Re-introducing Principles to Financial Accounting

A long time ago —  in 2004, to be exact — the FASB and IASB announced that they would jointly develop a common “conceptual framework.” They divided the work into eight phases.  It took them almost seven years to complete the first phase.

For the FASB’s part, the completion of the first phase resulted in the bootstrapping of Statement of Financial Accounting Concepts No. 8 with two chapters: Chapter 1, The Objective of General Purpose Financial Reporting; and Chapter 3, Qualitative Characteristics of Useful Financial Information.  The plan is that CON 8 will eventually be populated with the FASB’s complete conceptual framework.

In the wake of the protracted and failed attempt to converge U.S. GAAP and IFRS, the boards decided to go their separate ways on conceptual framework revisions around 2012.  Now, fully 13 years into their work and seven years after the completion of Phase 1, the FASB is getting ready to publish one more Chapter to CON 8: Chapter 7, Presentation.   It issued the exposure draft over a year ago, and the comment period expired last November.  The FASB’s website still indicates that the board continues deliberations on the ED — as opposed to developing the much more substantive topics of recognition and measurement, which the board is just now beginning to address.

To be fair, re-deliberations of an ED could take awhile depending on the volume of the comment letters and the variety of issues raised.  But that can’t possibly explain the delays here, because the ED drew only 17 comment letters – only two of which were from financial statement users.  Twelve were from CPA-based entities and issuers, and three were from academics.

I have written about the inherent flaws in the FASB’s so-called ‘due process’ a few times already.  Here, I explained why the FASB shouldn’t be counting on broad-based and/or well-reasoned reactions from users to an ED.   It would appear that this project is a supportive case study.

What the FASB should be doing, I wrote here, would be more fittingly described as “due diligence” instead of due process.  Due diligence has its origins in the Securities Act of 1933, and has spread to many other applications. I think most would agree that it connotes comprehensiveness, rigor and reason.

As for why the yawns from users on this particular ED, I think it likely that those who might consider taking the time to write a comment letter understand that, in addition to all other reasons why they wouldn’t write, the FASB is (pardon the expression) looking at the wrong end of the horse for this project.  A comprehensive basis of accounting should set forth important concepts, but they must be based on principles. Here, I wrote that the FASB is wont to avoid adopting principles, because they will surely reduce standards-writing flexibility.  Any sort of commitment to act in a certain way would make it less likely to find feasible middle grounds among competing “stakeholder” positions.

Concepts, on the other hand are not — or at least are far less — binding on the FASB.  For example, the FASB could identify ‘relevance’ as a concept — or first as a principle, and then a concept.  As a principle, it would commit the FASB to continually strive for greater relevance of financial statements, subject only to cost/benefit considerations.  Relevance as a concept absent a principle, on the other hand, merely states what it affect it would have on users – if it were present. (The distinction recalls for me the TV spot where a solemn guy in a white coat proclaims to the patient, “I’m not a dentist, I’m a dental monitor. You have a cavity.”)

We have arrived at a point in the history of U.S. Generally Accepted Accounting Principles where “principles” have faded into near total disuse. Other than in reference to GAAP itself, I cannot find a single occurrence of “principle” in the new SFAC No. 8 or the ED for its Chapter 7.  Instead, core components of a framework are finessed with pliable concepts like “primary user group”, “general purpose financial statements,” “relevance” and “representational faithfulness.”   (Again, to be fair, the Board made a small improvement when it demoted “reliability” and promoted “representational faithfulness,”  Although I am unable to think of any practical difference between “representational faithfulness” and ‘truthfulness’ — or how the juxtaposition of terms has had any effect on standard setting.)

S-OFA Will Start at the Beginning

As is often the case lately, I provide observations like these in order to share with you my plans for how Shareholder-Oriented Financial Accounting will be different than U.S. GAAP or IFRS.  S-OFA will begin by setting forth the principles to which accounting standards must hew.  A relevance principle, like the one I alluded to above, will be paired with a principle that I am calling (for now) the “Face Validity Principle.”

“Face validity” is a term borrowed from the behavioral sciences, where it is also sometimes referred to as ‘logical validity.’  The definition from the Dictionary of Behavioral Science (Van Nostrand Reinhold, 1973) on my bookshelf since graduate student daze, defines it as, “The extent to which a test seems to measure the variable to be tested because of its similarity to the criterion measure.” [italics supplied]

From this, I propose the following statement of the “Face Validity Principle”:

Amounts in financial statements should be seen to be based on measurements made in good faith of attributes of recognized assets or equities as of a given date.

There is nothing like the Face Validity Principle at the FASB or the IFRS. For if there were, then, among many other examples, the last three major projects — leasing, revenue recognition, loan impairment — could not have been permitted to see the light of day.  More generally, the principle commits a basis of accounting to the following:

• A number in a financial statement must be related to a specific attribute of an asset. In contrast, the list of financial statement numbers in GAAP and IFRS that can only be described by a calculation is long, and growing.
• Measurements based on historic cost would fail both a relevance and a face validity principle. Historic cost is an attribute of a past event, not of the asset itself.  Perhaps this analogy resonates for you: the birthweight of a 30-year old person, is an attribute of an event that occurred 30 years ago; it is no longer an attribute of the 30-year old person.
• Basic rules of logic are sacrosanct. For example, S-OFA will not permit addition of unlike attributes on a balance sheet – i.e., committing the mathematical sin of adding apples and oranges.  Similarly, and as I explained recently here with respect to revenue recognition and the income statement, S-OFA won’t permit a financial statement to be based on an equation that is overdetermined.

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Again, to be fair, the FASB has barely begun to deliberate the most substantive framework topics, recognition and measurement.   That may explain some of the inattention of financial statement users to the latest ED.  But, it doesn’t explain why the FASB has been procrastinating for so long on, by far, the most critical conceptual issues.

More important, though, is that a face validity principle doesn’t seem to be asking for much.  Yet the FASB won’t be able to explain why, for U.S. GAAP, it has become too much to ask for.