Response to IASB/FASB Exposure Draft: An Improved Conceptual Framework
for Financial Reporting: Chapter 1: The Objectives of Financial Reporting and
Chapter 2: Qualitative Characteristics and Constraints of Decision-useful
Financial Reporting Information
By Michael Page
Professor of Accounting
University of Portsmouth
Get a grip guys, the financial system is falling about our ears, the myth of the mighty
market has been exploded and you are trying to carry on business as usual. The
current version of a conceptual framework may try to be elegant but it does not
address the problems of the real world. In order to create the standards needed for a
stable, growing economy the Boards need to abandon some of the unfounded
assumptions that they cling to and undertake a radical rethinking of how they
accomplish their mission. The core assumptions that should be abandoned include:
There exists a single objective for financial reporting. Financial reporting is a
practical activity that serves multiple objectives: it can usefully help a number of
economic and social processes but trade offs need to be made to optimise its
usefulness.
Market prices are the best kind of information. The credit crunch illustrates in a very
vivid way the shortcomings of markets. In many situations financial reporting should
enable users to calculate alternatives to market prices so that they can make informed
decisions about what kind of relationship to enter into with the entity, what to buy and
sell (including both securities and goods) and what to invest in (including both
financial and real investment).
Financial reporting should be neutral. Financial reporting exists to remedy
information asymmetries and in so doing it prevents (or at least should attempt to
mitigate) dishonesty, greed and idleness by the informed at the expense of the
uninformed. That is to say, if it is to be effective financial reporting needs to constrain
certain kinds of behaviour.
Financial measurements should be statistically unbiased and statistical reliability is
not important. On the contrary, biased reliable estimates are frequently more useful
than unbiased unreliable ones. Where errors in one direction are more costly than
errors in the other, bias may actually be a good thing. There is a sound mathematical
and statistical logic underlying prudence in financial measurement. (Christoffersen
and Diebold, 1997)
Use of financial reporting information by financial markets is the most important kind
of use. The accountability function of financial reporting may be less glamorous but it
is more important for the functioning of the economy than the buying and selling of
securities in secondary markets.
Applying this thinking to the current draft of chapters 1 and 2 of the conceptual
framework gives two grave causes for concern.
Despite the overwhelming body of response to preliminary views paper, the Boards
have still not provided a separate stewardship objective. Stewardship is not just about
providing information for owners to take decisions, it is essentially about preventing
dishonesty and lack of diligence by agents (people entrusted with other people’s
resources). It does this by providing an assurance that if they are less than honest or
diligent, they will be found out. That is the fundamental nature of accountability and it
changes the behaviour of agents. The ED conspicuously fails to recognise this aspect
of accountability. While it makes some mention of stewardship as a kind of minor byproduct of financial reporting, at no point does it recognise that financial reporting is
about constraining the behaviour of agents who have the potential to act in
opportunistic, greedy and self-interested ways.
The substitution of ‘faithful representation’ for ‘reliability’ is confused, and if
interpreted as preferring unbiased estimates, however unreliable, to reliable biased
estimates would lead to very poor choices of measurement methods. A feature of the
current economic crisis is that it illustrates that market values, or market informed
estimates of value, are often very unreliable and that they can lead to dysfunctional
behaviour by market participants and consequent instability in the financial system.
We should consider whether it is the function of financial measurement not to mimic
market prices, but to provide useful alternative measurements that provide a basis of
comparison and a reality check.
The Boards’ Questions
The boards decided that an entity’s financial reporting should be prepared
from the perspective of the entity (entity perspective) rather than the
perspective of its owners or a particular class of owners (proprietary
perspective). (See paragraphs OB5–OB8 and paragraphs BC1.11–BC1.171.)
Do you agree with the boards’ conclusion and the basis for it? If not, why?
I’m not sure that the answer matters much. There are some advantages to the
proprietary perspective and the interests of residual claimants are different in kind to
the interests of holders of fixed claims – although financial instruments can mix these
up. The entity perspective would provide some difficulties since, logically, it would
be necessary to calculate the cost of equity finance at some point if equity is to be
treated on an equal footing with debt.
The answer would become more evident if the Conceptual Framework specified the
purposes of financial reporting before setting out objectives. Financial reporting does
many things: it encourages management to act in the interests of stakeholders; it
contributes to the smooth running of financial markets (except when it doesn’t); it
forms a basis for a wide range of possible economic relationships that could not
otherwise exist, it assists competition to work in factor markets; it is a source of
1
Sic – it should be BC1.16
information useful for regulation of entities and control of the economy; it may help
direct funds to economically productive uses.
The boards decided to identify present and potential capital providers as the
primary user group for general purpose financial reporting. (See paragraphs
OB5–OB8 and paragraphs BC1.18–BC1.24.) Do you agree with the boards’
conclusion and the basis for it? If not, why?
In making this selection the boards appear to have elevated the status of capital
providers at the expense of the notion of general purpose of financial statements. It
would be better if capital providers were the exemplar of users rather than the primary
users. That said, the notion of capital providers as users is a considerable
improvement on the preliminary views paper.
The boards decided that the objective should be broad enough to encompass
all the decisions that equity investors, lenders and other creditors make in
their capacity as capital providers, including resource allocation decisions as
well as decisions made to protect and enhance their investments. (See
paragraphs OB9–OB12 and paragraphs BC1.24–BC1.30.) Do you agree with
that objective and the boards’ basis for it? If not, why? Please provide any
alternative objective that you think the boards should consider.
As discussed above, the nature and focus of the stewardship objective is different
from information use in decisions about capital provision. A separate objective of
equal prominence to the decision-usefulness objective is needed for stewardship. It is
not clear that ‘capacity as owners’ is included within the category of ‘capacity as
capital providers’ – clarification is needed. It could also be added that the holding of
shares is a long way short of ownership of the enterprise (Kay and Silberston, 1997).
One of the points about legal personality of corporate entities is to circumscribe
shareholders rights and duties to be short of ownership.
Chapter 2 describes the qualitative characteristics that make financial
information useful. The qualitative characteristics are complementary
concepts but can be distinguished as fundamental and enhancing based on
how they affect the usefulness of information. Providing financial reporting
information is also subject to two pervasive constraints – materiality and cost.
Are the distinctions – fundamental and enhancing qualitative characteristics
and pervasive constraints of financial reporting – helpful in understanding
how the qualitative characteristics interact and how they are applied in
obtaining useful financial reporting information? If not, why?
The current kind of discussion of qualitative characteristics serves only to obscure the
disjunction between objectives and recognition and measurement. Furthermore the
poor quality of the reasoning relating to the different characteristics gives the chapter
an air of tendentiousness. The distinction between fundamental, enhancing and
pervasive serves no useful purpose. An entirely different chapter coming to different
conclusions is needed. It would be much better to concentrate on measurement before
looking at the qualitative characteristics that useful measurements entail.
1 Do you agree that:
(a) relevance and faithful representation are fundamental qualitative
characteristics? (See paragraphs QC2–QC15 and BC2.3–BC2.24.) If not,
why?
It would be hard to be in favour of irrelevance. But what counts as relevance? Users
have different decision-models. Should financial reports attempt to provide the
information they desire, or the information standard setters think they need. In
practice a compromise needs to be reached.
Faithful representation, as described, is a muddled concept dressed up with a valueladen name. It is muddled because of reliance on some confused notion of attempting
to measure an underlying reality. For example: does ‘profit’ exist independently of a
series of rules for calculating it? Arguably, no well defined notion of profit can be
constructed in a world of uncertain futures and discussions of the ontology of various
phenomena are probably outside the scope of the conceptual framework. The same
can even be said of market prices. If an asset has not been sold, the question of what it
could have been sold for at a particular time is mere conjecture, not an economic
phenomenon that exists objectively.
Reliability is a much more useful notion than faithful representation. In particular
users need measurements that reliably return values close to the value of what they
purport to represent so that users can confidently use the information in their decisionmodels. Information theory tells us that a biased reliable measure will often be better
than an unbiased unreliable one, and if measurement errors in one direction are more
costly than measurement errors in the other, then a biased measure may be useful than
an unbiased one.
The reasoning of QC9 is circular. All summarised information, such as financial
reporting, is to a certain extent, incomplete in that it seeks to focus on the important
characteristics of interest and to leave out the less important. In practice decisions like
appropriate level of aggregation need to be taken that result in incompleteness. Of
course, everything needs to be included in appropriate categories so in that respect
information needs to be complete – in which case it would better just to say that
nothing material should be omitted from summarisation of data.
Given relevance and completeness, materiality is redundant – relevance entails
including only important information and completeness means including all of it.
As stated above, financial reporting should seek to constrain some behaviours
(dishonesty) and encourage others (diligence) so that it cannot be behaviourally
neutral. A better word than neutrality would be something like ‘independent’ or
‘impartial’. It would be good to get away from ‘neutrality’ because the ED confuses
itself into thinking that neutrality implies freedom from statistical bias, which, as
explained above, it shouldn’t.
The paper needs to be clearer about what measurement error is and to recognise that it
is a continuous variable – not a dichotomy between material and non-material
amounts.
(b) comparability, verifiability, timeliness and understandability are
enhancing qualitative characteristics? (See paragraphs QC17–QC35 and
BC2.25–BC2.35.) If not, why?
Comparability of information saves users costs and legitimates the activities of
standard setters. It deserves more prominence.
‘Objectivity’ would be a better word for what is called ‘verifiability’. It would be
even better to replace the notion with one of ‘based on adequate evidential support’.
(c) materiality and cost are pervasive constraints? (See QC29–QC32 and
BC2.60–2.66.) If not, why? Is the importance of the pervasive constraints
relative to the qualitative characteristics appropriately represented in Chapter
2?
See previous comments.
2 The boards have identified two fundamental qualitative characteristics –
relevance and faithful representation:
(a) Financial reporting information that has predictive value or confirmatory
value is relevant.
But other information may also be relevant – some kinds of stewardship information,
for example.
(b) Financial reporting information that is complete, free from material error
and neutral is said to be a faithful representation of an economic
phenomenon.
The condition is neither necessary nor sufficient.
(i) Are the fundamental qualitative characteristics appropriately identified
and sufficiently defined for them to be consistently understood? If not, why?
See previous comments.
(ii) Are the components of the fundamental qualitative characteristics
appropriately identified and sufficiently defined for them to be consistently
understood? If not, why?
See previous comments.
3 Are the enhancing qualitative characteristics (comparability, verifiability,
timeliness and understandability) appropriately identified and sufficiently
defined for them to be consistently understood and useful? If not, why?
See previous comments.
4 Are the pervasive constraints (materiality and cost) appropriately identified
and sufficiently defined for them to be consistently understood and useful? If
not, why?
See previous comments.
References
Christoffersen, P. F., & Diebold, F. X. (1997). Optimal prediction under asymmetric
loss. Econometric Theory, 13(6), 808-817.
Kay, J. A., & Silberston, A. (1997). Corporate Governance. In F. M. Patfield (Ed.),
Perspectives on Company Law (Vol. 2). London: Kluwer International.