To begin this second installment on the boards' (IASB and FASB) Conceptual Framework project, here is a brief summary of my first post.
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A 'bridge to nowhere' – The boards (FASB and IASB) are planning to construct a new conceptual framework without first specifying how they would use it.
- Concepts without principles – The boards have studiously avoided being pinned down by a formal statement of basic accounting principles. That's why statements of mere concepts have proven, and will continue, to be utterly useless except as a storehouse of excuses for low-quality accounting standards.
I pride myself on "peeling the onion" of complex issues, so I feel (slightly) guilty that the first installment of my critique of the Conceptual Framework was pure low-hanging fruit. I didn't even have to peel back the cover on the new Statement of Financial Accounting Concepts (SFAC) No. 8 to find sufficient reason to conclude that the entire seven-year-and-counting effort was little more than old rotgut in new bottles. I had resolved to make amends for my sloth, but it again turned out to be the case that I wouldn't have to reach very far into SFAC 8 to come up with more of the same; the first few paragraphs of SFAC 8 were more than enough.
"General Purpose" – The Stealth Concept
Behold these excerpts from the first two paragraphs of SFAC 8:
"The objective of general purpose financial reporting forms the foundation of the Conceptual Framework…." [para. OB1]
"The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors …." [para. OB2]
If you have ever taught Accounting 101, early retirement would have been a cinch if you had a dollar for each time a student inquired as to which of several possible accounting treatments being discussed was "the right one." I eventually learned to reply with the following discussion-priming question: "For what purpose will the resulting financial statements be used?" That's when the fun would begin.
No student of mine ever proffered that the financial statements in question were to be used "for general purposes," because even those newbies to accounting could deduce that this was an absolutely dead-end answer. The boards' answer is even more dumbfounding for its naiveté: henceforth, these wise men and women will choose accounting treatments in their general purpose financial statements "…that will meet the needs of the maximum number of primary users." [para. OB8, italics supplied]
Need I say that the boards have given no indication as to how they will go about the task of determining "the needs of the maximum number of users"? Imagine how the FASB will apply its rubric to the deliberations on loan accounting: I shudder to think.
So, right there on the first page of the new and improved Conceptual Framework, we have a stealth concept, "general purpose financial reporting." There is nothing written in SFAC 8 to give you a clue as to how "general purpose" modifies "financial reporting." To even begin to understand the boards' intent, you would have to be nerdy enough to know that the term was accorded full status as a (fuzzy) concept more than 30 years ago in SFAC 1, which ironically has now been replaced by SFAC 8.
Be that as it may, the description of the concept of general purpose financial statements in SFAC 1 does nothing to explain why financial reporting shouldn't be more narrowly focused on, say, shareholders (you can see for yourself at paragraphs 28 – 30). That goes a long way toward explaining why the boards have abandoned all pretense for failing to recognize the primacy of current shareholders in financial decision making, and hence, financial reporting.
Shareholder-Purposed Financial Statements – Simple, and Therefore to be Avoided
Consider these reasons for why financial reporting should be shareholder-purposed:
- SEC rules (Regulations 14A and 14C) require that a company furnish its current shareholders with an annual report prior to holding a vote to elect members of the board of directors (as well as other significant matters).
- Virtually every (if not all) professor of corporate finance teaches that the sole financial objective criteria for financial decision making should be the maximization of return on shareholder investment.
If those examples are not convincing enough, here is some added reasoning. First, the resolution to some of the most vexing accounting problems becomes crystal clear if financial reporting were to become shareholder-purposed; shareholders should want assets to be measured at current worth,* because that is the only measure that should mean anything to them.
Second, and more fundamentally, shareholder-purposed financial statements yield the best possible measurements for assessing whether management has created value for shareholders. In accounting theory parlance, this is known as "stewardship." Financial reporting evolved out of mere bookkeeping as ownership and management tended toward functionally and physically separate activities. When owners are not involved in running a company, management is bound to act stewards of the shareholders' investment; and financial reporting is the principal way that 'absentee' shareholders assess how well management is doing that job.
Stewardship implies that shareholders want financial reports to help them answer two questions: (1) what is the current value of the resources invested in the company – both gross and net of liabilities; and (2) what is the expected return on that investment, considering the various sources of risk that could result in the actual return being different than the expected return. Shareholder-directed financial reporting can straightforwardly get at the first question, and it can also be a source of high quality information for answering the second.
I cannot conceive of an accounting standard, which if it were shareholder-purposed, would create information barriers for others. To take a timely example, I suppose one could argue (although I would not) that potential and current bank creditors are more interested in the discounted – at a totally arbitrary interest rate – net cash flows of the bank's own loan portfolio as estimated by the bank's management than the current value of the loan portfolio. Yet, I can't for the life of me see any honorable justification for depriving shareholders of knowledge of the current value of the portfolio. There should be absolutely nothing to prevent an accounting standard setter from requiring banks to provide the information that lenders supposedly crave in the notes to the financial statements.
In summary, these three criticisms of the Conceptual Framework – bridge to nowhere, concepts instead of principles, and general-purpose instead of shareholder-purposed – are nothing more or less than exercises in reverse engineering. The boards have started with a picture of where they think financial reporting should end up, and they are now engaged in a very drawn out process of cobbling together a joint "conceptual framework" to support their future Rube Goldberg creations.
The viability of accounting as a profession depends on the trust that users of financial reporting have in the integrity of their judgment. Since no set of rules or concepts can completely specify how those judgments are to be made for every circumstance, accountants need to have valid and boldly-stated principles for guidance. The predictable consequence of the absence of such principles has been the inexorable decline of the public trust in accountants and accounting. Nothing about the current conceptual framework project has dispelled concerns that accounting standards will continue to be available to the highest bidder.
Get ready for my next conceptual framework post on "reliability" versus "representational faithfulness." I'll bet you can't wait!
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*Current worth to economists is generally replacement cost, and that's how shareholders should also see their company's investments in product assets as well as financial instruments.
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