan impairment—Masquerading as an application of historic cost, bankers are allowed to make their own estimate of future loan losses and to discount the resulting “expected cash flows” (not the term I would choose) at the loan’s original yield to maturity — yielding a cipher that is wholly incomprehensible starting the moment after a loan is originated.
Leasing—The leasing standard in process is so convoluted that no label — most certainly not “right of use asset” — can come close to describing the dog food inside that can. For anything but the simplest of lease contracts, nothing about the reported number reflects the cost to acquire the asset, much less its current value.
Revenue recognition—This is a complex area, but suffice it to say that measures of contract assets, deferred costs and liabilities have been jiggered to get the ‘right’ number for revenue on the income statement, i.e., the measure that a sufficient number of issuers will at least tolerate and willingly change their accounting systems for hardly any good reason.
To be sure, I am against applying a historic cost approach to any asset. Notwithstanding, I do recognize the existence of numerous carefully reasoned arguments in support of historic costs. There are even reasoned justifications for a system that mixes historic costs with current values.
But, I don’t count Mr. Hoogervorst’s speech among them. Moreover, there are can be no good reasons other than political expediency for just making up numbers and slapping them next to captions, which is what the IASB and FASB have lately become addicted to.
I dread the publication of the IASB’s Conceptual Framework. It will be anything but. Accounting students will be misled, and the moneyed special interests will keep us on the road to another financial crisis.
*Much of what I say about assets applies to liabilities. This is because a liability of one entity is, by definition, an asset of its counterparty.
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