Our series on the Financial Accounting Standards Board's Conceptual Framework has focused so far on broad issues. We first explained the need to acknowledge that the goal for standard-setting is promoting efficiency in the capital markets by continually improving the information that flows to them about securities issuers.
We then explained that financial statement users are the key players because they consume the information. To produce information useful for decisions, managers' and auditors' concerns must take a back seat to issues about meeting the markets' demand for facts. It does no good to publish statements that no one cares to read or dares to believe.
This column goes deeper into Concepts Statement No. 1 and suggests how the board could improve its contents in the project to revisit the framework.
Although SFAC 1 is entitled "Objectives of Financial Reporting," it really states only one objective, which is then interpreted through a series of explanatory objectives. That primary objective is to provide information that is useful for rational investment and credit decisions.
Simply enough, the first explanatory objective clarifies that useful information helps decision-makers assess the amount, timing and uncertainty of their future cash flows. That is, they want information to size up the prospects for getting cash into their own pockets.
The next explanatory objective logically tracks these future cash flows back to their source - the cash flows experienced by the reporting entity. It explains that useful information should help decision-makers assess the amount, timing and uncertainty of the future cash flows to be experienced by the reporting entity. After all, the cash flows to the users (from dividends, interest and principal repayments) come from the entity's cash flows. In addition, future share values are strongly linked to the company's expected future cash flows.
The third objective elaborates on this by saying that useful information should describe the entity's "resources" and "obligations" and changes in them. (The board used those terms because it had not yet defined "assets" and "liabilities.") This explanation establishes the fundamental logical chain that we find to be so important: Information about assets and liabilities is useful when it tells users about the entity's future cash flows.
On the surface, these sub-objectives seem to say only the obvious - they might even be seen as after-the-fact justification for existing practices. We know that's true because that's how we looked at them into the mid-1990s. However, we experienced an insight that caused us to see through an entirely different lens.
The focal point for our new view is the huge importance that the capital markets place on future cash flows. What hit us with a thunk between our eyes was this conceptual two-by-four: The purpose behind reporting about assets and liabilities is providing insight into the amount, timing and uncertainty of the future cash flows related to them. When dealing with assets, statement users need to know about the cash flows that they will or can produce; when dealing with liabilities, users need to know about the cash flows that they will or can consume. In effect, the relevant characteristic (or "attribute," to use FASB's term) of assets and liabilities is their ability to affect the amount, timing and uncertainty of the future cash flows to be experienced by the entity. We even coined an acronym for it: AAATUC.
This shift in perspective caused us to see that financial statements provide useful information about assets and liabilities if and only if they convey timely facts about their potential to affect future cash flows. This analysis establishes what kind of information is relevant. As explained in SFAC 2, once relevance is determined, what's left is the search for reliable ways to describe it.
Accordingly, we think that the framework should be modified to call for providing information that usefully illuminates the AAATUC of the company's assets and liabilities. This call could not be issued when SFAC 1 was drafted because the board of that time did not know what would be in the succeeding statements. Because today's board is planning to fix the framework as a whole, its members can use the concepts in the latter statements to elevate the discussions in the first statements.
Specifically, FASB should now make it clear that useful (relevant and reliable) information about assets and liabilities helps users assess the amount, timing and uncertainty of future cash flows to the reporting entity. That information is relevant because it provides the desired insight with timeliness. However, it is useful only if it reliably depicts the assets' and liabilities' AAATUC.
The importance of this revised declaration is huge - indeed, the board members of the early 1980s struggled mightily (but in vain) with these issues while trying to wrap up the framework. As we see it, establishing that AAATUC is the goal shows that the traditional debate over which attribute is relevant was actually misdirected. Instead, the better route toward progress calls for evaluating competing methods for reliably measuring the ability to affect future cash flows.
In building the old framework, a line was drawn in the sand, with one side calling for market value while the other held fast to the status quo of mixed measures, including cost, book value, present value, net realizable value, and hybrids, such as lower-of-cost-or-market and LIFO. The former won in the sense that SFAC 5 said that market values can be useful and the latter won because existing practice was not dismissed as useless.
If FASB's new framework acknowledges that AAATUC is the relevant attribute, the door to progress will open wide because questions will be framed differently. Establishing the ultimate importance of future cash flows provides a clarity that is sorely lacking when the focus is on the vague concept of usefulness without knowing what's relevant. Having identified this relevant attribute, the board can frame all subsequent issues as the question of which alternative depiction of its amount has the most satisfactory reliability. This shift will invite a great many changes in financial reporting, all in the direction of greater capital market efficiency by providing more useful information.
To clarify, AAATUC is quite similar to the financial and economic concept of "intrinsic value." This value is inherent in an asset (or liability) through its ability to produce future benefits (or cause future sacrifices) either through use or through sale or settlement. It is the consequence of the supply and demand for future cash flows with different characteristics, including the amount, timing and uncertainty of future cash flows. The greater the prospective cash flows, the greater the inherent value; the shorter the time frame between the present and the future flows, the greater the inherent value; and the greater the certainty about the cash flows, the greater the inherent value.
The best anyone can do to describe an asset's inherent value, however, is a theoretical statement something like this: "the present value of the future cash flows discounted at the risk-appropriate rate." To produce this estimate, one must predict the future cash flows and find the right discount rate. The result is highly unreliable for most assets and liabilities, with the exception of contractual receivables and payables.
Bottom line: There has to be some better, more useful, measure for financial reporting.
It's sufficient for now to establish that the relevant attribute for assets and liabilities is their ability to affect future cash flows. Our next column will delve into the meanings of relevance and reliability, with a few suggestions on how FASB might modify the framework. Once those terms are clarified, we'll return in a later column to size up the reliability of various ways of describing AAATUC. The result of that analysis is likely to be surprising: That which is traditionally thought to be reliable will prove to be unreliable, while that which is usually branded as unreliable will turn out to be reliable.
This is heady stuff, but it's important. 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
