Building the Foundations of Financial Reporting: The Conceptual Framework

By Richard Gore and Dyan Zimmerman

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The Conceptual Framework makes standards setting more efficient by providing a common set of terms and premises for analyzing accounting issues. Each time a debate on an accounting issue arises, it isn’t necessary to reinvent the wheel. FASB and the IASB expect a common Conceptual Framework to promote the convergence of U.S. GAAP and International Financial Reporting Standards (IFRS), ultimately leading to a single set of high-quality global accounting standards. Additional information regarding the joint conceptual framework project can be found at www.fasb.org and www.iasb.org.

The project to revise the Conceptual Framework will involve the examination of the foundations of financial reporting and, indeed, accounting itself. In essence, every accounting concept and principle which financial reporting rests upon will be reexamined and either reaffirmed, revised, or discarded. This project will have far-reaching implications and will influence the direction of financial reporting for years to come. For example, the current Conceptual Framework originally defined the notion of comprehensive income 17 years before the term was made operational with the issuance of Statement of Financial Accounting Standards (SFAS) 130, Comprehensive Income. Over time, GAAP may be completely rebuilt. In addition, there is the very real possibility that the new Conceptual Framework will become, as suggested by the SEC, part of the authoritative literature, and thus have a direct impact on financial reports. The question facing FASB, the IASB, and the entire accounting profession is: What should be the unified theory of accounting on which financial reporting will be built?

Why Revise the Conceptual Framework?

The existing Conceptual Framework was written by FASB in the 1970s and 1980s. When issued, it represented a significant advancement of accounting thought and provided a basis for the transformation of financial reporting standards through the adoption of the asset-liability view. The asset-liability view represented a departure from the traditional view that accounting should focus on the measurement of income through the matching of costs with revenues. In contrast, the asset-liability view focuses on defining and measuring assets and liabilities, determining income via changes in these balance sheet accounts. The asset-liability view is based on the logic that it is necessary to define and measure the beginning and end points (the balance sheet) of a transition before measuring the transition (the income statement) itself.

Standards setters, including FASB, have long preferred the asset-liability view of accounting because the focus on income measurement proved to be inconsistent with the development of principles-based accounting standards. The inherent subjectivity of determining when revenue is earned, or when costs should be matched against future revenues, that is required in this approach resulted in the issuance of detailed rules-based accounting standards. The adoption of the asset-liability view in the original Conceptual Framework has had a significant effect on financial reporting standards and has led FASB to eliminate many of the deferred charges previously recorded in the balance sheet.

FASB does acknowledge that “certain aspects of the conceptual framework are incomplete, internally inconsistent, and lack clarity.” For example, the current definition of an asset, “a probable future economic benefit obtained or controlled by an entity as result of past transactions,” is vague at best. It raises questions about whether the asset is a tangible item, such as a truck, or whether it is the future benefits (cash flows) the truck is expected to generate. Thus, the definition confuses the measurement of the asset with the asset itself. This definition also fails to exclude anything from being viewed as an asset, because practically any and all expenditures are expected to generate future benefit.

The definition fails to meet the two important criteria of a good definition: It must be useful for classification, and it must harmonize with common usage. Although the task of defining fundamental elements may seem inconsequential, the best way to avoid large errors in any field is through careful attention to elementary distinctions, which is one of the purposes of a conceptual framework. Defining the fundamental elements of accounting is just one of the many issues in the Conceptual Framework that will be re-examined.

Questions to be debated in the Conceptual Framework project include the following:

• What is the objective of financial reporting?
• Should financial statements be prepared from an entity or proprietor perspective?
• What are the most important characteristics of accounting information?
• What is an asset?
• What is a liability?
• Should all assets or liabilities be recorded irrespective of the probability that they may be realized or paid?
• Is the matching principle dead?
• Will the revenue-recognition principle survive, or will it be replaced by the asset-liability view?
• Should an asset be measured at cost, or at fair value?
• Is depreciation an outdated concept tied to the matching principle, or is it a legitimate valuation technique?

Clearly, the resolution of these questions will have a profound impact on financial reporting and the accounting profession. Furthermore, it is important to understand that all professionals can influence the final determination of these issues. The boards operate under a system of due process where tentative decisions are vetted and comments are solicited from constituents before final standards are issued. Each comment letter is circulated among the board members and analyzed by the staff, and thereby becomes part of the debate.

What Is the Status of the Project?

The joint FASB/IASB Conceptual Framework project consists of six parts (Exhibit). They cover the entire spectrum of financial reporting, from the objectives and desired characteristics of financial reports, to the definition of the elements, the recognition and measurement of those elements, and the form and content of financial reports. The boards have adopted a timeline to manage the project in a series of steps. The entire project should be completed in several phases over the next three to five years. Each phase will involve the issuance of a preliminary views document, followed by an exposure draft, so that constituents can provide feedback regarding the boards’ decisions.

The first preliminary views (PV) document, “Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information,” was published jointly by FASB and the IASB in July 2006. This document represents the preliminary conclusions of the boards with respect to phase one of the whole project. Chapter 1 of the PV covers the objectives of financial reports and chapter 2 covers the qualitative characteristics. This first phase is critical for two reasons. First, it is essential that a consensus be reached regarding the objectives and desirable features of financial reports, to provide legitimacy and momentum for the rest of the project. Second, the objectives and qualitative characteristics will serve as the basis for evaluating alternatives related to the crucial recognition and measurement issues to be decided in later phases of the project.

The PV issued has generated a fair amount of controversy. The boards received a total of 179 comment letters from constituents regarding the document, many of which expressed concerns with one or more of the decisions reached by the boards. Some of the more significant issues related to the objectives of financial reporting include the exclusion of stewardship as one of the objectives of financial reporting and the adoption of the entity perspective. Other controversial issues related to the qualitative characteristics of financial reports involve the trade-off between relevance and reliability and the exclusion of traditional accounting concepts such as the going-concern principle, the substance-over-form doctrine, and conservatism. Further discussion of these issues is presented below.

Objectives. The PV holds that the sole objective of financial reporting is to provide information to users in making resource allocation decisions. Thus, stewardship, which may be defined as accounting for the resources entrusted to management, is no longer considered by the boards to be a separate objective of financial accounting. Instead, the PV suggests that stewardship is encompassed in the objective of providing useful information regarding resource allocation decisions. Many constituents disagree, however. More than 86% of the letters received on this issued disagreed with the opinion expressed in the PV and argued that stewardship should be retained as a separate objective of financial reporting (according to the staff handout for the Feb. 28, 2007, FASB meeting). This issue concerns the very nature of accounting and financial reporting, and may hinge on whether one believes that accounting and financial reports are used as much or more for control and evaluation of management as they are for resource allocation decisions. Given that only a small fraction of businesses are publicly traded, the boards might be giving too much consideration to the capital markets and not enough consideration to the needs of privately held business enterprises.

The issue of resource allocation versus stewardship is intertwined with the question of whether the Conceptual Framework should apply to all entities, both public and private. The PV states that the Conceptual Framework will apply to all entities, based on the premise that the objectives and fundamental principles of financial accounting should apply to all business entities. However, the PV also identifies the need to consider cost/benefit constraints in applying accounting standards, which may suggest that some entities could be exempt from certain reporting requirements. In addition, the AICPA has formed a new committee that would advise the boards on the need for different recognition and measurement standards for private enterprises. This could potentially lead to the development of two different sets of GAAP, one for public companies and one for private. It is questionable whether two sets of GAAP would promote greater confidence in accounting or make financial reports more understandable. The authors would encourage the boards to strive for a unified theory of accounting that can be applied to all business enterprises.

Other letters raised concerns regarding whether financial reporting should adopt the entity or proprietary perspective. In other words, when faced with a transaction, should the accountant ask how this transaction affects the entity or how it affects the owners’ equity of the entity? This is a particularly important decision for the boards, because adopting either the entity or proprietary perspective of accounting will influence several controversial accounting issues, such as accounting for stock options, distinguishing equity from liabilities in cases of instruments that carry some characteristics of both (such as convertible bonds), and using the parent-company or economic-unit concept in preparing consolidated financial statements. In the PV, the boards expressed a preference for the entity perspective; however, the PV does not provide clear rationale for this conclusion. Furthermore, in a nation where wealth is protected through property rights, it seems inconsistent to base financial reporting on the entity concept, which is silent regarding the division of property rights between the various stakeholders (i.e., management, creditors, and owners) of an enterprise. In addition, the majority of the letters commenting on this topic suggested that this issue would be more appropriately addressed in Phase D of the project, in which the reporting entity is to be determined.

Qualitative characteristics. In determining the desirable characteristics of financial reports, the PV makes several significant modifications to the current FASB Concept Statement 2. First, it replaces the hierarchy of qualitative characteristics with a sequential process approach. Second, it replaces the concept of reliability with faithful representation. Third, as noted above, it would eliminate well-established accounting concepts, such as the going-concern principle, the substance-over-form doctrine, and conservatism, from the conceptual framework. Although the qualitative characteristics are the most abstract piece of the Conceptual Framework, these changes will likely result in significant changes in the future direction of financial reporting. Accountants must pay close attention to what is and what is not included in the qualitative characteristics.

In the original Conceptual Framework, the two primary characteristics of useful information are identified as relevance and reliability. The Conceptual Framework also recognized that there could be a trade-off between these two characteristics, because the most relevant information might suffer from measurement error and the most reliable information might not be the most current. In contrast, the PV elevates relevance to the first item to be considered in the sequential-process approach, based on the assertion that information that is irrelevant is useless. It could be noted, however, that information which is relevant but so inaccurate as to be misleading may be even worse than useless; it might even be harmful to those who rely on it. Enron is just one example.

In addition, the PV replaces reliability with “faithful representation,” which had previously been viewed as only a component of reliability. Faithful representation is defined in terms of its correspondence with the underlying economic phenomenon, as opposed to the relative reliability of the measure of that phenomenon. Although the recognition and measurement issues have yet to be discussed, these changes in the qualitative characteristics suggest that the boards may be developing a rationale for the wider use of fair-value measurement in financial reports. Accounting has historically been valued for providing objective information. It is possible that accounting may lose its preferential standing in the business community as the provider of financial information if it evolves to report primarily relevant, but unverifiable, estimates.

Related to the usefulness of accounting information is whether financial reports should retain a conservative bias. In the PV the boards have proposed to eliminate the last remnants of conservatism from the Conceptual Framework. In its place, the boards promote “neutrality,” which in their view is a necessary condition to faithfully represent economic reality and a more desirable quality of financial reports. The PV states that conservatism, which implies bias to lower income and lower balance sheet values, is incompatible with the concept of neutrality. There is widespread agreement that financial statements should not be biased to favor one party over another; however, the question remains: In an imperfect world, what is the best way to achieve unbiased reporting?

Conservatism has a long history in accounting, and the authors wonder if the world has changed so much that it is no longer needed. Conservatism is consistent with the asymmetrical treatment of gains and losses, where good news is not reported until it is relatively certain, but bad news is reported as soon as it is likely. Thus, conservatism is embedded in many existing accounting standards, such as provisions requiring the recognition of impairments of long-term assets while prohibiting their write-up, and the treatment of contingent gains and losses pursuant to SFAS 5, Accounting for Contingencies.

Eliminating conservatism will open the door for revaluing assets to fair value. It is not clear, however, that recording assets at fair value will produce more-useful financial statements. Indeed, given the incentives for management to provide an overly optimistic assessment of assets and income, conservative accounting standards may be needed to produce a fair representation of a company’s financial position and performance.

It’s Up to the Profession

Although the Conceptual Framework may seem far removed from the day-to-day world of accounting, it has far-reaching implications for financial reporting and the accounting profession. The revised Conceptual Framework will form the basis for future financial reporting standards for decades to come. An updated and comprehensive framework should provide a unified theory of accounting and financial reporting for all business enterprises. In addition, such a Conceptual Framework should provide a strong foundation for boards in developing financial reporting standards that are logically consistent and useful to everyone interested in understanding the nature and content of financial reports.

It is unclear from the many well-reasoned comment letters expressing opposing views that the present PV will lead to these intended results. The outcome is pending and the question remains: Will future financial reporting standards be built on shifting sands that may lead to instability in financial reporting and the capital markets? Or will they be built on a solid foundation that will promote greater understanding of financial reports and increase their usefulness?

Although the boards will make the final decision, this issue is too important to be left entirely to the standards setters. What we need now is the collective wisdom of the accounting profession. Each of us can support the development of a new and improved Conceptual Framework by participating in the process through the AICPA, state societies, other industry or trade groups, and writing directly to FASB and the IASB. The future of financial reporting is up to each of us as much as it is FASB and the IASB.

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