Debate over FASB’s Conceptual Framework Ignores Owners and Managers

By Eugene H. Flegm

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In 1976, FASB published three documents for discussion: “Tentative Conclusions on Objectives of Financial Statements of Business Enterprises”; “Scope and Implications of the Conceptual Framework Project FASB Discussion Memorandum”; and “Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and their Measurement.” Although the nature of the proposals was downplayed as not being revolutionary, many people thought otherwise, notably Robert K. Mautz, who taught at the University of Illinois for 25 years before joining Ernst & Ernst. Mautz tried to rally the business world to what he termed a revolution in accounting, in which the income statement would no longer be the focus of financial reporting and the matching of costs and revenues concept would be phased out as the balance sheet became the basis for determining income. Business heeded Mautz’s warning, and the FEI and the Business Roundtable took positions opposing the radical changes that it seemed were planned to implement a valuation approach to the determination of income. FASB denied any such intent; one board member even told me in the 1980s that I would not see the change to current value and the use of comparing balance sheets to determine income in my lifetime. (Obviously he did not believe I would live as long as I have, for that is exactly what is being proposed in FASB’s latest edition of “Preliminary Views on the Conceptual Framework for Financial Reporting.”) This is not just my opinion. Ken Lever, chairman of the 100 Group Financial Reporting Committee, stated in his September 21, 2006, report to the U.K. Accounting Standards Board, that “[m]uch of what is contained in the Conceptual Framework may be setting the scene for ‘income’ to be based on the difference between two balance sheets and measurement to be based on fair value.”

Lever’s comment reminded me of a debate that I attended in 1976 at the annual meeting of the American Accounting Association. The debaters were Sandy Burton, then chief accountant of the SEC, and Robert Sprouse, then vice chairman of FASB. The subject, of course, was the new conceptual framework proposal. During the debate, Sprouse stated, “There could be no question that from a ‘pure theory’ view the net income of a company was the difference between the period beginning and ending balance sheets, using an appropriate discount rate. Unfortunately [he admitted], we have trouble determining the appropriate rate.” The words were barely out of his mouth when Burton snapped, “I cannot agree with that position.”

FASB’s Deaf Ear to Users

That the debate continues 30 years later is, I believe, because FASB has turned a deaf ear to the real users of financial data on a day-to-day basis—that is, the owners and managers of a company who use the accounting data for controlling the operations of the company, for protecting the assets, for evaluating employees and granting pay raises or bonuses, for judging the success of a new product or advertising program, and so on. One board member made FASB’s position clear to me when he told me that no one in business should be involved in setting accounting standards because we were the “foxes in the henhouse.”

The irony of this position is that FASB itself has become the fox in the henhouse with its highly subjective value-based standards, such as SFASs 133 (derivatives), 142 (goodwill), and 144 (impairment). Such subjective standards invite manipulation by unscrupulous managers; one could even argue that in the case of the Enron disaster, FASB and the SEC abetted the Enron managers in manipulating the books. Board and staff members of FASB have told me that FASB has no responsibility for how the standards are applied, a position that is no more tenable today than it would have been in l934 when the SEC was formed. The problem then and now was standards (or lack of such) that enable unscrupulous managers to manipulate their earnings. In 1934, the thrust of the law was to reduce, if not eliminate, accounting alternatives and the subjectivity of accounting. FASB’s move to fair value turns this view upside down. We now have the situation where a company whose credit rating is dropping can “earn profits” on its derivatives.

Oddly enough, FASB has ignored modifying SFAS 2 (R&D), under which all expenditures are expensed immediately. Companies spend billions of dollars on R&D. However, unless the managers are stupid, there must be some future value derived from the expenditures. Of course, the difficulty involved in determining that future value led to the very conservative position (once a basic tenet of accountants) of writing off the expenditures in the year made. If someday FASB decides to change this position (which is inevitable if FASB is true to its conceptual framework), we will then have another marvelous “sandbox” for the unscrupulous manager.

FASB has abandoned the users who use accounting to run their businesses on a day-to-day basis. The “Preliminary Views” makes this clear in paragraphs S2, S3, and S4, which refer only to potential investors and creditors while ignoring the real users—owners and managers. In paragraph S12, FASB mentions the need for comparability and consistency, something that is not achievable when each manager makes his own value judgments, particularly under the guidelines set forth under reliability level three in SFAS 157. Paragraph OB27 refers to the stewardship duties of nonowners concerning specifically protecting the company’s economic resources, but it never refers to the need for standards that are not subject to manipulation. Paragraph BC1.10 states that FASB decided to focus on a wide range of users, but fails to include the real users—the owners or managers. FASB comments on the perspective of management in paragraph BC1.42, stating that “management has the ability to obtain whatever information it needs,” and thus apparently management’s needs can be ignored by FASB.

It is correct that management can obtain whatever information it needs, but under the proposed conceptual framework it will have to keep a third set of books to do it. Most companies currently have two sets: one for operations and financial reporting, and another for the company’s income tax return. If FASB persists in moving to the determination of income through two balance sheets on a value-based system, every company will have to retain its historical-cost–based system to keep control of its day-to-day operations. Furthermore, while there are about 15,000 public companies, there are millions of private companies. Public companies will have to adopt a value-based system for reporting, but I would expect the majority of private companies to stay with historical-cost GAAP and ignore FASB standards that have nothing to do with operations per se. If a private company wants an audited report, it should be permitted to take a qualification for standards that do not apply.

What is GAAP?

The varying standards for public and private companies brings up another problem: GAAP—what is it? I am sure that when most non-accountants encounter the term they conceive of it as a codified set of rules much like the Internal Revenue Code. Although FASB has worked diligently at codifying accounting concepts, a large body of literature (textbooks, journal articles, etc.) still exists that is an informal part of GAAP. A lawyer once asked me to bring a complete set of GAAP with me to a meeting so we could refer to it during our discussion. He was surprised that the book was so small (this was in the l970s), until I explained that much of accounting thought had developed the way that case law developed. Unfortunately, lawyers have continued to make reference to GAAP in legal agreements as though it was a complete set of accounting rules. If FASB finally changes the accounting basis for financial reporting from historic cost to fair value, will it be GAAP? I don’t think so. The basis of accounting for transactions will, of necessity, still be cost. All companies, both public and private, will have to continue to keep the books of account on a cost basis in order to maintain the necessary control of operations. If fair value has to be applied, it will be at the very top of the company’s accounting departments. Should we call it generally accepted fair-value reporting?

Another reason for continuing to keep books of accounts on a cost basis is the Sarbanes-Oxley Act. Paradoxically, at the same time that FASB was abandoning the control aspect of accounting standards, Congress was passing a law that holds management criminally responsible for keeping accurate books and records.

The proposals contained in the Preliminary Views, if implemented, will complete the revolution started more than 30 years ago. I only hope that they do not lead to more and bigger Enrons.

Editors’ Note: This article was adopted from a letter sent by Flegm to FASB in October 2006 .