The Theoretical Foundations of Accounting Standards:

1. The Theoretical Foundations of Accounting Standards: The Conceptual Framework and accounting research Geoffrey Whittington CFPA Cambridge University

2. The Need for a Conceptual Framework • For Standard Setters, a framework to impose consistency between standards. • Also to defineconcepts 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).

3. 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.

4. 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?).

5. 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).

6. 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).

7. ‘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!

8. 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.

9. 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.

10. 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).

11. 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.

12. 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?

13. 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.

14. 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)?

15. 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.

16. 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!

17. 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.

18. 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.

19. 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.

20. 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?

21. 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!