The Theoretical Foundations of Accounting Standards: The Conceptual Framework and accounting research Geoffrey Whittington CFPA Cambridge University The Need for a Conceptual Framework вЂў For Standard Setters, a framework to impose consistency between standards. вЂў Also to define concepts that embody principles, to achieve вЂ�high qualityвЂ™ standards that meet the needs of users. вЂў For users and preparers of accounts, to help interpretation of standards. Especially important for international convergence. вЂў Also to fill gaps in standards: particularly important when they are not вЂ�rules basedвЂ™ (hence, not encouraged in USA). Limitations of a Conceptual Framework вЂў It should not be regarded as a set of immutable assumptions leading logically to a unique truth. вЂў This is because financial reporting deals with the needs of many different users and a great variety of transactions. Hence, there are different вЂ�truthsвЂ™ for different users and for different transactions. вЂў Hence, it should leave scope for interpretation at standardsetting level. вЂў Also, the Framework itself should be adaptable over time as needs and types of transaction change. The Existing IASB Conceptual Framework вЂў Dates from 1989, so need for revision. вЂў Based on the FASB Framework. вЂў But (mercifully) shorter than the FASB Framework. вЂў Has gaps (e.g. measurement) and ambiguities (liability/equity distinction?). The Conceptual Framework Revision Project вЂў Started in 2004 as part of FASB convergence. вЂў Driven largely by FASB technical staff, and joint IASB/FASB meetings. вЂў Hence, reflects FASB needs and past experience. вЂў Consequent detailed documents and perceived вЂ�Anglo-SaxonвЂ™ orientation (e.g. Stewardship issue). The вЂ�ActiveвЂ™ Revision Programme вЂў A: Objectives and Qualitative Characteristics (chapters 1 & 2 published in 2010). вЂў B: Elements and Recognition (currently deferred) . вЂў C: Measurement (currently deferred). вЂў D: The Reporting Entity (ED 2010). вЂ�FutureвЂ™ Programme вЂў E: Presentation and Disclosure. вЂў F: Purpose and Status. вЂў G: Application to not-for-profit entities. вЂў H: Over-view and possible consequential amendments. вЂў Completion: вЂ�Beyond 2010вЂ™ was the original intention! Progress to date (2011) вЂў Slow. вЂў And now suspended temporarily (2010) for convergence work to be completed (вЂ�after June 2011вЂ™). вЂў But CF issues continue to be addressed in other projects: Liabilities, Revenue Recognition, Financial Statement Presentation, Fair Value Measurement, etc. Problems of Objectives and Qualitative Characteristics вЂў This is the only section to be finalised. вЂў It contains fundamental difficulties. вЂў Making Stewardship a component of Decision Usefulness is the main problem of Chapter 1 (Objectives). вЂў Substituting Representational Faithfulness for Reliability is the main problem of Chapter 3 (Qualitative Characteristics). вЂў Rejection of Prudence as a characteristic is a consequence of these changes. Stewardship 1 вЂў Refers to the feedback role implied by accountability. вЂў Formalised by economists in Agency theory. вЂў Information asymmetry between principal (investor) and agent (manager) is alleviated by financial reports. вЂў Stewardship (agency) requires monitoring of past events as well as estimating future cash flows (as in decision usefulness). Stewardship 2 вЂў 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. вЂў US emphasis on role of financial markets as a discipline on management (share prices, debt covenants etc.). вЂў Stewardship is particularly relevant in вЂ�not for profitвЂ™ and public sector areas (recent work of IPSASB) and in co-operatives and other mutual organisations. вЂў 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. Faithful Representation вЂў Sounds wonderful! вЂў But why substitute it for Reliability? вЂў Reliability refers to reliable representation of what is purported to be represented. вЂў Faithful Representation has connotations of representing вЂ�economic phenomenaвЂ™ . This may include an element of Relevance, which is the other main qualitative characteristic. вЂў A вЂ�Trojan HorseвЂ™ for Fair Value? The Reporting Entity вЂў Chapter 2 of the new Framework, currently an Exposure Draft (2010). вЂў Usefully defines control as requiring power and benefit. вЂў An entity is defined by a legitimate user group. Fundamental Issues still to be Addressed вЂў Elements: What are assets and liabilities, and should equity be a residual (as in the present Framework) ? Is вЂ�arising from a past transaction or eventвЂ™ an essential component of the definition? вЂў 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? вЂў Measurement: Should a preferred measurement be defined? If so, should it be current or historic, and, if current, entry or exit (Fair Value)? Issues for Research вЂў The unresolved issues of the Framework project provide a full agenda for research. вЂў The issues are linked , e.g. Element definition, recognition and measurement. вЂў Add to that the problems of particular applications (pensions, insurance contracts, etc.) and the scope is enormous. What can academic research contribute? вЂў 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. вЂў 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. вЂў In the past, academics were perhaps too ambitious and hoped to solve everything! What are academics doing? вЂў New (or relatively new) journals: Accounting Horizons (AAA) and Accounting in Europe (EAA) specifically encourage academic papers with policy application. вЂў Within them are regular commentaries submitted to IASB (and FASB) by academic panels of AAA and EAA. вЂў These draw on research papers in other academic journals. вЂў Academics also contribute to the standard-setting process through other bodies, such as EFRAGвЂ™ s PAAINE initiative. вЂў This is welcome, but more needs to be done to unite academic research and policy-making. An Example: The Definition of Equity вЂў This is an obvious problem of the Conceptual Framework. вЂў 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 вЂ�resources embodying economic benefitsвЂ™ . Hence, the form of settlement is the basis of the definition. вЂў 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(вЂ�shares to the value of...вЂ™) 2. Shares that are puttable back to the issuer for cash at the shareholderвЂ™s option on terms that reflect the performance of the entity (as in some co-operatives). вЂў 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 FrameworkвЂ™s conceptual division between liabilities and equity. вЂў The debt/equity boundary is of great practical importance. For example, it is the basis of leverage ratios and of profit measurement. The IASB/FASB Position вЂў Debt/Equity is part of the Elements phase of the Conceptual Framework revision. вЂў In the shorter term, it is addressed for financial instruments in the FASB convergence programme (a bad idea?). вЂў Both projects are currently in abeyance (until вЂ�after June 2011вЂ™). вЂў Discussion Paper, вЂ�Financial Instruments with Characteristics of EquityвЂ™ (FASB,2007) considered 3 approaches: Basic Ownership Ownership-Settlement Reassessed Expected Outcomes вЂў Exposed by IASB (2008) as possible reform of IAS32. вЂў Lack of conceptual underpinning was a widespread response. Should be consistent with the rest of the Framework. Some Conceptual Issues вЂў 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. вЂў Should equity be defined as a residual and, if not, how do other element definitions (particularly liabilities) avoid inconsistency ? вЂў 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. вЂў How should recognition and measurement criteria apply to equity if it is no longer defined as a residual? вЂў How do we reconcile the balance sheet classification of equity with the need for an equity measure to define profit? Some Research Contributions вЂў EFRAG PAAINE discussion paper вЂ�Distinguishing between Liabilities and EquityвЂ™ provides a thorough discussion of the conceptual issues. вЂў Does have one academic author: a good example of academic involvement. вЂў Proposes a Loss Absorption approach. вЂў 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. вЂў 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? вЂў The field is open for more work!