As far as I can tell, financial statements have no such causal connections.  It might be tempting to say that “revenue causes a firm’s wealth to rise”, but I would view that as a misinterpretation.  Instead, revenue (just like any other item on the income statement or statement of changes in shareholder equity) is just a way of classifying a change in wealth according to its type. The change in wealth is in fact caused by an event that is external to the financial statements, and results in the simultaneous recording of an increase in assets and an increase in revenue.

Why do I bring it up?  When I put on my managerial accountant’s hat and ask “what do I want to know about a business”, the answer isn’t “I want to know how events were classified on the financial statements.”  Instead it is “I want to know the causal model that leads to future increases in wealth.” Financial statements don’t seem to shed much light on that causal model.  Neither do most of the disclosures discussed as possibilities for the Disclosure Framework; those simply shed more light on the financial statements.

Put another way:  The Conceptual Framework emphasizes the user’s need to predict future cash flows.  If you really wanted to predict future cash flows, would your first step be to create financial statements as you see them today?  Or would you want a balanced scorecard?  If the latter, does the existing Conceptual Framework misstate the goal of financial reporting?

But the biggest thought provoker for me came from Greg – he questioned how useful the conceptual framework would ever be if it continues to ignore human behavior.  Deducing standard practices from a framework might be possible if the practices were applied to/by objects that could not alter their behavior given the standards.  However, we are all familiar with cases where financial engineers are at work soon after the ink is dry on a new standard.

Shyam had an interesting photographic analogy – if a reconnaissance satellite takes a photo, the subject of the photo has no idea that his/her picture is being taken.  Therefore the person does not take any special action at the time the shutter clicks.  On the other hand, when a studio photographer is taking a picture of a model, the model responds to each click of the shutter.  I believe Greg and Shyam view the FASB and IASB conceptual frameworks as being designed to govern satellite photography whereas the reality of accounting practice is closer to studio photography.

I have heard some standard setters opine that their standards should not anticipate “economic consequences”.  But totally ignoring the feedback from standards to behavior seems a little too strong.  Two recent posts to this blog (Lisa Koonce: compensation disclosures and me: disclosures regarding the use of minerals from certain countries in Africa) discuss disclosures that are apparently intended to shame companies into different (better?) behavior.  These are not isolated incidents; a variety of standards (remember SFAS #123 pro forma disclosures?) are designed implicitly to change behavior of the reporting entity.

So I tried to think of how one would change the conceptual framework to incorporate the interaction between standards and people who apply the standards.  One possibility that the panelists mentioned was to avoid being overly prescriptive (somewhat like principles instead of rules) because people often respond badly when authorities (e.g. parents) impose very restrictive and detailed rules of behavior.  What other changes would we need in the conceptual framework?  This is very important, as many people are calling for more work on the framework once the crush of convergence projects are completed.  While I think imbedding behavior into the framework will be very difficult, but we should at least have the discussion on whether/how it could be done.

In this blog, let me highlight just one of these papers, which is forthcoming in Journal of Accounting Research. It is written by Gus de Franco (University of Toronto), S. P. Kothari (MIT), and Rodrigo S. Verdi (MIT) and is entitled, “The Benefits of Financial Statement Comparability.” In this paper, the authors define comparability across firms by saying that, “Two firms have comparable accounting systems if, for a given set of economic events, they produce similar financial statements.” That seems reasonable enough, but the paper’s approach gets a bit more complicated when it tries to measure comparability.

Essentially, their measure of comparability is constructed in two steps. In the first step, a firm’s earnings (left side variable) is fit onto that firm’s returns (right side variable). The authors argue that the coefficient on the firm’s returns represents the accounting function that translates economic events (proxied by returns) into the financial statements (proxied by earnings). The authors then argue that firms with similar accounting functions (proxied by the coefficient on firm’s returns in the first step) should produce comparable financial statements for a given set of economic events.

In the second step, the authors argue that if their definition of comparability holds and their proxies are correct, then you can measure how comparable one firm’s financial statements are to another by calculating the negative absolute difference between firm i’s predicted earnings and firm j’s predicted earnings, using each firm’s respective accounting function (proxied by the coefficient on returns in the first step) and one of the firm’s returns for that period—essentially holding constant the economic events across the two firms. The higher this number, the smaller the differences between their predicted earnings for a given set of economic events.

I have serious questions about whether market returns are a good proxy for the economic events a firm must account for, but I’ll leave that question for future researchers to address.

Based on this approach of measuring comparability between firms, the authors come up with aggregate measures of a firm’s comparability to other firms in its industry, and they find a number of interesting empirical results. The primary results are

• That comparability is positively related to analyst following and forecast accuracy, suggesting that the more comparable a firm’s financial statements are to other firms in its industry, the higher the number of analysts following that firm and the accuracy of those analysts.
• That comparability is negatively related to analysts’ dispersion in earnings forecasts, suggesting that the more comparable a firm’s financial statements are to other firms in its industry, the less dispersion in earnings forecasts among analysts.

The authors conclude that, “These results suggest that financial statement comparability lowers the cost of acquiring information, and increases the overall quantity and quality of information available to analysts about the firm.” Whether you agree with their proxies in this study, the paper certainly provides a new look at comparability and is a likely benchmark against which any future papers will need to compare their own measures of comparability.

So, what do you think about this paper’s notion of comparability? Do you agree with the construct? Do you agree with how it is measured? And finally, what do standard setters learn about comparability from this paper? Are there any other recent papers out there that you know of that address the issue of comparability? I look forward to your comments and any other related research you want to highlight.

1. Initially record cash and a liability. As corn is produced record an asset (corn inventory). At the end of each accounting period, mark the corn inventory to market and recognize income. As the corn is delivered, reduce the liability at an amount equal to the original price, reduce the corn inventory at current market value and recognize a gain or loss for the difference.
2. Initially record a gain equal to the amount of cash received.  If you grow any corn, record the corn inventory at market value and income equal to the difference between market value and the cost of growing the corn. Also, record a loss equal to the original amount of cash received with a corresponding credit to cash or a liability account depending on when payment occurs.
3. Same accounting as (2) except recognize the loss at the amount of the tax on the corn harvested.
4. Same accounting as (3) except recognize the loss at the amount of tax on corn harvested in excess of the limit.
5. Same accounting as (4) except (instead of cash) initially record an asset account at the market value of the allowances.  Continue marking the allowances to market at the end of each accounting period, at the time sale, and at the time of delivery to the government, and recognize corresponding gains or losses.  When allowances are sold, record the cash received and reduce the allowances asset by the same amount.  When the allowances are used to satisfy the tax, reduce the asset account (at market value of the allowances) and the liability account for amount of the tax, and record the difference as a gain or loss.
6. Same accounting as (5) except the tax is on emissions instead of corn.

Well, what do you think?  Any graders out there?  Bottom line is that there is no liability to NOT do something.

In any case, this (or something like it) might be a good exercise for students in our accounting theory courses (yes, I think the curriculum should include a course in accounting theory).

OK, here are the questions. If you’re game for this exercise, in each case, decide whether you have a liability and, if so, when you would recognize the associated revenue/gain or expense/loss, if any. 

(1) Based on the current forward price, you receive cash (from customers) for the entire crop of corn you intend to grow during the coming season. Part of the season falls in the current fiscal year and the other part of the season falls in the next fiscal year.

(2) The government pays you the same amount as you would receive in (1) in exchange for your commitment not to grow corn during the coming season. If you grow any corn, you have to return all the money that the government gave you.  Again, part of the season falls in the current fiscal year and the other part of the season falls in the next fiscal year.

(3) Same as (2) except that you get to keep the money the government gave you. However, if you grow corn, you pay a tax on the amount you grow.

(4) Same as (3) except that the tax only applies to corn that you grow in excess of some prespecified amount.

(5) Same as (4) except that instead of cash you receive allowances to grow corn and each allowance corresponds to a certain amount of corn. You can either sell these allowances at any time during the coming season, or you can use them to pay any tax you owe at the end of the season. Account for the allowances AND any obligation (associated or not).

(6) Same as (5) except replace corn with pollution emissions.

I’d be interested to know whether we can answer the above questions in a way that would form the basis for a consistent, coherent and comprehensive concept describing the accounting for an agreement NOT to do something. How would you write that concept?

If you think the above questions need tweaking (or dramatic revision), let me know, because I’d like to use something like this the next time I teach accounting theory. Also, if you have your own set of questions whose answers might help develop a conceptual framework (or understand/revise the one we have), please let me know, because our accounting theory students need all the help they can get!

Thanks!

As discussed on the conference website, the objective of this year’s conference is:

to provide the FASB and IASB with timely feedback on the Conceptual Framework issue of recognition criteria and their potential role, if any, in the revised conceptual framework. The FASB and IASB are engaged in projects aimed at improving and converging certain financial reporting standards, with the ultimate goal being the provision of comparable financial reporting information under U.S. GAAP and International Financial Reporting Standards. This year’s conference will focus on matters related to the relationship between Conceptual Framework recognition criteria and decisions the Boards have made in developing standard-setting solutions to the same issues in related projects (Leases, Insurance, Revenue Recognition, Financial Instruments and Emission Trading, among others). The conference will explore whether any inconsistencies in Board decisions can be attributed to weaknesses in the existing Conceptual Framework (relating to, for example, definitions of elements or other recognition criteria) or if key guidance is missing in the Framework (relating to, for example, presentation, measurement or the unit of account). These issues are of significant interest to participants in the financial reporting process, and relate to a number of the major joint projects currently on the FASB’s and IASB’s agendas. Academic participants also are urged to offer insights on these issues based on research with which they are familiar.

The conference materials are, as always, thought provoking. They consist of three sets of cases and several items of background reading. In the round table on Weds, we will review some of these case and discuss the role of recognition criteria, whether recognition criteria are necessary and, if so, what their purpose is intended to be.

One of the background readings that will be of particular interest to academics is a research paper on emission rights by Yonca Ertimur, Jennifer Francis, Amanda Gonzales, and Katherine Schipper. In that paper, the authors discuss at length several different methods of accounting for emission rights. They then simulate the likely effect that these treatments would have had on the financial statements of companies with significant annual emissions. As a final empirical test, they look at stock returns to see how the market values these various pieces of information.

Should be a fun discussion. Hope you can join us!

Details for participation are here.

For example, among many other items, the currently circulating exposure draft on revenue recognition “scopes out” any revenue recognized by a lessor (par. 6); and the currently circulating exposure draft on leases “scopes out” any valuation and revenue recognition issues related to investment properties (par. BC55-58). A separate project that hasn’t reached exposure draft stage deals with investment properties.  With a broad enough conceptual framework, perhaps one principles-based standard could cover revenue recognition, leases and investment properties. 

For example, if we had a standard that said revenue is recognized when the right of use and associated risks pass to the other party to the transaction, and assets with contractually identified future cash flows should be recorded at the discounted present value of expected future cash flows, it seems to me that this could cover construction projects, leases and investment properties under one umbrella. The challenge is to write a standard that creates a big enough umbrella to cover all three types of transactions.

The conceptual framework is moving through the standard setting process more slowly than individual projects on leasing, revenue recognition, investment properties, and many other issues. Perhaps this is an example of putting the cart before the horse. If the horse had broad enough shoulders, perhaps there would be less need for the amount of “scoping out” that we see in current exposure drafts. What do others think?

In 2008, the FASB and IASB wrote the exposure draft of what would become CON8 (“Exposure Draft of Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information.”).  That document proposed that the mandate of the Boards is as follows:

The Boards’ mandate is to assist in the efficient functioning of economies and the efficient allocation of resources in capital markets by developing high-quality financial reporting standards. (Para. OB3)

The final version of the Conceptual Framework No. 8 (CON8) did not include this statement, and explicitly rejected expanding the objective of financial reporting to include maintaining financial stability:

OB2. 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 in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.

OB10. Other parties, such as regulators and members of the public other than investors, lenders, and other creditors, also may find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.

Why the change?  From the Basis For Conclusions: CON8, BC 1.23-27):

…[S]ome may take the view that the best way to maintain financial stability is to require entities not to report or to delay reporting some changes in asset or liability values.

That requirement almost certainly would result in depriving investors, lenders, and other creditors of information that they need.

The only way to avoid conflicts would be to eliminate or deemphasize the existing objective of providing information to investors, lenders, and other creditors.

The Board concluded that eliminating that objective would be inconsistent with its basic mission, which is to serve the information needs of participants in capital markets.

The Board also noted that providing relevant and faithfully represented financial information can improve users’ confidence in the information and, thus, contribute to promoting financial stability.

I think we can better understand these tensions if we explicitly define three distinct ways of assessing whether a standard “works”:

• Conceptual Approach. Reporting standards should result in financial statements that are with a Conceptual Framework that defines the desirable characteristics of financial reports, the nature financial statement elements and the appropriate methods of recognition, measurement and disclosure.
• Decision-Usefulness Approach. Reporting standards should result in better economic decisions by individual users of financial statements.
• Economic Consequences Approach. Reporting standards should result in better aggregate outcomes, such as higher rates of economic growth, greater economic stability and more desirable distributions of wealth and income.

These are all normative judgments, but they suggest some interesting positive questions:

1. Do standards that are conceptually appealing also result in better decisions and economic consequences?
2. Do better individual decisions also result in favorable economic consequences?
3. Do favorable economic consequences necessarily reflect more decision-useful or conceptually appropriate standards?

What research addresses these questions?

This new concept statement, SFAC 8, deals with the objectives of financial reporting and the qualitative characteristics of accounting information and so is a replacement of SFAC 1 and 2, respectively. The new statement is available on the FASB’s website here.

Having now read through both chapters and the basis for conclusions, I have to say that my first impression is that chapters are refreshingly succinct, especially as compared to Concept Statements 1 and 2.

Noteworthy items in the Objectives chapter:

• Although the word “stewardship” does not show up in the statement on objectives, the Board clearly indicates that one purpose of financial reporting is to provide information that allows users to assess how efficiently and effectively management has been in using the reporting entity’s resources.
• In the basis, they also indicate that there was never an intention to subjugate stewardship decisions to investment and credit decisions. However, they also note that information designed for resource allocation will also generally be useful for assessing management performance.
• In reaffirming that investors and creditors are the primary user group for general purpose financial statements, the Board (not surprisingly) discusses the push that was made during the recent financial crisis to make maintaining financial stability an objective of financial reporting.

Noteworthy items in the Characteristics chapter:

• Reliability has been replaced by faithful representation; timeliness and verifiability are now enhancing characteristics, rather than components of relevance and reliability, respectively; and the Board provides a clear priority when applying the fundamental characteristics – saying, essentially, first identify a relevant economic phenomenon and then consider whether it can be faithfully represented in the financial statements.
• The components of faithful representation are: completeness, neutrality, and freedom from error.
• Freedom from error does NOT mean the same thing as “accurate” or “precise”. Instead, it is described as meaning that “there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process.” Honestly, I found this point to be a little subtle and, given the inclusion of the other two components (completeness and neutrality), I’m not sure how much the notion of free from error adds, especially given the likelihood that it will be misinterpreted by lay readers as implying accuracy or precision.

Overall, I think the new hierarchy of information characteristics is significant improvement over the previous hierarchy…but that’s just my opinion.