Peeling away financial reporting issues one layer at a time

Why the FASB Won’t Define “Financial Accounting”*

The FASB has been prolific by any measure. The codification of authoritative GAAP alone is almost 8,000 pages for goodness sake. Believe it or not, that’s about twice as wordy as the U.S. Tax Code.

“Financial Accounting” versus “Financial Reporting”

There are many explanations for why U.S. GAAP is so detailed. One that doesn’t attract much attention is the Financial Accounting Standard Board’s claim that it has a role in capital market regulation that extends beyond “financial accounting” — as its name unequivocally states — to “general purpose financial reporting”:

“The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.” [¶ OB2]

I omit the ensuing eight elaborative paragraphs in CON 8, because they do little except to state the obvious: to wit, finance and investing is about future cash flows, valuation, return on investment and uncertainty. Consequently, they do nothing to alter the initial impression from ¶ OB2 that the term “general purpose financial reporting” is like big box with tall sides. Practically anything the FASB wants to put into it will fit.

And never mind that the owner of that big box is actually the SEC. It’s Codification of Financial Reporting Policies has long provided that it looks to the FASB to establish “accounting principles.” (It would be helpful to recall that the predecessor body to the FASB was the Accounting Principles Board.)  The clear implication is that “financial accounting,” however defined, is regarded by the SEC as a subset of its larger “financial reporting” mission.

But, for reasons that I’ll explain later, the FASB throughout its 42-year history has avoided defining “financial accounting” (or “accounting principles”) – i.e., where that subset of financial reporting it is responsible for begins and ends.

If it were to define “financial accounting,” methinks that, unless the FASB were to upend centuries of thinking and practice, the definition would have to look something like this:

“Financial accounting” is an information service for assisting shareholders of public companies in evaluating the performance of an entity for a given period of time. Accordingly, it is primarily concerned with the production of financial statements and accompanying notes that, at an appropriate level of detail, report the following: (1) assets and liabilities of an entity as of the beginning of the period; (2) comparable information as of the end of the period; and (3) information about the flows of assets and liabilities that took place during the period.

It’s pretty obvious that there is a big disconnect with that traditional view of financial accounting and the FASB’s “general purpose financial reporting.”  And it is not hard to find other writers, who like myself, believe that the FASB has lost its way:

Baruch Lev and Feng Gu, The End of Accounting: and the Path Forward for Investors and Managers

Karthik Ramanna, Political Standards: Corporate Interest, Ideology, and Leadershipo in the Shaping of Accounting Rules for the Market Economy

David Mosso, Early Warning and Quick Response: Accounting in the Twenty-First Century

Walter Schuetze, Mark-to-Market Accounting: “True North” in Financial Reporting

Perhaps not all, but some of these authors strongly signal their belief that U.S. GAAP is the worse for wear because the FASB has strayed outside of the bounds of financial accounting.  It would certainly include the last two authors, Messrs Mosso and Schuetze, who incidentally are former FASB members themselves.

Why the Words Matter

Below are a few areas of the clash between “general purpose financial reporting” and “financial accounting.”

The goal of financial accounting is not valuation —It is limited to providing current measurements of present rights and obligations. Having said that, it is not an accident that analysts use a good deal of what is reported in financial statements in their forecasting/valuation/decision models, but it shouldn’t be the primary objective of accounting.

The primary objective of financial accounting in the capital markets should be to provide information to investors about the past performance of the reporting entity and its management as stewards of the company’s assets. For this, it also logically follows that management should have as little as possible to do with the preparation of the financial statements.  Just as a professor wouldn’t permit students to grade their own exam papers, management shouldn’t be making the judgments that directly feed back into their own compensation.

When management believes that financial statements do not provide a complete picture of financial performance, changes in resources and liquidity, they are invariable correct. Consequently, shareholders should also have some opportunity to see the company through the eyes of management. But, that’s not a financial accounting consideration.  It is appropriately a consideration for the SEC, which they have largely dealt with by their MD&A disclosure rules (and extensive interpretive guidance).

IMHO, if we had more financial accounting and less “general purpose financial reporting,” analysts who care to estimate share value would find the information in financial statements and notes even more relevant than what is being reported today.

Limited scope — Financial accounting, like any other information system is not comprehensive. It does not report every asset (liabilities are nothing more or less than assets of another entity).

I would argue that the line between the assets to recognize in the financial statements and everything else should be drawn conservatively.  Accordingly, we should limit assets to present legal rights. That would include much of what GAAP currently recognizes; but it would exclude contingencies, such as deferred taxes, and rights/obligations that are subject to legitimate legal disputes.  Again, this information is in the SEC’s bailiwick, not the FASB’s.

Comprehensible — The foregoing definition of “financial accounting” clearly indicates a balance sheet focus, which is consistent with the uses of accounting through the ages. For an excellent historic perspective, see Jacob Soll’s acclaimed Financial Accountability and the Rise and Fall of Nations.

Given a balance sheet focus, to which the FASB pays lip service only, measurement of assets should be an attempt to capture their economic utility to the reporting entity. Unfortunately, this is not the way the FASB wrote U.S. GAAP. Over the decades, it has salted financial statements with random numbers subject to arbitrary and capricious recognition and measurement protocols.

To take just one example, assess the capital adequacy of any one of the large U.S. banks from its balance sheet. Current capitalization ratios are on the order of 5%, which means that a 1% error in there reported amounts for assets could wipe out 20% of the equity in these banks.  Do you trust these numbers enough to base the safety and soundness of the U.S. economy on them? I wouldn’t think so.

* * * * * *

Everyone save the cynic must see financial accounting as a subset of the SEC’s broader financial reporting mandate. As such, ether the FASB or SEC should be expected to write a carefully-crafted statement that delineates the FASB’s role.  The absence of a definition of “financial accounting” in the FASB’s voluminous literature or in the SEC Codification of Financial Reporting is at minimum a curiosity, if not an astonishment.

Hardened cynics, however, are far from astonished. They are reconciled to the fact that even though traditional “financial accounting” standards is what the FASB should produce to best serve the public interest, that would ill serve powerful special interests.

To this latter “constituency,” the FASB kowtows so as to be assured of its continuing existence. It must have sufficient degrees of freedom so as to deliver the goods when called upon to do so, or as has been threatened on occasion, to be squashed like a bug if it doesn’t deliver.

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*In memoriam, Ray G. Stephens (1943 – 2016). My dissertation adviser, supporter, master teacher at all levels, credit to academia and the profession, and great friend.

2 Comments

  1. Reply James Noel November 7, 2016

    Firms need both capital, and distribution of capital. I think financial accounting needs to be designed to be adequate for debt holders to make evaluation and covenants, and provide restrictions (through the definition of income and dividends as set forth in the incorporation) on distributions. While one could call this in the interest of shareholders, I think explicit consideration of debt holder needs (esp. long term) should be part of the purpose of financial accounting.

  2. Reply Kenneth Ashe December 28, 2016

    I agree that more financial accounting would be beneficial. More and more companies are reporting and talking to “non-GAAP” measures. This makes to hard to focus on the underlying financials.

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