We have been writing about the Financial Accounting Standards Board's Conceptual Framework, offering suggestions to the board as it fixes up the framework some 20 years after it was produced.

So far, we have looked at the overall goal of standard setting, the objective for financial reporting, the relevance of the future cash flows to the reporting entity, and the role played by the entity's assets and liabilities through their ability to affect the amount, timing and uncertainty of those cash flows. We are persuaded that this ability, which we call "AAATUC" for convenience, is the elusive relevant attribute that escaped the grasp of accounting theorists for decades.

This column addresses relevance and reliability, the two key qualities of information that make it useful for decisions. By and large, the framework explains them well, thanks to the work of two departed scholars: Dr. David Solomons, of the University of Pennsylvania, and Dr. Reed Storey, who served many years on FASB's staff.

We believe that the board should produce a more helpful explanation of these qualities because we find that they are not fully understood. It seems that most folks still rely on their vernacular meanings, instead of the more rigorous and precise definitions in SFAC 2.

We also think that the board should amend its discussion of the relationship between relevance and reliability, specifically the idea that tradeoffs can take place between them.

Finally, we again encourage FASB to boldly and decisively identify AAATUC as the relevant attribute of assets and liabilities. Doing so would open the door to improving not just the framework but also generally accepted accounting principles, which is, after all, the whole purpose of the exercise.


The original framework describes relevance as the "capacity of information to make a difference in a decision by helping users to form predictions about the outcomes of past, present and future events, or to confirm or correct prior expectations."

Simply put, relevance comes from the content of the information. It is created by timeliness and either predictive value or feedback value. Based on the objectives described in SFAC 1, the relevant content provides insight into the entity's future cash flows, which, in large part, result from assets that it controls and liabilities that it owes.

Relevance exists in qualitative information about assets, such as their nature and liquidity, and about liabilities, such as their terms and demands on liquidity. For example, inventory is different from receivables and buildings, and long-term debt is different from derivative liabilities and accounts payable.

The most crucial information describes the AAATUC of assets and liabilities. It is clearly helpful to have a quantitative representation of this cash flow potential that is inherent in, for example, receivables, investments or even goodwill.

Timeliness means that information is relevant when it provides up-to-date insight into AAATUC as of the reporting date; information is not helpful for looking forward if it provides insight only into past AAATUC. While an old fact may have been timely at an earlier date, it means nothing today if it doesn't reflect current conditions and circumstances. Consider, for example, shares of Enron and Apple. Information about their past market values does not provide a timely description of their present cash flow potential.

Despite its necessity, relevance is not sufficient for creating usefulness.


In particular, useful information must also have reliability, which SFAC 2 defines as "the quality of information that assures that [it] is free from error and bias and faithfully represents what it purports to represent." The statement explains that reliability exists when information has representational faithfulness, verifiability and neutrality.

Faithfulness occurs when the reported magnitude of the relevant attribute is sufficiently close to the real amount. Faithfulness is not the same as exact or precise measurement - in effect, it's OK to be within an acceptable range. Of course, any measurement (faithful or otherwise) accomplishes nothing if people place no confidence in it. That issue led FASB to identify verifiability as essential. Specifically, credibility is enhanced by having others confirm that the amount is close enough. Neutrality also boosts credibility because it assures users that the information was created through an unbiased process, with no agenda for encouraging one kind of decision over another.

Like relevance, reliability is necessary to usefulness but not sufficient. Indeed, the framework has a very good discussion pointing out that it does absolutely no good to have a reliable depiction of an irrelevant fact.

Relevance and reliability

The relationship between relevance and reliability can be understood by bringing them together in four pairs.

First, information is not useful if it unreliably describes irrelevant facts. Furthermore, nothing can be done to this information to make it useful.

Second, consider information that is reliable but irrelevant. Because the goal is to help statement users predict future cash flows, it does little good to describe a particular asset's past AAATUC after it has changed over time. Even though the past ability used to be relevant and can still be reliably described using past facts (such as last year's fair value), the past measure no longer has predictive value, nor can it be useful for that purpose again. Nothing can make this irrelevant information useful.

Third, information that is both relevant and reliable is the only kind that is useful. To be useful, it must provide faithful insight into real future cash flow potential. Further, the reported amount must be verifiable and emerge from a neutral process. Users will make good decisions about cash flows to themselves if - and only if - both these qualities exist.

Fourth, what if the information is relevant but not reliable?

This question leads us to the point that relevance is not a continuous quality that exists in various degrees. Information is either relevant or irrelevant.

In contrast, there are degrees of reliability. Once AAATUC is known to be relevant, it's possible to consider various ways to estimate its magnitude with different levels of reliability.

For example, it is relevant to know the cash flow potential of a building acquired in a business combination. One measure might be its book value in the seller's accounts. Others might be market values estimated by the seller or the buyer. Still others might be its insured value or an appraised value. Indexed cost would be yet another measure. Finally, management could consult a database of prices from a large number of recent transactions. Each estimate would have relevance because it would be intended to provide insight into the asset's cash flow potential.

However, they definitely differ in terms of their reliability. Some would be unfaithful representations because they wouldn't come from a process intended to describe current AAATUC (such as book value). Others would lack verifiability because they would come from uncorroborated sources. Still others would lack neutrality by coming from processes designed to generate a particular kind of information, including that which is "conservative."

Somewhere along the spectrum between less and more reliability is a point that constitutes "sufficient reliability," taking into consideration the cost of generating it and the perception by users - not auditors - of how close the estimate comes to the real amount.

Unlike relevance, however, reliability can be improved by exerting additional effort. For example, bringing in one independent appraiser will produce more reliability than having a corporate officer estimate value, and engaging five appraisers will produce more reliability than one. Consulting a database with 50 recent transactions will add even more reliability.

Trading off

This analysis leads us to disagree with SFAC 2, which claims that it's possible to trade relevance to gain reliability. As soon as relevance is sacrificed, any chance for usefulness is lost.

However, a tradeoff can be made, but the 1980 board didn't describe it well. We think it's possible to trade off degrees of reliability. For example, some representational faithfulness might be given up to achieve more verifiability, or vice versa. Neutrality can also be traded, especially to save effort.

The real issue

This perspective opens up whole new avenues for reform in financial accounting, perhaps even for a revolution. In particular, it shows that accountants have been on the wrong page when they have debated whether cost or market value is the relevant attribute. Both of us were trapped in this mistake when we worked at FASB, trying to help the board members resolve that alluring but misdirected question.

Instead, the important issue is whether cost or market value is a more reliable description of AAATUC, where preparation cost, faithfulness, verifiability and neutrality all come into play. That question makes a huge difference.

We'll illustrate that difference in the next column, when we size up the reliability of various means of describing the magnitude of an asset's AAATUC. The answer turns things upside down: That which is traditionally embraced as reliable is unreliable, and that which is traditionally rejected as unreliable turns out to be reliable.

Stay tuned.

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. Reach them at paulandpaul qfr.biz.

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