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© 2011 Wiley Periodicals, Inc.Published online in Wiley Online Library (wileyonlinelibrary.com).DOI 10.1002/jcaf.20679

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Conceptual Framework Revisions: Say

Goodbye to “Reliability” and “Stewardship”

INTRODUCTION

In September 2010, the Financial Accounting Standards Board (FASB) and the Inter-national Accounting Standards Board (IASB) issued updates to the conceptual frameworks of US generally accepted account-ing principles (GAAP) and international financial reporting standards (IFRSs), respectively. The updates are part of the joint FASB/IASB project aimed at developing an improved, com-mon framework. The framework project, which was begun in October 2004, is designed to be implemented in eight phases, three of which are currently on the active agendas of the FASB and IASB, and only one of which has now been completed.1

The FASB’s update is presented in the Statement of Financial Accounting Concepts No. 8 (SFAC 8), Conceptual Framework for Financial Report-ing, which replaces SFAC 1 and 2. The stated purpose of the conceptual framework is to establish the objectives to guide the Board’s reasoning when considering accounting and reporting alternatives. Given its purpose, the framework project

seems oddly out of sync with the standard-setting activity aimed at converging US and interna-tional accounting standards, which has been proceeding vig-orously. Logically, one would expect that establishing the goals of an endeavor and its concep-tual foundation would precede and determine all other actions related to the endeavor. However, the presumption is that if the Boards had waited until comple-tion of the conceptual framework project, other standard-setting activity aimed at converging US and international accounting standards would have been unac-ceptably delayed.

In this column, we discuss the context of the conceptual framework generally and then recently issued updates, the first of which deals with the objective of financial reporting and the second with the qualities of use-ful financial information.

CONCEPTUAL FRAMEWORK—CONTEXT

The conceptual frameworks are not part of the authorita-tive accounting standards issued by the FASB or IASB. The US GAAP conceptual framework

is presented in concepts state-ments, which are not part of the FASB’s Accounting Standards Codification (the single source of authoritative US GAAP). Similarly, the IASB’s Conceptual Framework for Financial Report-ing2 is not an IFRS. Note, how-ever, that the IASB framework is part of the IFRS hierarchy of accounting rules, as described in paragraphs 10 through 12 of International Accounting Stan-dard 8, Accounting Policies, Changes in Accounting Estimates and Errors. The IFRS hierarchy provides that when a transaction is not specifically covered by an IFRS, a preparer can consult, in descending order: another IFRS for a similar transaction; the IASB framework; and, finally, pronouncements by other stan-dard setters that use a similar conceptual framework.

While the frameworks are not part of accounting standards, they do serve to describe the objectives and concepts under-pinning the standards. As such, the frameworks directly benefit the Boards in their standard-set-ting role. In addition, the FASB indicates that the framework will also benefit “those affected by or interested in” the standards;

Elaine Henry and Oscar J. Holzmann

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and the IASB indicates that its framework will assist national standard setters, preparers, audi-tors, and users.

THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING: CHAPTER 1

Chapter 1 of SFAC 8 super-sedes FASB’s SFAC 1, Objec-tives of Financial Reporting by Business Enterprises, and includes various changes to both US and international standards. As with SFAC 1, the scope of the conceptual framework cov-ers financial reporting, not just financial statements. The con-verged scope is a change for international standards, however, where previously the IASB framework applied only to finan-cial statements.

The objectives of finan-cial reporting in the updated frameworks, Chapter 1, take the perspective of capital providers (existing and potential investors, lenders, and other creditors) as the primary user group. Specifi-cally, the framework provides that:

The objective of general purpose financial report-ing is to provide finan-cial information about the reporting entity that is useful to existing and potential inves-tors, lenders, and other creditors in making deci-sions about providing resources to the entity. Those decisions involve buying, selling, or hold-ing equity and debt instruments and provid-ing or settling loans and other forms of credit.3

The focus on a primary user group was deemed necessary to

avoid producing a framework that would be too vague to be useful. The Boards chose capital providers as the primary user group for three reasons: (1) this group has the most critical and immediate need for informa-tion, (2) the Boards are required to focus on the needs of capital market participants, and (3) the information needed by this group would likely meet most of the needs of other user groups.4

Capital providers use finan-cial reporting to assess cash-flow prospects and also to assess management’s fulfillment of its stewardship responsibilities. The Boards were careful, however, to avoid including language that sounded like there were two objectives rather than a single objective of financial reporting.5 Thus, the single objective is to provide decision-useful informa-tion, and the frameworks indi-cate that decisions relate both to resource allocation and to stewardship evaluation. The basis for conclusions implies that the standard setters view these uses as equally important:

The Board did not intend to imply that assessing prospects for future cash flow or assessing the quality of management’s stewardship is more important than the other. Both are important for making decisions about providing resources to an entity, and information about stewardship is also important for resource providers who have the ability to vote on, or oth-erwise influence, man-agement’s actions.6

The relative importance of assessing cash-flow prospects versus assessing management’s

stewardship has been debated in the accounting literature sur-rounding the conceptual frame-work process. For example, the Financial Accounting Standards Committee (FASC) of the American Accounting Associa-tion (AAA) explicitly criticized the preliminary view of the conceptual framework for de-emphasizing the stewardship role of accounting information by not including it as a separate, explicit objective.7

Interestingly, the newly issued updates do not even include the term stewardship. The Basis for Conclusions indicates that the term was excluded because of difficulty in translating it into other lan-guages. Instead, the updated framework refers to “how efficiently and effectively the entity’s management and gov-erning board have discharged their responsibilities to use the entity’s resources.”8

QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION: CHAPTER 3

The second chapter in the new pronouncement is labeled Chapter 3, leaving the concep-tual framework with an odd—hopefully temporary—gap in its numbering. Chapter 2 is being reserved for a chapter on the reporting entity. The Exposure Draft for the Chapter 2 topic was issued in March, with a comment period that ended in July 2011.

Chapter 3 of SFAC 8 super-sedes FASB’s SFAC 2, Qualita-tive Characteristics of Account-ing Information. The updates specify that the two fundamental qualitative characteristics of useful financial information are relevance and faithful represen-tation.9 The so-called enhanc-ing qualitative characteristics

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important objective of financial reporting and that historical cost is more useful than fair value in assessing management’s steward-ship. With stewardship no longer an objective of financial report-ing, proponents of historical cost have lost another fundamental, if semantic, basis for their argument.

Finally, the updates eliminate conservatism and prudence as desirable characteristics of finan-cial reporting. Both are viewed as conflicting with the desired neutrality. Some proponents of historical cost (including related measurement practices such as lower-of-cost-or-market) claim that historical cost is more con-servative than fair value, which permits the values of assets to be written up as well as written down. An argument in favor of conservatism is that it prevents inappropriate early distributions to shareholders or management.13 In the updated frameworks, con-servatism is no longer a desired financial characteristic. Here, proponents of historical cost have lost another fundamental basis for their argument, and this one goes beyond semantics. Overall, with the updates to the conceptual framework, several debate-laden words disappear down the drain of accounting history.

CONCLUSION

The updates to the concep-tual framework were accepted by unanimous vote of the FASB. News of the Boards’ issuance of the new concept statement did not merit attention in the main-stream financial media (the pre-mature resignation of the FASB chairman was considered more newsworthy). Yet arguably, the changes in the framework have significance beyond what might

and is inconsistent with either conservatism or prudence.

THE SUBTEXT? FAIR VALUE VERSUS HISTORICAL COST

Several changes in the con-ceptual framework that appear subtle are arguably much more significant when viewed in the context of the debate between fair value and historical cost as a basis for measurement of assets. First, the updates replace reliability as a desirable char-acteristic of financial report-ing. The stated reason is that it was not possible to explain the meaning of reliable, so the term faithful representation is used instead. Broadly speaking, proponents of historical cost claim that historical cost is more reliable than fair value, primar-ily because it is based on audit-able records of amounts paid to purchase an asset rather than on fair value (often estimated based on the asset’s future cash flows). In contrast, proponents of fair value claim that fair value is more relevant than historical cost. The fair value/historical cost debate is, in some ways, encapsulated in those two words: reliable versus relevant. With reliability no longer specified as a desired financial characteris-tic, proponents of historical cost have lost a fundamental basis for their argument—albeit a semantic one.

Similarly, the updates explic-itly avoid the term stewardship in the objectives of financial reporting. The stated reason is difficultly in translating the word into other languages, and the longer phrase mentioned earlier is used instead. Broadly speaking, some proponents of historical cost have claimed that assessment of manage-ment’s stewardship is the most

are comparability, verifiability, timeliness, and understandabil-ity. The update treats materiality as it has been treated in IFRSs: an aspect of relevance. Thus, including materiality as a com-ponent of reliability is a change for US GAAP, where materiality had previously been character-ized as a constraint, but not for IFRSs.

The updates replace the term reliable with the term faithful representation—a change for both US GAAP and IFRSs. The Boards decided to use the new term because it had not been possible to explain successfully the meaning of reliable, with people variously interpreting reliable to mean verifiable, free from material error, neutral, precise, faithful representation, or some combination of these terms.10 The concept of faith-ful representation subsumes the concept of substance over form, a concept that previously appeared in the IASB framework as a separate characteristic but has now been excluded because of its redundancy with faithful representation.

The characteristics of finan-cial reporting that faithfully represents economic phenomena are as follows: complete, neu-tral, and free from error.11 The aim for neutrality means that the conceptual frameworks explic-itly exclude conservatism and prudence as desirable character-istics of financial reporting. The relative desirability of neutrality versus conservatism has been the topic of debate in accounting research. Some have cautioned, for example, that eliminating the concept of conservatism as a desirable characteristic will impair the usefulness of finan-cial information.12 However, the Boards conclude that neutrality is the paramount characteristic

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critical analysis. Accounting Horizons, 21, 229–238. See also O’Connell, V. (2007). Reflections on stewardship reporting. Accounting Horizons, 21, 215–227.

8. SFAC 8, ¶ OB4. 9. Previously, US GAAP had provided

that relevance and reliability are the two characteristics that make financial infor-mation useful (SFAC 2).

10. SFAC 8, ¶ BC3.24. 11. SFAC 8, ¶ QC12. 12. See for example, LaFond, R., & Watts,

R. L. (2008). The information role of conservatism. The Accounting Review, 83, 447–478. Watts, R. L. (2003). Conservatism in accounting Part II: Evidence and research opportunities. Accounting Horizons, 17, 287–301.

13. Watts, R. L. (2006). What has the invis-ible hand achieved? Accounting & Busi-ness Research, 36, 51–61.

should provide information that is use-ful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions” (SFAC 1, ¶34). International rules had provided: “The objective of financial statements is to provide infor-mation about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions” (IASB Framework 1989, ¶12).

4. SFAC 8, ¶ BC1.16. 5. Refer to the IASB staff paper “Sweep

issues from the ballot draft” dated May 18, 2010.

6. SFAC 8, ¶ BC1.27. 7. American Accounting Association’s

Financial Accounting Standards Com-mittee. (2007). The FASB’s conceptual framework for financial reporting: A

be widely understood and may represent a final shot in a battle between fair value and historical cost.

NOTES

1. Conceptual Framework—Joint Project of the IASB and FASB, Project Informa-tion Page, as updated through November 1, 2010. Available at http://www.fasb.org.

2. Conceptual Framework for Financial Reporting 2010, issued by the IASB in September 2010, is available at http://www.iasb.org. The prior version was the IASB’s Framework for the Preparation and Presentation of Financial State-ments 1989.

3. SFAC 8, ¶OB2. Previously, US GAAP had provided: “Financial reporting

Elaine Henry, Ph.D., CFA, is an Assistant Professor of Accounting at the University of Miami, where she teaches courses in financial statement analysis, valuation, and international financial accounting stan-dards. Professor Henry is a member of the American Accounting Association, the International Association for Accounting Education & Research, the Harvard Business School Club of South Florida, and CFA Miami. Oscar J. Holzmann, PhD, is an associate professor of accounting at the University of Miami, where he teaches financial accounting and financial statement analysis courses. Professor Holzmann received his BA in economics from Gannon University and an MS and PhD in accounting from the Pennsylvania State Uni-versity. He has won teaching awards, has been published in academic and professional journals, and is one of four accounting experts performing final reviews of the Spanish-language translation of the pronounce-ments of the International Accounting Standards Board. He chairs the board of directors’ audit committee of BFC Financial Corp., parent company of BankAtlantic Bancorp and Levitt Corp. Professor Holzmann is a member of the American Accounting Association and the Institute of Internal Auditors.

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