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Reinforcing the Underpinnings of Accounting Standards

Robert Herz | October 29, 2013

In July, the International Accounting Standards Board issued a discussion paper entitled “A Review of the Conceptual Framework for Financial Reporting” as part of its project to revise the conceptual framework that guides the development of IASB's standards. The project could have a significant impact on future IASB standards, which would be important given the widespread use of International Financial Reporting Standards by non-U.S. companies and the substantial allocation of U.S. investment portfolios to securities issued by them.

It could also be important to U.S. investors and companies as the Financial Accounting Standards Board continues to seek convergence between U.S. Generally Accepted Accounting Principles and IFRS, especially if the SEC decides on potential “incorporation” of IFRS into U.S. GAAP.

As part of this project, IASB is consulting with its recently formed Accounting Standards Advisory Forum, of which FASB is a member, so the results of the project could also lead to similar revisions to the conceptual framework that guides FASB's development of standards. IASB is accepting public comments on the framework through Jan. 14, 2014.

FASB and IASB's conceptual frameworks are, in my view, both in need of improvement. Much of FASB's conceptual framework was originally developed in the 1970s and 1980s. It consists of a series of documents that address key concepts relating to the objectives and users of financial reporting, qualitative characteristics of financial reporting, definitions of the elements of financial statements (assets, liabilities, equity, revenue, and expenses, for example), and recognition and measurement of items in financial statements. The much shorter IASB conceptual framework covers similar matters. While these documents have been helpful in guiding standard setting, experience shows that they are in need of improvement in order to address and help resolve various cross-cutting issues that have come up repeatedly in developing standards and to fill in a number of gaps in important areas.

The controversial subject of measurement—that is whether to measure particular assets based on historical cost, at fair value, or at other amounts—is an area often cited as in need of better conceptual elucidation. Other related areas, including when to recognize and derecognize assets and liabilities and how to deal with uncertainly in measurement and disclosure, are also being addressed in the IASB project, as well as fundamental conceptual matters relating to the definitions of assets, liabilities, and equity and the presentation of profit or loss and other comprehensive income. These are subjects that have  challenged accounting standard setters for years.

The absence of solid conceptual guidance on these fundamental matters may be one reason why standard setters have addressed these issues in inconsistent ways over the years through a hodgepodge of approaches, thereby adding to the complexity and reducing the overall understandability of financial reports. While not providing a panacea in addressing all accounting issues, I agree with many others that enhancing the conceptual underpinnings of accounting is a necessary step in getting to more consistent, comparable, coherent, understandable, and useful financial reporting.

The recognition of the importance of such an effort is not new. In 2004, FASB and IASB commenced a joint project to improve and merge their respective frameworks. That joint effort resulted in the issuance by the two boards in 2010 of revised conceptual guidance on the objectives and qualitative characteristics of financial reporting.

While these documents have been helpful in guiding standard setting, experience shows that they are in need of improvement in order to address and help resolve various cross-cutting issues that have come up repeatedly in developing standards and to fill in a number of gaps in important areas.

The joint conceptual framework effort, however, stalled in the face of FASB and IASB needing to address urgent reporting issues arising from the financial crisis of 2008 and 2009 and the drive in recent years by the boards to complete a number of major joint standard-setting projects.  Accordingly, in late 2010 FASB and IASB suspended work on their joint effort to improve and merge their conceptual frameworks. Nevertheless, in 2012 IASB, in response to strong encouragement from its stakeholders, decided to restart work on improving its own conceptual framework.

The IASB discussion paper explores a number of fundamental conceptual areas and sets forth preliminary conclusions on potential revisions to its conceptual framework. In regard to the definitions of assets and liabilities, for example, it tries to focus more clearly on economic concepts of resources and obligations.  It also clarifies that assets and liabilities may include items that are not certain to result in future inflows and outlflows. The discussion paper suggests that an entity should recognize all assets and liabilities, unless IASB decides in a particular circumstance that recognizing an asset or liability would provide users with information that is not sufficiently relevant to justify the cost or where no measure of a particular asset or liability would result in a sufficiently faithful representation of that asset or liability and of the resulting income or expense.            

On the subject of measurement, the paper indicates that IASB should limit the number of measurement bases used in financial statements. It suggests that in selecting an appropriate measurement basis for a particular asset or liability IASB should consider how the asset in question contributes to future cash flows or, in the case of a liability, how the entity will settle or fulfill it. It should also consider what information the use of the measurement basis will produce in both the statement of financial position and in the statements of income and comprehensive income. Accordingly, by way of example, the paper suggests that fair value may be the most relevant measurement basis for a financial asset that has complex features and is held for trading, but depreciated cost might be more relevant for assets, such as property, plant, and equipment, that contribute to future cash flows indirectly in combination with other assets.

The discussion paper says that entities should provide an enhanced statement of changes in equity in order to provide more information about the claims of different classes of equity investors and to show how wealth is transferred between these classes of equity. Finally, the paper sets forth certain disclosure concepts that might help enhance the relevance of information included in the financial statements and footnotes and reduce the burden on preparers.

Over the years, both FASB and IASB have decided in specific standards and for a variety of reasons that certain items of income, expense, gain, or loss, should be included in other comprehensive income and not in net income or earnings. These have included, for example, unrealized gains and losses on certain investments in debt and equity securities, foreign currency translation gains and losses, and, under IFRS, gains and losses on revaluing certain fixed assets. They have also specified whether and when such items should be “recycled “ from OCI into net income.

There are a number of differences, however, between U.S. GAAP and IFRS in these areas that can result in significant differences in the reported results under the two sets of standards. Moreover, neither set of standards seems to be based on a consistent conceptual approach to distinguishing between what goes into earnings and what goes into OCI or whether, what, and when to recycle items from OCI to earnings. The IASB paper discusses two potential methods, dubbed the “narrow approach” and the “broad approach” to determining which items might be included in OCI and whether and when to recycle them from OCI to net income. Under both approaches, all items of income or expense would be recognized in net income unless they are eligible for inclusion in OCI.

IASB has set a rather ambitious target for completing the project to improve its conceptual framework, hoping to publish an exposure draft for public comment in 2014 and to finalize the revised conceptual framework the following year. As part of its process, it will actively consult the ASAF, as well as its Capital Markets Advisory Committee of financial statement users and its Global Preparers Forum. I would also expect IASB to hold public roundtable meetings on this important project.

Overall, while I found the paper interesting, I question how much it advances the ball toward a more complete, clear, and solid conceptual framework for financial reporting. Hopefully, as the project progresses, IASB—working with the ASAF, including FASB, and with input from other stakeholders—will achieve these objectives. In my view, to be successful the effort needs to be more than a recitation of current practices and standards. It will require wrestling to ground a number of fundamental issues that have challenged accounting standard setters and financial reporting for many years. That would be a very welcome and important outcome that over time could have far-reaching effects on financial reporting both internationally and in the United States.