Conceptual Framework: Revisiting
the Basics
A comment on Hicks and the
concept of ‘income’ in the
conceptual framework
Michael Bromwich, London School of Economics
Richard Macve, London School of Economics
Shyam Sunder, Yale School of Management
American Accounting Association, Anaheim
Aug. 4-6, 2008
An Overview
• The FSB/IASB joint project on the conceptual
framework purports to base its approach on
Hicks’s well known definition of income.
• Hicks’s concept has been misquoted,
misunderstood and misapplied.
• We explore some alternative approaches also
suggested by Hicks and others.
• We present an alternative view (to FASB/IASB’s)
of how accounting concepts and conventions are
be related.
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Introduction
• FASB/IASB joint Conceptual Framework project
started in October 2004
• Discussion papers on the core areas (elements,
recognition and measurement) planned for
release during 2008.
• Overall approach outlined in an early paper
Revisiting the Concepts (May 2005).
• Intended to replace conventions with concepts
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The Foundation
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‘...a wise man, which built his house upon a rock………..a foolish man, which built
his house upon the sand…and it fell; and great was the fall of it.’ Matthew, 7: 2427.
All elements can be derived from the definition of assets (FASB/IASB 2005, p.6).
They quote: ‘An entity’s income can be objectively determined from the change
in its wealth plus what consumes during a period’ (Hicks 1946, pp. 178-9).
This is the foundation for the claim of ‘conceptual primacy’ of assets, and the
superiority of the ‘asset/liability’ view over the ‘revenue and expense view’ in
measuring a business’s income (FASB/IASB 2005, p.7).
But the FASB/IASB quote only a part of the sentence. The remaining part is:
'So long as we confine our attention to income from property, and leave out of
account any increment or decrement in the value of prospects due to changes in
people's own earning power (accumulation or decumulation of “Human
Capital”), Income No. 1 ex post is not a subjective affair, like other kinds of
income; it is almost completely objective'.
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Why Is This a Problem
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If everyone can buy and sell every resource at a known price (including interest
on money), income is fully determined and objective; Beaver and Demski (1979).
Then the magnitude of wealth and changes in wealth (‘Income No.1’) are known
ex ante and ex post. But then, the reporting of income is informationally
redundant.
When markets are not complete and perfect, the value of the future cash flows
of a business enterprise must includes elements which are not captured in the
market prices of its net assets
This element of value (‘internal goodwill’) depends how assets are used (the skill
of management and employees in exploiting resources , markets, business, social
and political opportunities (Hicks’ ‘Human Capital’).
The ‘objective’ version of Hicks’s ‘No.1 ex post’ income of a listed enterprise likely
to be the measure of its ‘shareholder return’ (dividend plus/minus change in
share price), i.e. the change in its ‘capital value’ at the stock market level, not net
assets. Hicks (1979).
But if firms are merely to report their stock price return (plus dividends) as their
income, their accounts are redundant. No profit in perfect markets; without
perfect markets, assets values cannot capture all value of business.
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Comparing Hicks and FASB/IASB
IASB/FASB
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Net assets
Firm
Developed in Hicks (1979)
as ‘proprietors’
Objective
Subjective
Income ex post
Income ex ante
cf. Hicks (1948)
Income 1
Income 2
Or ‘No.3’ cf. Paish (1940)
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Firm or Net Assets of the Firm
• IASB/IASB (2005, p. 18) render Hicks’s ‘capital value’ as ‘in
accounting terms, its assets and liabilities’ (cf. Shipper & Vincent,
2003; Barth, 2007).
• Extensive literature on the limited consistency between Hicks’s
‘capital value’ and net asset based measures of income (e.g.,
Edwards & Bell 1961).
• Such consistency depends on restrictive assumptions (FASB/IASB
2005 paper pp. 15-16 identifies ‘cross-cutting issues’ of
uncertainty, unit of account and management intentions.
• FASB/IASB 2005 cites Hicks (1946). Hicks (1979) revisits income:
owner seeks to ascertain ‘the maximum that could be safely taken
out of the business...without damaging the prospects of the
business; clearly a matter of judgement.’
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Permanent Income
• Hicks’ argument and analysis lead him to regard profit as that
defined by Lindahl: (C1t1 + V1t1) - V0t1 = rV0t1 i.e. income with the
benefit of hindsight, which, if interest rates do not change will
now be ex ante income for the future.
• ‘This is effectively what Friedman would call the permanent
income derived from the business (p.11)’. [Also favoured in
Solomons’ (1989) Guidelines.]
• And although he has been ‘looking for a definition of current
profit which, as far as possible, should register the performance of
the business within the year, excluding what has happened before
and what is to come after… V1t1 …would appear to have a large
part, even, in many cases, the dominant part, in determining the
current profit’ (p.10). Moreover, it is the income of the
proprietors, rather than of the business (p.11).
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How Useful is Income ex post
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In the paragraph following the one cited by FASB/IASB, Hicks says about expose
income: 'Ex post calculations....have no significance for conduct... can have no
relevance to present decisions.' If decision usefulness is the prime consideration,
irrelevance of ex post income shows the FASB/IASB argument to be built on sand.
Hicks allows a role for his Income No. 1 ex post to ‘have their place in economic
and statistical history; they are a useful measuring rod for economic progress;
but… they have no significance for conduct (1946, p. 109).
The main issue with Income ex post is ‘how much of the future is it useful to
bring into accounts of the past if they are to be helpful in forming expectations
about future Income ex ante?
This is primarily an empirical question, and the answer depends on how far
‘permanent’ and ‘transitory’ elements can be distinguished, and by business
activity (e.g. Penman, 2007); and different emphases on ‘relevance’ and
reliability’ (cf. Sundem, 2007).
But note that there is no necessary merit in simply tracking Hicks’s ‘Income No. 1
ex post’.
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A role for ‘Income ex ante’ ?
• Some authors argue for estimating ‘standard stream income’ so
that stream and a (constant) discount rate leads of the value of
the firm by capitalisation (e.g. Whittington, 1983, p.33) and to
supplementary ‘underlying’ EPS numbers’ (Black (1993) ).
• AstraZeneca for the half-year ended 30 June 2007: ‘Management
believes that investors’ understanding of the Company’s
performance is enhanced by disclosure of Core EPS, as it provides
an understanding of the underlying ability to generate returns to
shareholders. The Core EPS measure is adjusted to exclude certain
significant items, such as charges and provisions relating to
restructuring and synergy programmes, amortisation of significant
intangibles rising from corporate acquisitions and those related to
our current and future exit arrangements with Merck in the US,
and other specified items. Core EPS is not, and should not be
viewed as, a substitute for EPS in accordance with IFRS.’ [p.17].
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Defining Income without Assets and
Liabilities
• The FASB/IASB paper claims that the challenge of defining income
without reference to assets and liabilities cannot be met.
• Hicks met the challenge: Dissatisfied with his ‘No. 1’ version he offered
‘Income No.2’ (1946, p.174): In the case of a joint stock company this
could translate as ‘the maximum dividend the company could pay this
period to its current equity shareholders and expect to be able to be able
to pay them the same dividend in all future periods’, which is equivalent
to what financial analysts call its ‘maintainable (or ‘permanent’) income’.
• Income No. 2 is the same thing as Income No. 1 only when there is no
expected (or actual) change in the rate of interest used for capitalization.
• When there is inflation, the expectation needs to be ‘in real terms’
(Hicks’s ‘Income No.3’ (1946, p.174)).
• It was this ‘No.2’ concept of income that underlay the proposals in the
UK’s Sandilands Report (1975) for ‘current cost accounting’.
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Living with Duality
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Given the conceptual tension between ‘Income No.1’ (expressed
in terms of capital value changes) and ‘Income No.2’ (expressed in
terms of maintainable income), there are also conceptual grounds
for believing that the most relevant income concept for users and
their economic decisions will vary with their individual
circumstances and conditions (Paish, 1940).
• This insight can go a long way towards explaining why the
underlying motivations of those who identify with the
‘asset/liability’ view and those who identify with the
‘revenue/expense’ (or ‘matching’) view are sometimes
complementary, but are often seen as in opposition with regard to
what is the most useful approach to measuring enterprise income
in the context of individual standards.
• Can accounting live with this duality (just as physicists learned to
live with the particle and wave theory of electromagnetic
radiation)
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Conventions’ vs ‘Conceptual
principles
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The FASB/IASB 2005 sees the conceptual framework project as a crusade against
conventions. ‘To be principles-based, standards cannot be a collection of
conventions but rather must be rooted in fundamental concepts.’
Naïve to overlook the power of conventions, and their surrounding beliefs, in
maintaining social structures and interaction. Do accounting conventions need to
be replaced, how, and with what. Has the alternatives shown to be better?
Academic discussion reviewed here, and the FASB/IASB paper recycle over 50
year old arguments (Solomons 1961 on the ‘twilight of income measurement’).
There have been recent practical developments in alternative ways of setting out
‘income’ and ‘value’ in accounting reports.
E.g., supplementary reporting of life insurance profitability according to a
‘(Market Consistent) Embedded Value’ model which bears structural similarity to
a ‘Hicks no.1 ex ante-ex post’ cycle (Horton, Serafeim & Macve, 2007).
Implications of emerging practices for the conception of performance
measurement and reporting—perhaps it is better to look to emerging practices,
rather than attempt to refine concepts such as ‘income’ or ‘assets’.
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Conclusions
• Both the “gain” and “standard stream” views have some merits in
triangulating the amount to be reported as a firm’s earnings.
• The ‘new conceptual framework’ project of FASB and IASB does not
present convincing arguments to reject “standard stream” in favor of
“gain” view; or revenue-expense in favor of asset/liability view.
• If the standard setters choose “gain” and “asset/liability”, in absence of
arguments, they will simply be using their authority to force a new
convention, not replace existing conventions by concepts (e.g.
Christensen & Demski, 2003, Hoskin & Macve, 2000).
• To rewrite a key sentence from p.1 of the FASB/IASB 2005 paper: ‘To be
principles-based, standards have to be a collection of (socially) useful
conventions, rooted in fundamental concepts.’
• Hicks’s (1946) analysis neither provides a conceptual justification for the
FASB/IASB’s exclusive focus on a ‘balance sheet’ approach to accounting,
nor for its avoiding addressing the difficult problems of how best to
measure and report business performance and to help users identify the
drivers of value creation.
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Thank You
• Shyam.sunder@yale.edu
• www.som.yale.edu/faculty/sunder
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