Comments on the Proposed Conceptual Framework for Financial Reporting.

by
Professor Martin Walker
Manchester Business School (Manchester, England)
This paper is a comment on the recent discussion paper of the IASB entitled Preliminary
Views on an improved Conceptual Framework for Financial Reporting: The Objective of
Financial Reporting and Qualitative Characteristics of Decision-useful Financial
Reporting Information.
The adoption of a conceptual framework by an accounting standard setting body
potentially influences how individual accounting standards are set and, perhaps more
importantly, how the agenda of the standard setting body is set. Accounting standards
are highly political, and anyone who understands anything about political processes
will know that the shaping of the political agenda exerts a significant influence over the
outcomes delivered by such processes. Thus although the conceptual framework may
seem to be somewhat removed from immediate policy relevance, the likelihood is that
the design of the conceptual framework will exert a significant influence over when and
how accounting issues are settled. If the conceptual framework is badly designed it is
likely that the deleterious effects will be long lasting and difficult to reverse. Hence it is
important that that the claims of the discussion paper are subjected to the closest
possible scrutiny.
I believe that the proposed conceptual framework is fundamentally flawed, and that its
adoption will inevitably lead to financial reporting that is not fit for purpose.
I have two major concerns.
Failure to Articulate the Importance of Stewardship
It is alarming that the paper notes that there is substantial disagreement within the boards
on the relative importance of stewardship as an objective of financial reporting.
The paper struggles to produce a form of words designed to satisfy all parties, but I do
not think this is a logically sustainable position.
The paper indicates that there are fundamental differences within the board/s about how
accounting standards ought to be set and how the accounting standard setting agenda
should be shaped. As someone who has studied financial reporting for many years, this
is not surprising to me. The uncomfortable fact is that there are perfectly reasonable
conceptual differences over the nature of Accounting and over the role of Accounting in
the economy. In other words there can be more than one logically valid conceptual
framework.
It seems to me that the opposing sides of the stewardship debate have two quite different
conceptual frameworks. One side adopts a traditional stewardship perspective the other
adopts a value relevance perspective. If this is the case then IASB needs to think very
carefully about the logic of trying to find a compromise between these two rival points of
view. If you attempt to merge two different conceptual frameworks, you do not end up
with a better framework. You end up with a logical mess.
As it stands the content of the paper relating to the stewardship issue is logically flawed
and therefore unsuitable as a foundation for the development of accounting standards. For
example the paper states,
Financial reporting provides information about an entity during a period when it was under the
direction of a particular management, but i t does not directly provide information about that
managements performance. To make stewardship a separate objective might exaggerate what is
feasible for financial reporting to accomplish.
However, if this is true of the stewardship objective it is equally true of the decision
relevance role of financial reporting. For example, accounting information can never
provide all the information that is relevant for valuing a firm. Thus the logic that the
paper provides for denying a separate stewardship objective applies equally well to the
logic of having a separate decision usefulness objective. To allow the paper to proceed
without rectification of such logical flaws runs the risk of seriously undermining the
credibility of the joint boards.
To overcome these concerns there are only two logical options.
1. Choose one logically consistent framework recognising that other measures may
be needed to give attention to issues not captured by that framework i.e. make an
explicit choice between the stewardship perspective and the value relevance
perspective with regard to the formulation of accounting statements.
2. Produce a new framework that explicitly recognises that financial statements in
general must provide information both for stewardship/control and for
valuation/resource allocation. This would be my personal preference, and so I
provide further guidance on this below.
With regard to option 1 the following remarks are relevant.
a) If the joint boards choose to adopt a pure stewardship perspective for designing
financial statements then the statements will need to be augmented by additional
mandatory value relevant disclosures, some of which may need to be subject to audit.
b) If the boards choose to adopt a pure resource allocation perspective in designing
financial statements, then other mandatory and audited financial disclosures will be
needed in order to improve the ability of external investors to govern company managers.
c) To some extent the issue of choice between stewardship and value relevance cuts
across the issue of whether the design of financial statements needs to be different for
different kinds of entities. If the conceptual framework is to apply to unlisted companies
and not-for-profits as well as listed companies then the framework should be appropriate
for all these cases. It is generally understood that the main role of not-for-profit
accounting is one that is primarily concerned with accountability and stewardship. Thus
if a decision is made to focus the conceptual framework for IFRS on resource allocation
then it seems to me very likely that this will result in calls for a different conceptual
framework that is more tailored to the needs of entities other than listed firms.
With respect to option 2 the following remarks may prove helpful to the boards.
a) An excessive focus on the idea that external investors make the important
resource allocation decisions seems to me to be the root cause of the difficulties in
the paper. Whilst it is true that external investors do decide whether or not to buy
and sell shares, the fact is that the buying and selling of shares is a relatively
unimportant set of decisions. The most important decisions are the real
investment decisions made by company managers. It is important to change the
mind set of FASB and IASB away from their current obsession with CAP-GAAP.
This is an obsession borne in the USA where the needs of Wall Street are
paramount. This is a dangerous obsession and it is not one that should be allowed
to stunt the development of international accounting. Trading in stocks and
shares is largely froth on the economic seascape. Financial reporting should be at
least equally concerned with the ocean of real economic decisions that lies
beneath.
b) The stewardship problem is concerned with the fact that the interests of company
managers are not automatically and everywhere aligned with the interests of the
owners. To put it only slightly crudely, corporate managers are given the
privilege of being allowed to gamble with other peoples money. Corporate
managers have to be monitored and provided with appropriate incentives to make
resource allocation decisions that are optimal from the investors point of view.
The financial reporting system is an essential part of the monitoring and incentive
system that ensures that the resource allocation decisions of managers are made in
the interests of the owners.
c) The boards have asked for examples of how a stewardship perspective would
materially alter the design and content of financial statements. There is a vast
literature that shows that external parties exhibit an implicit demand for financial
statements that are conservative. The demand for conservatism in financial
reporting is a reflection of the fact that corporate managers have insider
information advantages, and the fact that managers cannot be relied upon not to
use such information opportunistically. The lessons of Enron, the recent
controversy over option rebasing, and a multitude of other examples in the
empirical literature on accounting choice all point to the fact that such
opportunistic behaviour is never far away.
Failure to Recognise the Importance of Earnings.
The discussion paper gives the impression that it is practically informed, but in fact fails
to pay much regard to how capital markets actually work. There are hundreds of capital
market studies that show that share prices are driven by earnings expectations. It is
puzzling that an attempt to produce a conceptual framework, apparently focused on the
needs of investors, chooses to ignore the most important information need of investors,
information about future earnings. The conceptual framework will remain fundamentally
incomplete until it comes to terms with the fact that stock market prices are largely driven
by earnings and earnings expectations.
Rather than ignoring the importance of earnings, the boards should produce a framework
in which a major focus of financial reports and the published accounts is to assist users in
understanding the reported earnings number a) as a performance measure, and b) as the
starting point for predicting future earnings. Sir David Tweedie has joked that if you
knew what was in earnings you wouldnt touch it with a barge pole!! I suspect that this
way of thinking has led IASB to believe that this is a good reason for downgrading the
importance of earnings. However, whilst I agree with the view that reported earnings can
often hide critical information, I do not think this is a good reason for seeking to write
earnings out of the script. Rather IASB should focus on improving financial reporting so
as to improve the quality of reported earnings, and the quality of the information
supporting the earnings figure.
The report recognises that the financial statements need to be related to the broader
communication framework in which there are other disclosures outside the financial
statements. Some disclosures are mandatory some are not. Some disclosures are audited
some are not. Some disclosures are voluntary some are not. Some disclosures are made
within the annual reports others are disclosed in other ways. Hence there is a wide
variety of formal and informal financial communication that takes place outside of the
financial statements. Investors need a conceptual framework that allows them to make
sense of all these disclosures, and allows them to relate them to the hard information in
the financial statements.
This can be achieved by adopting a forward-earnings-centred approach to financial
reporting. Ohlson has shown how company value can be expressed directly in terms of
expected earnings and expected abnormal earnings growth. The abnormal earnings
growth framework provides a valuable conceptual basis for linking up the various
components of the financial communication package. For example many firms are now
producing Key Performance Indicators within their OFRS. Using the AEG model it is
easy to show that a KPI will be value relevant if and only if it is relevant for predicting
future earnings or earnings growth. The AEG model also helps one understand why we
need more detailed and transparent financial statements. For example we need better
information about transitory items to improve our ability to forecast future earnings.
The forward-earnings-centred approach to financial reporting also helps in understanding
the links between the past and the present. For example todays earnings can be viewed
as the payoffs to real investment decisions made in the past. If investors want to assess
the quality of past managerial decisions they need to be able to trace the link from past
real investment decisions to current earnings. Similarly statements about the potential
benefits of current resource commitments are more credible if couched in terms of their
impact on future earnings.
In summary the conceptual framework needs to explicitly acknowledge the demand for
earnings information by capital market participants. It is essential that the financial
statements, and the supporting information related to these, provide the information that
capital market participants need in order to produce reliable forecast of future earnings. In
addition companies should be encouraged to produce their own audited estimates of core
earnings along with any information needed to interrogate the judgements made in
arriving at such figures.
References
IASB (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
Ohlson, J.A. (2003) On accountingbased valuation formulae Stern School of
Business, New York University.
Ohlson, J.A., and Juettner-Nauroth,B.E. (2003) Expected EPS and EPS Growth as
Determinants of Value, Stern School of Business, New York University.