the Foundations of Financial Reporting: The Conceptual Framework
Gore and Dyan Zimmerman
2007 - The Financial Accounting Standards Board (FASB), together
with the International Accounting Standards Board (IASB), has embarked
on a project to rebuild the foundations of financial reporting by
revising the Conceptual Framework. The Conceptual Framework is like
a constitution for financial reporting, providing the foundation
for standards. The Conceptual Framework provides structure to the
process of creating financial reporting standards and ensures that
standards are based on fundamental principles. This helps prevent
standards from becoming ad hoc and transitory. Without a framework,
accounting standards might be based on the most expedient solution
to a particular issue, rather than a solution that is consistent
with a unified theory of accounting. The Conceptual Framework is
an essential element in the development of principles-based accounting
Conceptual Framework makes standards setting more efficient by
providing a common set of terms and premises for analyzing accounting
issues. Each time a debate on an accounting issue arises, it isn’t
necessary to reinvent the wheel. FASB and the IASB expect a common
Conceptual Framework to promote the convergence of U.S. GAAP and
International Financial Reporting Standards (IFRS), ultimately
leading to a single set of high-quality global accounting standards.
Additional information regarding the joint conceptual framework
project can be found at www.fasb.org and www.iasb.org.
to revise the Conceptual Framework will involve the examination
of the foundations of financial reporting and, indeed, accounting
itself. In essence, every accounting concept and principle which
financial reporting rests upon will be reexamined and either reaffirmed,
revised, or discarded. This project will have far-reaching implications
and will influence the direction of financial reporting for years
to come. For example, the current Conceptual Framework originally
defined the notion of comprehensive income 17 years before the
term was made operational with the issuance of Statement of Financial
Accounting Standards (SFAS) 130, Comprehensive Income.
Over time, GAAP may be completely rebuilt. In addition, there
is the very real possibility that the new Conceptual Framework
will become, as suggested by the SEC, part of the authoritative
literature, and thus have a direct impact on financial reports.
The question facing FASB, the IASB, and the entire accounting
profession is: What should be the unified theory of accounting
on which financial reporting will be built?
Revise the Conceptual Framework?
Conceptual Framework was written by FASB in the 1970s and 1980s.
When issued, it represented a significant advancement of accounting
thought and provided a basis for the transformation of financial
reporting standards through the adoption of the asset-liability
view. The asset-liability view represented a departure from the
traditional view that accounting should focus on the measurement
of income through the matching of costs with revenues. In contrast,
the asset-liability view focuses on defining and measuring assets
and liabilities, determining income via changes in these balance
sheet accounts. The asset-liability view is based on the logic
that it is necessary to define and measure the beginning and end
points (the balance sheet) of a transition before measuring the
transition (the income statement) itself.
setters, including FASB, have long preferred the asset-liability
view of accounting because the focus on income measurement proved
to be inconsistent with the development of principles-based accounting
standards. The inherent subjectivity of determining when revenue
is earned, or when costs should be matched against future revenues,
that is required in this approach resulted in the issuance of
detailed rules-based accounting standards. The adoption of the
asset-liability view in the original Conceptual Framework has
had a significant effect on financial reporting standards and
has led FASB to eliminate many of the deferred charges previously
recorded in the balance sheet.
acknowledge that “certain aspects of the conceptual framework
are incomplete, internally inconsistent, and lack clarity.”
For example, the current definition of an asset, “a probable
future economic benefit obtained or controlled by an entity as
result of past transactions,” is vague at best. It raises
questions about whether the asset is a tangible item, such as
a truck, or whether it is the future benefits (cash flows) the
truck is expected to generate. Thus, the definition confuses the
measurement of the asset with the asset itself. This
definition also fails to exclude anything from being viewed as
an asset, because practically any and all expenditures are expected
to generate future benefit.
fails to meet the two important criteria of a good definition:
It must be useful for classification, and it must harmonize with
common usage. Although the task of defining fundamental elements
may seem inconsequential, the best way to avoid large errors in
any field is through careful attention to elementary distinctions,
which is one of the purposes of a conceptual framework. Defining
the fundamental elements of accounting is just one of the many
issues in the Conceptual Framework that will be re-examined.
to be debated in the Conceptual Framework project include the
is the objective of financial reporting?
financial statements be prepared from an entity or proprietor
- What are
the most important characteristics of accounting information?
is an asset?
is a liability?
all assets or liabilities be recorded irrespective of the probability
that they may be realized or paid?
- Is the
matching principle dead?
- Will the
revenue-recognition principle survive, or will it be replaced
by the asset-liability view?
an asset be measured at cost, or at fair value?
- Is depreciation
an outdated concept tied to the matching principle, or is it
a legitimate valuation technique?
the resolution of these questions will have a profound impact
on financial reporting and the accounting profession. Furthermore,
it is important to understand that all professionals can influence
the final determination of these issues. The boards operate under
a system of due process where tentative decisions are vetted and
comments are solicited from constituents before final standards
are issued. Each comment letter is circulated among the board
members and analyzed by the staff, and thereby becomes part of
Is the Status of the Project?
FASB/IASB Conceptual Framework project consists of six parts (Exhibit).
They cover the entire spectrum of financial reporting, from the
objectives and desired characteristics of financial reports, to
the definition of the elements, the recognition and measurement
of those elements, and the form and content of financial reports.
The boards have adopted a timeline to manage the project in a
series of steps. The entire project should be completed in several
phases over the next three to five years. Each phase will involve
the issuance of a preliminary views document, followed by an exposure
draft, so that constituents can provide feedback regarding the
preliminary views (PV) document, “Conceptual Framework for
Financial Reporting: Objective of Financial Reporting and Qualitative
Characteristics of Decision-Useful Financial Reporting Information,”
was published jointly by FASB and the IASB in July 2006. This
document represents the preliminary conclusions of the boards
with respect to phase one of the whole project. Chapter 1 of the
PV covers the objectives of financial reports and chapter 2 covers
the qualitative characteristics. This first phase is critical
for two reasons. First, it is essential that a consensus be reached
regarding the objectives and desirable features of financial reports,
to provide legitimacy and momentum for the rest of the project.
Second, the objectives and qualitative characteristics will serve
as the basis for evaluating alternatives related to the crucial
recognition and measurement issues to be decided in later phases
of the project.
The PV issued
has generated a fair amount of controversy. The boards received
a total of 179 comment letters from constituents regarding the
document, many of which expressed concerns with one or more of
the decisions reached by the boards. Some of the more significant
issues related to the objectives of financial reporting include
the exclusion of stewardship as one of the objectives of financial
reporting and the adoption of the entity perspective. Other controversial
issues related to the qualitative characteristics of financial
reports involve the trade-off between relevance and reliability
and the exclusion of traditional accounting concepts such as the
going-concern principle, the substance-over-form doctrine, and
conservatism. Further discussion of these issues is presented
The PV holds that the sole objective of financial reporting is
to provide information to users in making resource allocation
decisions. Thus, stewardship, which may be defined as accounting
for the resources entrusted to management, is no longer considered
by the boards to be a separate objective of financial accounting.
Instead, the PV suggests that stewardship is encompassed in the
objective of providing useful information regarding resource allocation
decisions. Many constituents disagree, however. More than 86%
of the letters received on this issued disagreed with the opinion
expressed in the PV and argued that stewardship should be retained
as a separate objective of financial reporting (according to the
staff handout for the Feb. 28, 2007, FASB meeting). This issue
concerns the very nature of accounting and financial reporting,
and may hinge on whether one believes that accounting and financial
reports are used as much or more for control and evaluation of
management as they are for resource allocation decisions. Given
that only a small fraction of businesses are publicly traded,
the boards might be giving too much consideration to the capital
markets and not enough consideration to the needs of privately
held business enterprises.
of resource allocation versus stewardship is intertwined with
the question of whether the Conceptual Framework should apply
to all entities, both public and private. The PV states that the
Conceptual Framework will apply to all entities, based on the
premise that the objectives and fundamental principles of financial
accounting should apply to all business entities. However, the
PV also identifies the need to consider cost/benefit constraints
in applying accounting standards, which may suggest that some
entities could be exempt from certain reporting requirements.
In addition, the AICPA has formed a new committee that would advise
the boards on the need for different recognition and measurement
standards for private enterprises. This could potentially lead
to the development of two different sets of GAAP, one for public
companies and one for private. It is questionable whether two
sets of GAAP would promote greater confidence in accounting or
make financial reports more understandable. The authors would
encourage the boards to strive for a unified theory of accounting
that can be applied to all business enterprises.
raised concerns regarding whether financial reporting should adopt
the entity or proprietary perspective. In other words, when faced
with a transaction, should the accountant ask how this transaction
affects the entity or how it affects the owners’ equity
of the entity? This is a particularly important decision for the
boards, because adopting either the entity or proprietary perspective
of accounting will influence several controversial accounting
issues, such as accounting for stock options, distinguishing equity
from liabilities in cases of instruments that carry some characteristics
of both (such as convertible bonds), and using the parent-company
or economic-unit concept in preparing consolidated financial statements.
In the PV, the boards expressed a preference for the entity perspective;
however, the PV does not provide clear rationale for this conclusion.
Furthermore, in a nation where wealth is protected through property
rights, it seems inconsistent to base financial reporting on the
entity concept, which is silent regarding the division of property
rights between the various stakeholders (i.e., management, creditors,
and owners) of an enterprise. In addition, the majority of the
letters commenting on this topic suggested that this issue would
be more appropriately addressed in Phase D of the project, in
which the reporting entity is to be determined.
characteristics. In determining the desirable characteristics
of financial reports, the PV makes several significant modifications
to the current FASB Concept Statement 2. First, it replaces the
hierarchy of qualitative characteristics with a sequential process
approach. Second, it replaces the concept of reliability with
faithful representation. Third, as noted above, it would eliminate
well-established accounting concepts, such as the going-concern
principle, the substance-over-form doctrine, and conservatism,
from the conceptual framework. Although the qualitative characteristics
are the most abstract piece of the Conceptual Framework, these
changes will likely result in significant changes in the future
direction of financial reporting. Accountants must pay close attention
to what is and what is not included in the qualitative characteristics.
In the original
Conceptual Framework, the two primary characteristics of useful
information are identified as relevance and reliability. The Conceptual
Framework also recognized that there could be a trade-off between
these two characteristics, because the most relevant information
might suffer from measurement error and the most reliable information
might not be the most current. In contrast, the PV elevates relevance
to the first item to be considered in the sequential-process approach,
based on the assertion that information that is irrelevant is
useless. It could be noted, however, that information which is
relevant but so inaccurate as to be misleading may be even worse
than useless; it might even be harmful to those who rely on it.
Enron is just one example.
the PV replaces reliability with “faithful representation,”
which had previously been viewed as only a component of reliability.
Faithful representation is defined in terms of its correspondence
with the underlying economic phenomenon, as opposed to the relative
reliability of the measure of that phenomenon. Although the recognition
and measurement issues have yet to be discussed, these changes
in the qualitative characteristics suggest that the boards may
be developing a rationale for the wider use of fair-value measurement
in financial reports. Accounting has historically been valued
for providing objective information. It is possible that accounting
may lose its preferential standing in the business community as
the provider of financial information if it evolves to report
primarily relevant, but unverifiable, estimates.
the usefulness of accounting information is whether financial
reports should retain a conservative bias. In the PV the boards
have proposed to eliminate the last remnants of conservatism from
the Conceptual Framework. In its place, the boards promote “neutrality,”
which in their view is a necessary condition to faithfully represent
economic reality and a more desirable quality of financial reports.
The PV states that conservatism, which implies bias to lower income
and lower balance sheet values, is incompatible with the concept
of neutrality. There is widespread agreement that financial statements
should not be biased to favor one party over another; however,
the question remains: In an imperfect world, what is the best
way to achieve unbiased reporting?
has a long history in accounting, and the authors wonder if the
world has changed so much that it is no longer needed. Conservatism
is consistent with the asymmetrical treatment of gains and losses,
where good news is not reported until it is relatively certain,
but bad news is reported as soon as it is likely. Thus, conservatism
is embedded in many existing accounting standards, such as provisions
requiring the recognition of impairments of long-term assets while
prohibiting their write-up, and the treatment of contingent gains
and losses pursuant to SFAS 5, Accounting for Contingencies.
conservatism will open the door for revaluing assets to fair value.
It is not clear, however, that recording assets at fair value
will produce more-useful financial statements. Indeed, given the
incentives for management to provide an overly optimistic assessment
of assets and income, conservative accounting standards may be
needed to produce a fair representation of a company’s financial
position and performance.
Up to the Profession
the Conceptual Framework may seem far removed from the day-to-day
world of accounting, it has far-reaching implications for financial
reporting and the accounting profession. The revised Conceptual
Framework will form the basis for future financial reporting standards
for decades to come. An updated and comprehensive framework should
provide a unified theory of accounting and financial reporting
for all business enterprises. In addition, such a Conceptual Framework
should provide a strong foundation for boards in developing financial
reporting standards that are logically consistent and useful to
everyone interested in understanding the nature and content of
It is unclear
from the many well-reasoned comment letters expressing opposing
views that the present PV will lead to these intended results.
The outcome is pending and the question remains: Will future financial
reporting standards be built on shifting sands that may lead to
instability in financial reporting and the capital markets? Or
will they be built on a solid foundation that will promote greater
understanding of financial reports and increase their usefulness?
the boards will make the final decision, this issue is too important
to be left entirely to the standards setters. What we need now
is the collective wisdom of the accounting profession. Each of
us can support the development of a new and improved Conceptual
Framework by participating in the process through the AICPA, state
societies, other industry or trade groups, and writing directly
to FASB and the IASB. The future of financial reporting is up
to each of us as much as it is FASB and the IASB.
Gore, PhD, is an associate professor in the school of business
administration at Fort Lewis College, Durango, Colo. Dyan
Zimmerman, CPA, is a former postgraduate technical assistant
at the Financial Accounting St.