The Theoretical Foundations of Accounting Standards:

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Dec 13, 2013 (3 years and 7 months ago)

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The Theoretical Foundations of
Accounting Standards:

The Conceptual Framework and
accounting research


Geoffrey Whittington

CFPA

Cambridge University



The Need for a Conceptual Framework


For
Standard Setters
, a framework to impose
consistency

between standards.



Also to define

concepts that embody
principles
, to achieve
‘high quality’ standards that meet the needs of users.



For
users and preparers
of accounts, to help
interpretation
of standards. Especially important for international
convergence.



Also to
fill gaps

in standards: particularly important when
they are not ‘rules based’ (hence, not encouraged in USA).

Limitations of a Conceptual
Framework


It should not be regarded as a set of immutable
assumptions leading logically to a unique truth.



This is because financial reporting deals with the needs of
many different users and a great variety of transactions.
Hence, there are
different ‘truths’
for different users and
for different transactions.



Hence, it should leave
scope for interpretation
at standard
-
setting level.



Also, the Framework itself should be
adaptable

over time
as needs and types of transaction change.

The Existing IASB Conceptual
Framework


Dates from
1989
, so need for revision.



Based on the
FASB

Framework.



But (mercifully)
shorter

than the FASB
Framework.



Has
gaps

(e.g. measurement) and ambiguities
(liability/equity distinction?).

The Conceptual Framework Revision
Project


Started in

2004
as part of FASB convergence.



Driven largely by
FASB technical staff
, and joint
IASB/FASB meetings.



Hence,
reflects FASB
needs and past experience.



Consequent

detailed
documents and perceived
‘Anglo
-
Saxon’ orientation (e.g. Stewardship
issue).


The ‘Active’ Revision
Programme


A: Objectives and Qualitative Characteristics
(chapters 1 &
2 published in 2010).



B: Elements and Recognition
(currently deferred)
.



C: Measurement
(currently deferred).



D: The Reporting Entity
(ED 2010).

‘Future’
Programme


E: Presentation and Disclosure.



F: Purpose and Status.



G: Application to not
-
for
-
profit entities.



H: Over
-
view and possible consequential
amendments.



Completion:
‘Beyond 2010’ was the original
intention!

Progress to date (2011)


Slow
.



And now
suspended temporarily
(2010) for
convergence work to be completed (‘after June
2011’).



But CF issues continue to be addressed in

other
projects
: Liabilities, Revenue Recognition,
Financial Statement Presentation, Fair Value
Measurement, etc.




Problems of Objectives and Qualitative
Characteristics


This is the only section to be
finalised
.



It contains
fundamental difficulties
.



Making
Stewardship

a component of Decision Usefulness is
the main problem of Chapter 1 (Objectives).



Substituting
Representational Faithfulness
for Reliability is
the main problem of Chapter 3 (Qualitative Characteristics).



Rejection of
Prudence

as a characteristic is a consequence
of these changes.


Stewardship 1


Refers to the
feedback

role implied by accountability.



Formalised by economists in
Agency

theory.



Information asymmetry
between principal (investor)
and agent (manager) is alleviated by financial reports.



Stewardship (agency) requires

monitoring of past
events

as well as estimating future cash flows (as in
decision usefulness).


Stewardship 2


Concern with stewardship as a central element in

corporate
governance
seems to be a
European

rather than a North American
emphasis, possibly reflecting institutional differences.



US

emphasis on role of
financial markets as a discipline
on
management (share prices, debt covenants etc.).



Stewardship is particularly relevant in

‘not for profit’ and public
sector
areas (recent work of IPSASB) and in
co
-
operatives

and other
mutual organisations.



The
entity

approach (as opposed to
proprietorship
) adopted in
Chapter 1 of the new Framework may lead to under
-
emphasis on
stewardship/corporate governance issues.


Faithful Representation


Sounds wonderful!



But why substitute it for
Reliability?



Reliability refers to reliable representation of
what is purported to
be represented
.



Faithful Representation
has connotations of representing

‘economic
phenomena’
. This may include an element of
Relevance
, which is
the other main qualitative characteristic.



A ‘Trojan Horse’ for
Fair Value
?

The Reporting Entity


Chapter 2 of the new Framework, currently an
Exposure Draft (2010).



Usefully defines
control

as requiring power
and benefit.



An entity is defined by a

legitimate user
group
.


Fundamental Issues still to be
Addressed


Elements
:


What are
assets

and
liabilities
, and should
equity
be a residual (as in the
present Framework) ?


Is ‘arising from a
past transaction or event’
an essential component of the
definition?



Recognition
:


When should an item be included in the accounts?


At present,
probability

of occurrence and reliability of
measurement

are
framework criteria (but not necessarily applied in recent standards, such
as IFRS3).


Are such recognition filters needed?



Measurement
: Should a preferred measurement be defined? If so, should
it be current or historic, and, if current, entry or exit (Fair Value)?

Issues for Research


The
unresolved issues
of the Framework
project provide a full agenda for research.



The issues are
linked
, e.g. Element definition,
recognition and measurement.



Add to that the problems of particular
applications

(pensions, insurance contracts,
etc.) and the scope is enormous.

What can academic research
contribute?


Theory
: both deductive (logical deduction from assumptions) and
inductive (rationalisation of practice).



Theory has been unfashionable, but is being revived, e.g. through
analytical models using agency theory, and valuation models of Penman,
Ohlson

and others.



Empirical studies:
history, surveys of practice, econometric studies of
market reaction and valuation, etc. Empirical research has dominated
academic research for about 40 years.



These should inform the debate but not determine it: the element of
judgment will be decisive and is essentially political.



In the past, academics were perhaps too ambitious and hoped to solve
everything!

What are academics doing?


New (or relatively new) journals: Accounting Horizons (AAA) and
Accounting in Europe (EAA) specifically encourage academic papers
with policy application.



Within them are regular commentaries submitted to IASB (and
FASB) by academic panels of AAA and EAA.



These draw on research papers in other academic journals.



Academics also contribute to the standard
-
setting process through
other bodies, such as EFRAG’ s PAAINE initiative.



This is welcome, but more needs to be done to unite academic
research and policy
-
making.


An Example: The Definition of Equity


This is an obvious
problem of the Conceptual Framework
.



The Framework currently defines
Equity as a residual
: assets minus liabilities. A credit that is not a
liability must be equity. A liability is a present obligation whose settlement is expected to give rise
to an outflow of ‘resources embodying economic benefits’ . Hence, the
form of settlement

is the
basis of the definition.



Application problems
of this definition in IAS 39 have led IASB to deviate from it in two cases where
it gave counter
-
intuitive results:


1. Commitments to settle in the number of shares that will yield a given value(‘shares to the value
of...’)


2. Shares that are
puttable

back to the issuer for cash at the shareholder’s option on terms that
reflect the performance of the entity (as in some co
-
operatives).



Case 1 does not involve settlement in cash or cash equivalents, but is classified as a financial
liability (IAS 32). Case 2 does involve cash settlement but is classified as equity, if the restrictive
conditions on redemption terms are met (2008 amendment to IAS 32) . In both cases, the IASB has
over
-
ruled its Framework’s conceptual division between liabilities and equity.



The debt/equity boundary is of great practical importance. For example, it is the basis
of leverage
ratios and of
profit measurement
.


The IASB/FASB Position


Debt/Equity is part of the Elements phase of the
Conceptual Framework revision
.



In the shorter term, it is addressed for financial instruments in the
FASB convergence programme
(a
bad idea?).



Both projects are currently
in abeyance
(until ‘after June 2011’).



Discussion Paper
, ‘Financial Instruments with Characteristics of Equity’ (
FASB
,2007) considered 3
approaches:


Basic Ownership


Ownership
-
Settlement


Reassessed Expected Outcomes



Exposed by
IASB

(2008) as possible reform of IAS32.



Lack of conceptual underpinning
was a widespread response. Should be consistent with the rest of
the Framework.


Some Conceptual Issues


What is the equity/ debt distinction for?


Stewardship

points to proprietorship (owners), but
decision
-
usefulness

points to
risk
-
bearing aspects and a wider range of investors.



Should equity be defined as a

residual
and, if not, how do other
element
definitions
(particularly liabilities) avoid inconsistency ?



If equity is a residual,
how should its residual character be defined
? (settlement,
loss absorption, etc.). The settlement criterion has caused particular problems for
co
-
operatives

with
puttable

shares.



How should
recognition and measurement
criteria apply to equity if it is no longer
defined as a residual?



How do we reconcile the
balance sheet
classification of equity with the need for
an equity measure to define
profit
?



Some Research Contributions


EFRAG PAAINE discussion paper
‘Distinguishing between Liabilities and Equity’ provides a thorough
discussion of the conceptual issues.



Does have one
academic author
: a good example of academic involvement.



Proposes a
Loss Absorption
approach.



Other academic contributions include
Botosan

et al. (2005) and many papers on liabilities and the
Framework in general, but little on the debt/equity distinction and the nature of equity.



Can we learn from the
corporate finance
literature? The
Modigliani
-
Miller

debt/equity theory was a
fundamental contribution: does it assume a loss
-
absorption approach?



The field is open for more work!