In an unheralded but potentially earthshaking move, the Financial Accounting Standards Board voted last spring to reconsider its conceptual framework, which was mostly completed in the 1970s and 1980s. In addition, the board plans to work closely with the International Accounting Standards Board to accomplish convergence with that institution's own framework.
The board will revisit the concepts statements, looking for holes left behind in an earlier era, when business was far less complex and the board was not as experienced. Frankly, some holes were constructed on purpose to avoid divisive issues that were protracting the debates far too long.
Probably no one applauds this project more than we do.
Indeed, we suspect that most folks will consider it to be no big deal, because we both were on FASB's staff while the project was underway 20 years ago, and we saw that the public had little interest in, and little comprehension of, what the board was doing.
For instance, most people didn't (and still don't) realize that the board basically tossed out the old matching principle in favor of the "asset-liability" theory that forces income to reflect real observed changes in assets and liabilities. The key result is that management and the auditors cannot use the conceptual framework to justify putting imaginary numbers on the income statement to burnish a positive image or avoid recrimination.
Just to illustrate the difference, consider depreciation accounting. Under matching, accountants compute make-believe depreciation expense by the totally unverifiable route of predicting a future life and a future salvage value and then picking some formula to do the allocation. They don't, and never did, intend to provide any useful information about the asset on the balance sheet.
In fact, the book value is an afterthought, a mere byproduct of the process for recognizing the smooth expense they want in the first place. Imagine reporting sports results on the basis of predicting who is going to win and by how many points, instead of waiting to see how the game actually plays out.
What utter nonsense.
The asset-liability theory takes an entirely different approach. Rather than trying to guess the future and report expectations, accountants observe the present and then report what they find whether they like the result or not. If an asset's value goes up, the current amount is reported on the balance sheet, followed by a holding gain on the income statement; if it goes down, the balance sheet reports the lower amount and the income statement shows a holding loss.
Notice that the balance sheet valuation becomes the driver, producing an income statement that reports contemporary facts, not ancient and obsolete conjectures about a future that had little chance of actually coming true. Furthermore, there is no biased, preconceived notion that the asset's value will go down, much less in some systematic pattern.
Here's the difference: Matching (which still describes most generally accepted accounting principles) finds it sufficient to report what was expected to happen instead of what actually happened. Framing the issue in those terms makes it plain that change is needed. The FASB that created the framework certainly felt that way. We have doubts about the current board, however, especially considering its present approach to expensing options, which systematically amortizes the initial cost while ignoring changes in the options' real value.
So, what is it about the framework that could be changed? We have spent some time thinking along these lines (that's part of our job as academicians). We want to use a few columns to describe what we think needs to be fixed.
The mission of regulation
SFAC 1 started the conceptual framework by defining the objective of financial reporting. We have no serious complaint with the idea that financial reporting should provide information that is useful for decisions, although it now seems remarkable that some 60-plus percent of the original comment letter writers opposed that thought! What we would do is add a statement that articulates the mission for agencies that regulate reporting, especially FASB.
Specifically, we asserted that the mission involves building a reporting system that nurtures and improves the efficiency of the capital markets with the ultimate goal of nurturing and improving the efficiency of the national and global economies.
Why would this change be important?
Lots of reasons. For one thing, it would open other avenues for progress. Currently, the widely held attitude is that progress can be accomplished only through new mandatory standards. From experience, everyone ought to know by now that capital markets react promptly to all available information, including but not limited to GAAP financial reports. Sharpening the focus on enhancing efficiency would provide a constant reminder that GAAP reporting is only one of many information sources.
If this truth is internalized, people will come to see that the markets can be informed by well-executed supplemental reporting (not to be confused with trashy pro-formas). If so, managers will respond to incentives to innovate that are ignored in today's regulation-driven reporting world. It's quite possible that this view would encourage standard setters to embrace more experimentation by allowing managers to test promising new but unproven methods that could improve practice.
In addition, if its mission is enhancing market efficiency, FASB might find it harder to justify standards that accommodate preparer and auditor concerns through transparent compromises that fall short of that goal. If the evidence suggests that reporting certain information to capital markets would help them price securities more efficiently, the board might be more capable of withstanding pressure from preparers and auditors to keep it unreported.
Focusing on market efficiency also should make obsolete the familiar formulation of the cost/benefit equation, which fails to incorporate the information-gathering and processing costs incurred by financial statement users. Far too much time and attention are wasted today on facile arguments that consider only the preparers' costs, with the often-stated whine that it's unfair for users to enjoy all the benefits.
In fact, both users and preparers have costs, and the real issue is who is more efficient at gathering and dispensing useful information. The obvious answer is that efficiency is promoted if management does the compiling once instead of forcing all users to make their own individual (and redundant) guesses with incomplete data.
Furthermore, both users and managers benefit when statements are more complete. We never grow tired of explaining that reporting greater amounts of useful information reduces the markets' uncertainty, which cuts perceived risk, which decreases the demanded rate of return, which then knocks back the security issuer's cost of capital. In turn, the lower market discount rate drives up the market value of those securities, thus enriching the stockholders and managers.
Finally, reduced risk in capital markets leads to a more productive and stable economy. It is indeed possible for everyone to win, but the current objective for the conceptual framework doesn't promote this kind of analysis.
This is enough for our first shot. We will be bringing other thoughts in coming columns, including such things as misunderstandings about relevance and reliability, definitions of assets and liabilities, useful measurements of assets and liabilities, tradeoffs between costs and benefits, timeliness, comparability, the role of transactions in financial reporting, and present values as useful measures.
At some point, we'll also raise the issue of whether convergence with the IASB is wise, or merely a warm and fuzzy, even politically correct, apparition that may ultimately prove to be a disaster. We're still of two minds on this point, and we want to stimulate some discussion there, too.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Email them at paulandpaul
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