Phase A of the Framework convergence project: Main changes and stakeholder comment summary
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have been working together on specific projects for some years now to update and harmonize some of their existing accounting standards. This is in order to underscore and promote the importance of a sound single set of principle-based and consistent accounting standards, that will lead to sound financial reporting. The Framework project is only one of the joint projects currently being undertaken by the boards; however, the importance of this project cannot be over-emphasized. The effects of any changes to the Framework will obviously have far-reaching implications for how other standards are set and updated, and will lay a new foundation for the colossal structure that accounting has become. This will result in changes to basic principles that accountants have complacently come to accept as ‘never changing’.
The project is being conducted in eight phases, and phases A to D are already in different stages of completion. The Phase A discussion paper – focusing exclusively on the objectives of financial reporting and the qualitative characteristics of decision-useful financial reporting information – was issued in July 2006. The comment period came to an end in November 2006, and the IASB issued information for observers in February 2007 summarizing the comments received from the different types of constituents.
This article attempts to draw attention to some of the most significant changes that can be expected in response to the outcome of phase A of the project, and to highlight some of the comments made by constituents.
The objective of financial reporting
Paragraph OB2 of the abovementioned discussion paper (DP) sets out the proposed new objective of financial reporting:
“The objective of financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit and similar resource allocation decisions.”
The objective of financial reporting is the underlying alpha and omega of every standard that follows the framework, as it provides the foundation upon which standard setters can make decisions about what should be reported to reach this objective. If the objective changes, it is expected that standards should change accordingly.
What is important to note is that emphasis is placed on ‘financial reporting’ and not on ‘financial statements’, implying that financial reporting entails far more than traditional financial statements alone. This change proposed in the DP implies that standard setting should relate not only to the traditional financial statements that are subject to audits, but also to other documents that have not traditionally been considered as part of financial reporting, such as management commentary and additional disclosures, for example a director’s report. Constituents are concerned that the boards have not adequately determined the ‘boundaries’ for these ‘other documents’ that could form part of financial reporting.
Will press releases, public addresses, information made available on web-sites and environmental impact studies fall within the scope of financial reporting as well? A question that arises is whether or not the boards have the authority to make such decisions, especially considering that the corporate laws in different countries differ, and most countries do not legally require such disclosures. Constituents were also concerned that the qualitative characteristics may not be so readily applicable to financial reporting as they may be to financial statements.
In addition to this, this proposed increase in scope could have a significant impact on already pressured audit firms, which in turn will significantly increase the costs of compliance from a company’s perspective. The boards will need to define, clarify and set boundaries for the scope of ‘financial reporting’ so that constituents can fully grasp the implications and comment accordingly.
Decision usefulness vs Stewardship
What is the single overriding objective of financial reporting? The proposed new objective focuses on providing information that is useful for decision-making, and the boards argue that assessing management’s stewardship is “encompassed within the decision usefulness objective”. 86% of respondents disagreed with the boards in this regard, and stated that stewardship should be a separate and just as important objective. Many constituents argued that assessing management’s stewardship and its accountability was in some instances the key objective, especially when looking at the not-for-profit sector. Financial reporting should be a manner in which to assess management’s performance and integrity, and this should not be underemphasized. The boards should therefore take these comments into consideration going forward.
Users of financial statements
Another important change in the objective of financial reporting is the obvious emphasis on ‘investors and creditors’ compared to general ‘users of financial statements’. The boards have given many reasons for singling out these two parties as the primary focus groups within the objective, the most important of which is that these parties are the most prominent external groups and without a defined group of primary users, the framework would become abstract and vague. Most respondents have agreed with the boards in this regard; however, some argue that this creates the impression that ‘general purpose financial statements’ which are ‘understandable’ are not being promoted. Constituents feel that the board might be biased by placing too much emphasis on publicly traded entities where the shareholders and creditors are ‘sophisticated financial statement users’, and that this will lead to financial statements being too complicated for the other not so sophisticated users of financial statements of non-publicly traded entities.
Another significant section of the proposed objective is that within the primary user group identified, the boards include ‘potential and current’ investors and creditors. Some respondents felt, however, that the focus should be on current investors alone. They argued that this would not mean that other users were not important, but rather that their needs would be met by the current shareholder perspective anyway. They further reiterated this point by stating that existing shareholders are exposed to the highest risk as they are compensated last after all other stakeholders have received a return. Other stakeholders are protected by contractual and legal rights (e.g. creditors), and potential investors should not have different financial reporting needs compared to those of current investors.
Assessing an entity’s ability to generate future cash flows
The most important, but not so obvious, effect of this primary user group which has been proposed, however, is that investors and creditors have a common interest in financial reporting: assessing the entity’s ability to generate future cash flows. The boards are thus indirectly placing more emphasis on reporting information to assess the future cash-generating ability of entities. Traditional financial statements as we know them will not be sufficient to meet this objective – they are prepared using the accrual basis and the inherent limitations of the income statement and balance sheet all provide information relating to the past.
It is not contested that accrual accounting provides much more information about an entity’s existing economic resources and claims to them, which would be omitted if only cash flows were reported, and it will certainly not be possible to have a relevant and reliable set of financial statements relating to a future period. There is an underlying drive towards a more ‘futuristic approach’ in terms of financial reporting; however, it can only be a tool to help assess the cash-generating ability and will always be rooted in providing historical information of preceding years. Applying fair value accounting instead of cost accounting would be a step in the direction the boards envisage as it would make it decidedly easier to assess the cash-generating ability of the entity’s assets as a whole. More detailed management commentary would also aid this drive towards a more futuristic approach. This envisaged management commentary could include explanations regarding the cash-generating power of assets and expected future cash flows, as well as a discussion of trends – past, present and future. Respondents have indicated that disclosure regarding the general economic conditions in which the entity trades should form part of this commentary.
The proposed additional management explanations and commentary will enhance the usefulness of financial statements, as well as give an indication of management’s stewardship. Management commentary (in a limited manner) has been around for years; however, it has been gaining more attention over the past few years, especially with the issuance of IFRS 7, which deals with the disclosure of financial instruments and the heavy burden on management to comment and assess risks within the entity.
Financial statements are not sufficient on their own to meet the objectives of financial reporting, and management commentary, which is forward-looking and provides information about future cash flows could be the solution. A move towards more vigorous application of fair value accounting and more detailed and structured management commentary will provide more useful information regarding the cash-generating ability of the entity. Although management commentary as such is not dealt with in Phase A of the project (a separate project is underway regarding management commentary, but it will also be dealt with in the Disclosure Phase of the Framework Project – see BC 143 of Phase A DP), this highlights the boards’ move towards financial reporting that is more focused on the cash-generating ability of the entity that is encompassed in the new proposed objective. It is also in our view a tool to assess management’s stewardship and accountability.
The qualitative characteristics distinguish more useful information from less useful information when economic decisions are made.
It is interesting to note that although the boards’ individual frameworks contain the same qualitative characteristics, they are presented in different manners. The IASB Framework does not rank the qualitative characteristics in order of importance, but assigns equal status to understandability, relevance, reliability and comparability. On the other hand, the FASB Framework (Concept statement 2) places the qualitative characteristics in a hierarchy. This hierarchy ranks understandability as the most important characteristic; relevance and reliability are ranked as primary qualities, and comparability is ranked as a secondary quality. Finally, materiality forms the threshold for recognition.
The DP illustrates the qualitative characteristics in what it refers to as a “logical order” (DP QC 43 & 44): relevance, faithful representation, comparability and understandability. The boards felt that the term ‘reliable’ was not clearly understood and that ‘faithful representation’ could be a clarification of what ‘reliable’ actually means. Many respondents have disagreed with this and feel that ‘faithful representation’ is still not precise enough, especially when being translated into other languages. On examination of the DP (BC 261), it appears that relevance is ranked more important than faithful representation. The basis for conclusions also state that relevance is the quality that should be considered first, and faithful representation should then be considered thereafter. The boards have argued that faithful representation is not secondary to relevance; however, the respondents felt that the sequential ordering makes it appear that way. Although it is not explicitly stated that relevance is ranked higher than faithful representation, it certainly is implied.
Relevance and reliability – the trade-off
Information is considered to be relevant if it is capable of making a difference to the decisions made by the users – it either has a predictive or confirmatory value. On the other hand, useful information needs to be a faithful representation of the ‘real world economic phenomena that it purports to represent’. It is also important to remember that reliability does not imply or require absolute precision in the estimate or certainty about the outcome. Preferring relevance to reliability depends on who you are. It is safe to assume that preparers of financial statements and auditors will choose reliability as the superior characteristic, since reliable information will minimize the risk of legal exposure (Bullen & Crook, 2005).
There has always been a trade-off between relevance and reliability. Although SFAC 2 admits that both relevance and reliability are crucial, paragraph 90 of SFAC 2 states that “reliability and relevance often impinge on each other”. The placement of relevance above reliability (faithful representation) in the discussion paper will induce accountants to account for transactions and adjustments if they are relevant, even if the faithful representation of the amount cannot be determined.
The implication of this implied ranking is that fair value accounting (very relevant, but not as reliable) will in future in all likelihood take precedence over historical cost accounting (very reliable, but not as relevant). There is no doubt that fair value accounting is more relevant, as it embodies a truer economic phenomenon. Historical cost accounting, on the other hand, is the trusted old method, and the reason we trust it is that the numbers we see are more reliable. Fair value accounting provides more useful information in assessing future cash flows of an entity and provides a truer representation of the true value of an element.
The real difficulty with applying fair value accounting (which has justifiably raised the fear of accountants should they do so) is the calculation of that fair value. Valuations of many different elements, using complicated instruments, can be done in numerous ways. Many assumptions and estimates need to be made, and without any good guidance (which we currently do not have), there is a wide range of answers that could be considered acceptable. Observable market data should be used whenever possible in determining the true fair value of an instrument or transaction.
This, however, is often not possible in a third world developing economy, as the markets for most of these instruments do not exist. Valuation techniques using unobservable ‘internally generated’ data and assumptions are then the only alternative in order to determine a fair value. It is these calculations that cause much frustration and despair for accountants and auditors, as the fair value calculation outcomes for two similar items valued by two different entities might be on opposite sides of the spectrum depending on what assumptions were made regarding future cash flows, risk analysis, discount rates, etc.
Where do we stand?
Fair value accounting is without a doubt more relevant – although less reliable, for the reasons explained earlier. The importance of relevance over reliability is a move towards the promotion of fair value accounting, and a move away from absolute precision in the numbers that get reported.
Despite all this discussion concerning fair value, it is interesting to note that the current IASB and FASB Frameworks do not give recognition to fair value as a basis for measurement. This is despite the fact that several other International Accounting Standards require fair value as the basis for measurement. An example would be IAS 39, which requires held-for-trading, derivative and available-for-sale financial instruments to be measured at fair value. The reason for this seeming contradiction is simply that both the FASB and IASB Frameworks date back a long time. Phase C of the project will deal exclusively with measurement and the boards anticipate publishing the measurement DP in the first half of 2009.
Preparers and auditors ultimately prefer reliability; investors and creditors, on the other hand, prefer relevance. It is clear that the objective of financial reporting considers investors and creditors at the top of the food chain when it comes to these preferences, and preparers and auditors need to adjust attitudes to the fact that numerical precision is not as important as the relevance of the reported number.
The formulation of a converged framework is an arduous task, and the efforts made by the IASB and FASB to achieve this must be applauded. The current frameworks are long overdue for change and refinement, and judging by the results of phase A it seems that constituents are for the most part in agreement with the proposed changes. However, a lot more refinement and clarification in most areas are required.
BULLEN, HG & CROOK, K 2005: Revisiting the Concepts: A New Conceptual Framework Project. May 2005. [On-line]. Accessed on 9/2/2006. Available: http://www.fasb.org.
FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) 1980: SFAC No.2, Qualitative Characteristics of Accounting Information. Stamford/ Norwalk: FASB
FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) 2001: Status report, Financial Accounting Series No. 223-A. [On-line]. Accessed on 16/10/2005. Available: http://www.fasb.org.
INTERNATIONAL ACCOUNTING STANDARDS BOARD 2007: Framework for the preparation and presentation of financial statements. London: IASB
INTERNATIONAL ACCOUNTING STANDARDS BOARD 2007: IAS 39, Financial instruments: Recognition and Measurement. London: IASB
INTERNATIONAL ACCOUNTING STANDARDS BOARD 2006: Discussion paper: Preliminary Views on an improved Conceptual Framework for Financial Reporting: The objective of financial reporting and qualitative characteristics of decision-useful financial reporting information. London: IASB
INTERNATIONAL ACCOUNTING STANDARDS BOARD 2007: Information for observers. Phase A: Objective of financial reporting and qualitative characteristics – comment letter summary. (Agenda paper 3A). London. IASB
Krysta Heathcote, B Com, CA(SA). Krysta is a senior lecturer in Accounting at the University of Johannesburg.
Erica Human, M Com, CA(SA) is a senior lecturer in accounting at the University of Johannesburg.