I hoped that my previous post would make a compelling argument for why a more focused objective for the FASB could lead to standards that would better serve the public interest. Some readers liked it; however, two former policy makers were not persuaded. Both felt that my criticisms of the FASB’s (and by extension, IASB’s) statements about “general purpose financial reporting” was not warranted. One of them opined that failure to hew to the conceptual definitions of “assets” and “liabilities” was more of a problem. The other stated that he could barely make sense of what I had written!
Accordingly, one of the objectives of this post is to restate more clearly the views expressed in my previous post. I have one other related objective, which I’ll say more about later.
The Three (Shaky) Pillars of the FASB’s Conceptual Framework
The foundational features of the conceptual framework are: (1) the objectives of “general purpose financial reporting”; (2) the definition of an “asset”; and (3) the definition of a “liability.”
As to the description of general purpose financial reporting, CON 8 states that the objective is to provide “existing and potential investors, lenders, and other creditors … information to help them assess the prospects for future net cash inflows to an entity.” (¶¶ OB 2 – 11)
As a statement of modern financial theory, this is irrefutable. But as a basis for making improvements to GAAP, it has not worked well at all. It has turned out that from such a broad statement of objectives a great deal of subjectivity and political maneuvering is reflected in practically all of the majority standards the FASB has produced.
It could be argued that appropriate definitions of “assets” and “liabilities” should function as a constraint on financial statement recognition and measurement, but the extant definitions have clearly failed to serve that purpose. Perhaps that is because the definitions are themselves too broad, or that the overarching objective of “general purpose financial reporting” trumps them when the political pressure is too great for even well-meaning board members to withstand.
As evidence of my concern, these are just a few of the changes to accounting standards that have been justified as progress toward the great cause of “general purpose financial reporting”:
- Foreign currency translation — my favorite example from many for producing arbitrary amounts in financial statements. Even cash could be screwed up by this standard, and it was the beginning of the quagmire that has come to be known as “other comprehensive income.”
- Impairment of long-lived assets
- Consolidation rules that recognize liabilities that the parent company doesn’t owe
- The needlessly complex rules for distinguishing liabilities from equities.
- And most recently:
Just these few examples among many others conclusively show that the objective of “general purpose financial reporting” has worked like a big box with tall sides. Practically anything one might want to fit in the box will fit when accompanied by the right “basis for conclusions.” It matters little how irregularly shaped the thing that goes in the box may be, or unlike the other stuff already in the box.
I believe that there is a better way to state the objective of the FASB’s standard setting. The FASB’s conceptual framework must state in specific terms what may — and may not — be reported on the face of financial statements. I must concede that I have been struggling with the composition of such a statement. But just recently, I found one that I like a lot:
Financial statements should help a financial analyst evaluate the entity’s portfolio of net assets and the changes in that portfolio.
The above is my adaption of a statement in a 1992 article in Accounting Horizons by Harold Bierman.* These are the reasons why it works for me:
- The objective of accounting is not directly about valuing the entity as a whole. It is about reporting selected assets and liabilities. Therefore, it is not necessary for the balance sheet to list all assets/liabilities of an entity. It could reasonably omit some (e.g., certain executory contracts, contingent assets/liabilities, intangible assets), and still produce relevant information for analysts.
- Similarly, this more specific objective that I would adopt is thwarted by reporting items as assets or liabilities that are not economic assets/liabilities of the entity (e.g., costs per se, or deferred losses/gains).
- The only relevant basis of measurement for the assets and liabilities that are recognized can be current value. Comparative amounts must presented in constant units of purchasing power.
- The objective is congruent with broader analytical objectives, including the FASB’s cash flow prediction objective and the “stewardship” objective of evaluating management’s performance. By “congruent,” I mean that it produces relevant information in support of them, and nothing about would thwart them.
That Other Thing
I am in good health and hope to live for a long time. But, perhaps as a result of writing this blog since 2007, I have eventually come to realize that I will not be able to go in peace unless I produce a new comprehensive basis of accounting that comports with my vision for a simpler, more logical and more understandable way to produce an accounting for a public entity. A major feature will be that, while U.S. GAAP runs to 8,000 pages, my document could be only 80 pages.
Without going into the detail at this time, these are some of the topics that you won’t see in my “GAAP”, because they won’t be needed:
- Asset impairment.
- Inventory cost flow assumptions.
- Other comprehensive income.
- Deferred taxes.
- Non-controlling interest (although I haven’t yet decided what to do with “goodwill”).
- Special foreign currency translation or hedge accounting rules.
- Multiple measurement objectives for assets and liabilities.
- The equity method of accounting for investments.
- Revenue recognition.
- Highly complex rules for distinguishing between liabilities and equities.
That ought to take care of a few thousand pages, at least. But I will also offer some significant additions. These are some of them:
- The core of note disclosures will be detailed reconciliations of beginning and ending balance sheet amounts, and lots of other tabular information. Except for a required MD&A, narratives will be kept to a minimum.
- Expenses will be presented by source and by function.
- Proportionate consolidation will be the predominant form of accounting for significant intercorporate equity investments.
- Comparative information and flows of assets/liabilities will be adjusted for changes in general price levels through the most recent balance sheet date.
Target date for a reasonably complete first draft: December 31, 2017.
*“Proportionate Consolidation and Financial Analysis,” Accounting Horizons, December 1992, pp. 5 – 17. Incidentally, Hal was my teacher while at Cornell (MBA ’77). A great many of his classes about accounting and finance were formative and indelible. I cannot fully express how fortunate I feel to have been one of his students.