Measurement and the Conceptual Framework

1. Measurement and the Conceptual Framework Recent changes at the IASB Geoffrey Whittington

2. Outline • To explain the importance of the IASB, the Conceptual Framework, and Measurement concepts • To explain my critique of the IASB’s ‘fair value view’ of financial reporting ( Abacus, 2008). • To assess the development of the IASB’s standards since that view was formed (2006). • To explain the apparent change in IASB’s direction (why did it accept my views more often after I left??

3. The IASB • Mary Barth has already made the case for the IASB in promoting transparency in global capital markets. • Relevance, reliability and comparability are key objectives. • Principles are preferred to rules.

4. The Conceptual Framework • A high level statement of objectives of FRS’s, desirable properties of accounting in formation, and definitions of components of accounting statements. • Guides standard-setters towards providing ‘good’ information and also internal consistency of standards (avoiding loopholes for ‘creative’ accounting). • Also a guide for interpretation of IFRS, especially where specific guidance in standards is unclear or absent.

5. Measurement • The process of attributing monetary amounts to items in accounts. • Traditionally historical cost (HC). • In practice, HC often modified by lower recoverable amount (conservatism or prudence) so really mixed measurement. • 1970-1985 debate on current cost. • Later emergence of Fair Value (market price or selling price). • Recent controversy on fair value and the Financial Crisis.

6. Measurement and the Conceptual Framework • FASB’s pioneering conceptual framework project did not reach a conclusion on which basis of measurement should be preferred. • IASC’s statement of principles (1989) (adopted in 2001 by IASB) also avoided the choice of measurement method. • Perhaps this was the correct approach: conceptual frameworks should state objectives, not prescribe solutions. • Perhaps also, mixed measurement methods are appropriate, but some standard setters hoped to prescribe a single measurement method, as did FASB and IASB when they started to develop a joint Conceptual Framework (2004).

7. The IASB, 2001-2006 • Replaced IASC in 2001, with prospect of EU adoption (2005) and IOSCO support. • Improvements project to revise IASC standards (suggestions from IOSCO and National Standard Setters). • Agreement with FASB (2002) to work jointly on new standards, with the intention that IFRS would eventually be accepted for dual listing of overseas companies in the USA (achieved in 2007). • Business Combinations (FRS3) and Employee Stock Options (FRS2) followed FASB standards closely. • Tensions with EU, and EU ‘carve out’ of IAS 39.

8. Critique of IASB in 2006 • Abacus (2008) paper. • Based on subjective interpretation of IASB decisions, 2001-2006. • The IASB view is called the Fair Value view, because FV is a prominent feature, but the issue is not merely the choice of measurement method. The FV view sees the objective of financial reports as being to measure value and performance: a ‘measurement perspective’. The alternative view sees the objective as providing information that will enable users of financial reports to assess value and performance: an informational perspective’. • An Alternative View is a dissenting view in an IASB Exposure Draft.

9. The Fair Value View • Emphasis on decision usefulness and relevance to current and prospective investors and creditors. • Forecasting future cash flows is the focus, done as directly as possible. • Accounting information ideally relates to future, not past transactions and events. • Reliability les important than representational faithfulness. • Fair Values, defined as current selling prices, give a neutral, non-entity specific view of cash flow potential, because markets are complete and efficient enough to give a faithful representation .

10. Implications (FV) • Present shareholders have no special status. • Stewardship is a distraction from decision-usefulness (future cash flows). • Past transactions and events are relevant only for predicting the future. • Prudence is distortion (bias). • Cost relates to the past: fair value (exit) reflects future cash flows, and is the ideal measurement. • The balance sheet (ideally at fair value) is the most important financial statement, supplemented by comprehensive income.

11. An Alternative View • Present shareholders of the holding company have special importance, and stewardship is as important as decision usefulness. • Future cash flows may be endogenous: feedback from shareholders and markets to management. • Past transactions and events are important for stewardship, as well as inputs to prediction of future cash flows. • Reliability matters: financial reporting relieves information asymmetry in a world of uncertainty and imperfect and incomplete markets. • The economic environment contains imperfect and incomplete markets in which opportunities are entity-specific.

12. Implications (Alternative) • Needs of present shareholders, including stewardship, must be met as a priority. • Past transactions and events are relevant information and have good reliability. • Prudence may enhance reliability, especially for stewardship. • Cost is potentially relevant, e.g. as input to cash flow prediction. • Entity-specific measures represent actual opportunities available to the reporting entity and are therefore relevant. • Income statements can be more important than balance sheets, and the components of comprehensive income matter.

13. Evidence for IASB’s FV View • Conceptual framework revision (Chapters 1 & 3) : down-grading of stewardship, faithful representation substituted for reliability, emphasis on investors. • Conceptual work on measurement: Discussion paper on initial recognition, early drafts for CF measurement chapter. • Standards : Business combinations (FRS3) (intangibles, goodwill), Financial Instruments (IAS39 revision) (fair value option). • Developments in progress: Provisions (IAS 37 revision), Revenue Recognition , Insurance, Performance Reporting (and others).

14. Developments since 2006 • Some progress towards the Fair Value view, but mainly as completion of work in progress in 2006. • Some important retreats from a Fair Value approach, indicating a more open-minded view by the IASB and also reflecting some strong opposition from preparers and users of accounts and regulators.

15. The Conceptual Framework, 2006-12 • Slower progress than initially planned. • Chapters 1 & 3 finalised, incorporating the basic approach of the original Discussion Paper, with little concession to stewardship and continued emphasis on faithful representation. Consolidates a ‘FV View’. • Measurement chapter deferred. Most recent drafts defined desirable properties of measurement methods rather than attempting to choose a single ‘best’ method. Consistent with the ‘Alternative View’. • Work on Conceptual Framework is currently suspended, pending agenda review. Only 3 chapters published (Reporting Entity, Chapter 2, as an ED).

16. Standards Development: 2006-2012 • Slower than expected: FASB convergence and (from 2008) the Financial Crisis. • FV view did not prevail as expected in 2006. • Work on Provisions, Insurance Contracts, Revenue Recognition and the Performance Statement illustrates this. • Financial Instruments developments (2008 onwards) continue mixed measurement, although with strong FV elements. • But FV Measurement Standard (FRS 13 ) was issued (2011).

17. Provisions • Revision of IAS37, Provisions seemed in 2006 to be widening application of the FV View by abolishing ‘more likely than not’ recognition criterion, by adopting measurement at market price of disposal of an obligation, and by extending application to all liabilities not covered by othe standards (‘mission creep’) • Project now suspended (awaiting agenda review). • ED, Measurement of Liabilities (2010) adopted measurement as ‘the amount that the entity would rationally pay’ to be relieved of the obligation, but this included total resources required for fulfilling the obligation, if lower than market price. • Recognition still avoids ‘probable outflow’ by referring to ‘judgment’.

18. Insurance Contracts • An agenda item since 2001 (IASB’s inception). • To 2006, an FV view was favoured for insurance obligations (reinsurance price, with possible ‘Day1 Profit’, as in 2007 Discussion Paper). • Since 2007, change to ‘entry’ rather than ‘exit’ (FV) initial measurement of obligations, and entity specific expected costs allowed for periodic allocation (ED, 2010). • No ‘Day1 Profits’ to be recognised on insurance contracts.

19. Revenue Recognition • 2006 preferred approach: recognise performance obligation at Fair Value (the amount charged by a third-party market participant to assume the obligation). • Recent ED ‘s (2010 & 2012) recognise obligation as a proportion of the contract price: entry value. Revenue is recognised when each separate obligation is discharged. Expected cost of performance/discharge recognised only when contract is onerous (prudence).

20. Performance Reporting • The FV view led to a preference for Comprehensive Income in the early IASB discussions. • By 2011 (revision of IAS1), acknowledgment that operating profit is a key component of comprehensive income and reporting components of other comprehensive income is important. • This is a retreat from the ‘FV View’ that aggregate change in net worth (comprehensive income) is the central performance measure.

21. Financial Instruments • Financial Crisis Working Group (2008- ). A response to claims that FV of financial instruments added to the Financial Crisis by creating artificial volatility. • Reclassification from FV to amortised cost made easier (2009 amendments to IAS39 & IFRS7). • Proposed simplification of asset categories ; 2009 ED retains amortised cost as one category and abolishes ‘available for sale (FV direct to equity). • Proposed change of loan loss provisions from ‘incurred’ to ‘expected’ may seem like more FV, but is really a sensible application of prudence in a mixed HC model: 2011 ED. • Revised (2011) treatment of Own Credit Risk, transferring gains/losses to Other Comprehensive Income.

22. Fair Value Measurement • IFRS13 (2011) implements the FASB (SFAS157) definition of Fair Value. • FV is a sale price, not an exchange amount. • Alters definition of FV only when FV is already required, so does not extend use of FV. • BUT does extend the use of the FASB definition of FV (IASB would say it ‘clarifies’ it).

23. Conclusion • Since 2006, the IASB has moderated its previous apparent preference for the FV view. • Mixed measurement methods and conservative (stewardship) implementation now seem to be accepted, in the pragmatic spirit of the Alternative View.

24. Why has the IASB changed direction? • Changes in Board membership: less dominance of North American / ‘Anglo-Saxon’ membership. • Changes in governance of IASB Foundation: Monitoring Board, appointed by securities regulators, etc. • Lobbying by constituents, starting with the EU ‘carve-out’ of IAS39. • The Financial Crisis raised specific doubts about the reliability of Fair Value in illiquid markets.

25. Future Prospects • The IASB change of direction is welcome , demonstrating concern with the practical needs of constituents. • BUT a Conceptual Framework is still needed to ensure consistency and sound principles in standards. • The IASB must lead towards better accounting, not simply follow what is currently expedient as a political compromise. But it will have to persuade rather than dictate. A good CF should help the process of persuasion. • The CF should therefore be high on the new agenda. Unfortunately, the revised chapters 1 and 3 are unlikely to be revisited.