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The Accounting Cycle
Objective of Financial Reporting and Qualitative Characteristics: Some Comments

July 2008On May 29, 2008, the Financial Accounting Standards Board issued an exposure draft, "The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information." Once adopted, it will supersede SFAC Nos. 1 and 2. This editing of the conceptual framework is carried out in conjunction with the International Accounting Standards Board.

Chapter 1 presents the objective for financial reporting, and the description differs little from what is in Concepts Statement No. 1. This objective is "to provide information that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Information that is decision useful to capital providers may also be useful to other users of financial reporting who are not capital providers." This emphasis on capital providers is appropriate as this information assists capital formation in this country and capital reallocation.

Yet, I quibble with the discussion of users. I wish the board would replace the term "users" with "users and their advisers" to emphasize that a degree of sophistication is required to read financial reports. Indeed, without some significant education and experience in accounting and finance, I think it impossible for a user to grasp what is contained in today's financial statements; conversely, it is inappropriate to dumb down the financial report just to allow as many people as possible to read the corporate chronicles, as the statements and the footnotes would lose their utility to sophisticated investors and creditors. FASB does discuss this topic a bit in the second chapter (paragraphs QC23 and BC2.32) but insufficiently.

FASB moves from a proprietary viewpoint to an entity viewpoint (OB5 and 6 and BC1.11-16). I have no problem with that, but I wonder how deeply the board has pondered this perspective inasmuch as it makes the inconsistent statement that "Financial reporting also should provide information about … financing transactions between the entity and its owners" (OB24). If FASB truly wants to adopt an entity approach, then it should amend this sentence to "entity and its capital providers" because creditors are elevated to equal footing with the investors in an entity framework. The entity perspective also implies that interest would no longer be an expense but a capital distribution quite similar to dividends. Is this really where the board wants to go?

I am happy that the board concluded that the term "comprehensive income" does not convey what it had in mind when examining financial performance (BC1.37). I would go further and suggest the elimination of comprehensive income altogether and require all gains and losses to run through the income statement. If an item is sufficiently relevant and faithfully representative and verifiable to recognize on the balance sheet, then it has the necessary prerequisites for recognition on the income statement.

Chapter 2 develops the qualitative characteristics of this financial information. The board posits two fundamental qualitative characteristics, relevance and faithful representation. It also adds the enhancing characteristics of comparability, verifiability, timeliness, and understandability. It then notes two pervasive constraints, materiality and cost. For the most part, this theoretical template is good and is an improvement on SFAC No. 2; nonetheless, I have several comments pertaining to this section of the exposure draft.

The exposure draft discusses faithful representation in QC7-11; however, the exposure draft eliminates an important paragraph that was contained in the Preliminary Views. When explaining faithful representation, FASB wrote (Preliminary Views, QC18):

The phrase real-world economic phenomena deserves emphasis because its implications have often been overlooked. The phenomena depicted in financial reports are real world because they exist now or have already occurred. For example, a stamping machine exists in the real world. In contrast, an accounting construct such as a "deferred charge" (that is not an economic resource) or a "deferred credit" (that is not an economic obligation) is a creation of accountants. Because such deferred charges and deferred credits do not exist in the real world outside financial reporting, they cannot be faithfully represented as the term is used in the framework.

In other words, deferred debits and credits do not possess faithful representation because they are merely the creation of accountants and do not exist in the real world. As the board is correct in its explication and because this thought best illustrates the concept of faithful representation, I think the board should reinstate this paragraph.

Paragraph QC9 describes how a depiction needs to be complete to have faithful representation. I agree with the board. My hope is that the board will now realize the danger of its crusade against complexity. The problem of oversimplifying accounting for complex transactions is that the accounting becomes incomplete and thus not possess faithful representation.

Comparability is an important characteristic to include in this analysis (QC16). The board then avers that "comparability should not be confused with uniformity" and that "an overemphasis on uniformity may reduce comparability…" I would like to see FASB prove these claims rather than merely asserting them. In particular, as FASB (and IASB) continues moving toward principles-based accounting, it should realize the peril that an under-emphasis on uniformity will likely produce financial reports that are less comparable with one other. Lease accounting is a great example. Principles-based accounting may well lead one corporation to capitalizing more leases while another enterprise turns all its leases into operating leases. Where is the comparability under that scenario?

Verifiability implies similar measures by different measurers (QC.20-21). As a component of verifiability, FASB ought to include auditability. If an external auditor cannot audit something, it is hardly verifiable. More importantly, the audit function must be strengthened for financial reports to have integrity; FASB can play a role in strengthening the audit function by not issuing reporting requirements that involve measures that cannot be audited.

Understandability (QC23-24) means that "Users of financial reports are assumed to have a reasonable knowledge of business and economic activities and to be able to read a financial report." FASB should add in the body or in its basis of conclusions that the ability to read a financial report does not imply a superficial understanding about the financial condition of the business enterprise. As it reads, somebody might think that an individual has such an ability to read financial reports if he or she can employ a profit analysis model or ratio analysis on a set of financial statements. This activity is insufficient for determining that a person can read a financial report because the individual may likely mis-analyze a firm's condition because he or she did not make analytical adjustments for off-balance sheet items and other fanciful tricks by managers. This includes so many of Enron's investors and creditors. To understand financial reporting today, you must be an expert in accounting and finance.

IASB included substance over form as a component of reliability, but FASB has not embraced substance over form in this exposure draft. FASB defends its decision by saying that substance over form is redundant once you admit representational faithfulness to the conceptual framework (BC2.18-19). While I agree with the reasoning, I would nonetheless prefer to add substance over form as a defining element of representational faithfulness. The discussion becomes more lucid by emphasizing substance over form instead of ignoring it.

In conclusion, U.S. investors and creditors witnessed unprecedented distortions in financial reporting during the last decade or so. With this context in mind, I wonder whether this document will improve financial accounting and reporting or itself become part of the problem. As it reads, the exposure draft is on balance a good document, though I think it can be improved further. The major issue is not so much the exposure draft but what FASB will do in the near future. The concern is whether the board has the courage to follow through and produce standards that are consistent with the conceptual framework.

"Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information" Exposure Draft (May 29, 2008) Comment deadline: September 29, 2008.

"Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information" Preliminary Views (July 6, 2006) 

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.

2008 SmartPros Ltd. All Rights Reserved.

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