evaluating concept based vs ruled based.pdf

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20 03 Am erican Accounting AssociationAccounting H orizonsVol. 17 No. 1March 200 3pp . 73-89

COMMENTARY

Evaluating Concepts Based vs.Rules Based Approaches to

Standard Setting Financial cc ou ntin g Standards C om m itteeLaureen A Maines, Chair Eli Bartov; P atricia Fairfield D. Eric HirstTeresa E . lannacon i; Russell Mallett Catherine M. Schrand Dou-glas J. Skinner Linda Vincent principal author .

INTRODUCTIONIn its new project on Codification and Simplification, the F SB indicates its inte nt

to evaluate the feasibility of issuing concepts-based standards rathe r th an issuing de-tailed, rule-based standa rds with exceptions and alternativ es. Related to this project,members ofthe F SB board and staff asked the Fin andal Accounting Standa rds Com-mittee of the American Accounting Association (hereafter, the Committee) to providecomments on concepts-based stemdards and to recast two stan dards as concepts-based.*This article simimarizes comments ofthe Comm ittee on issues related to concepts-basedvs. rules-based stan dards. Comments in this article reflect the views ofthe individualson the Comm ittee and not those o fthe American Accoimting Association.

The Committee strongly supports the commitment by the FASB to evaluate thefeasibility of concepts-based standsirds. We believe th at tbe economic substance, not

The FASB approved the new project on Codification and Simplification on January 9 ,2002 . Members ofthe FASBboard/staffand accounting practitioners also refer to concepts-based standards a s p rindples-based or conceptualstandards. Individuals sometimes refer to rules-based standards as bright line or cookbook standards.The Committee wrote two comment letters related t concepts-based standards. The first, Response t FASBInvitation t Comment on the FASB Proposal for a New e n d a Project on Issues Related t the Recognition ofRevenues and Liabilities, contedns the Committee's comments on concepts-based standards as they relate tothe FASB s proposed project on recognition of revenues and liab ilities. The second, Comments t the FASB onConceptual Standards, presents the Comm ittee's general comments on concepts-based standards, a s well asthe recasting of two st{indards as concepts-based (SFAS No. 87, Employers' Accounting for Pensions and SFASNo. 133, Accoimting for Derivatives and H edging Activities). Linda Vincent, Pa tti Fairfield, and Eli Bartovrevised SFAS No. 87 and Cathy Schrand and Anne Beatty revised SFAS No. 133. The AAA web site(http:/Avww.aaa-edu.org) contains both original comm ent lette rs.The Committee is neither first nor alone in advocating a return to concepts-based standard setting. Forexample, Ralph E. Walters (member, FASB) dissented to SFAS No. 66 Accounting for Sales of RealEstate) in 1982 with the following comments:

(Mr. Wai tors

believes th at the accounting profession can serve its m embers by offering more specific guid-ance for applying standards in p articular specialized areas, but such d etailed and arbitrary g uidelinesshould not be dignified as accounting standard s. To do so debases accounting standards and inevitably willdi i i h h d ff i f h i f i h h{ id i f


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74 Accounting Horizons /March 2003

the form, of any given transaction should guide finandal reporting and standard setting,and tha t concepts-based s tandards represent th e best approach for achieving th is objective. Rules-based standards provide companies the opportunity to structure trzmsaction

to meet the requirements for particu lar accounting treatm ents, even if such trea tmentdon't reflect the true economic substance ofthe transaction . We recognize, however thatthe current p lethora of detailed ru les has been demand-driven, suggesting that companies may request more guidance than that provided by concepts-based s tandards . Addi-tionally, a change from rules-based to concepts-based standards magnifies the importanceof informed professional judgment and expertise for implementation of standard s. Overall, however, we believe that concepts-based standards, if applied properly, better sup-port the FASB's stated mission of improving the usefulness of financial reporting byfocusing on the primary characteristics of relevance and reliability....

RULES BASED VS. CONCEPTS BASED STANDARDSAn Illustration of Rules Based and Concepts Based Standards

In order to make our discussion of concepts-based vs. rules-based standards m oreconcrete, we characterize the accounting standard-se tting process and its products as acontinuum ranging from imequivocally rigid standards on one end to general defini-tions of economics-based concepts on the other end. An example of the extreme lef(rigid) end of tbe continuimi is :

Annual depreciation expense for all fixed assets is to be 10 percent ofthe original costof the asset until the asset is fully depreciated.

Sucb a ru le leaves no room for judgment or disagreement about tb e eunount of deprecia-tion expense to be recognized. Comparability and consistency across firms and throughtime is virtually assured under s ud i a rule. However, sucb a standard lacks relevancedue its inability to reflect the underlying economics of tbe reporting en tity, wbicb differacross firms and tbrough tim e.

At tbe opposite right) end of tbe continuimi is a provision or rule sucb as tbe following:

Depreciation expense for the reporting period should reflect the decline in the eco-nomic value ofthe asset over the period.*

Sucb a standard requires tbe application of judgment and expertise by both managersand auditors. Tbe gosil is to record economic depreciation of tbe asse t, something aboutwhich the manager arguably has more information tha n anyone else. Many might agreeth at such a rule reflects the underljang purpose of financial reporting, but argue tha t itis too costly to implement and would likely lead to results tbat are neitber comparableacross firms nor consistent tbroug h tim e.

Benefits and Costs of Rules Based vs. Concepts Based StandardsRules-Based Standards

Evidence abounds tbat detailed stan dards csmnot meet tbe challenges of a complexand rapidly cbanging financial world, nd that tbey frequently provide a benchmark fordetermining compliance in form but not in substance (Finnerty 1988). The Committee

By using this example, the Committee is not takin g a position about the appropriateness of using decline


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76 Accounting Horizons/March 2003

Concepts Based StandardsTbe committee recognizes tba t tbe latitude inh eren t in concepts-based standard s i

a double-edged sword. Such latitude allows managers to choose accoimting treatm en t

th at reflect their informed un derstanding o fthe underljang economics of transaction sThis latitude, however, also permits managers to advocate reporting treatments tb ado not reflect tb e underlying economics of a transaction. M anagers, audit committemem bers, ind auditors mus t possess both expert judgm ent and a desire for tinbiasereporting in order for conceptual standeirds to result in financial reporting th at reflectunderlying economics. Both the SEC and the Auditing Standards Board support thiview with the ir focus on the quality, as opposed to simply the acceptability, of financiereporting, as well as tbeir empbasis on tbe need for expert judgment and imbiasedreporting (AICPA 1999; SEC 1999).

Concepts-based standards have the potential to promote tbe financial reporting

goals of tbe FASB in ways tba t rules-based standards cannot. F irst, as educators, webelieve tb at individuals m ust possess a conceptual framework for financial informationin order to use th is information appropriately in decision making. Concepts-based standards reflect a more cons istent application of tbe FASB's Conceptual Framew ork andenbsmce individuals' understanding of tbe framework. Tbus, a concepts-based approacis consistent witb tbe FASB's stated goal to improve tbe common understand ing of tbena ture and purposes of information contained in financial reports.

Second, we believe concepts-based standards are consistent w itb tbe stated goal otbe FASB to promote convergence of accounting stan dards worldwide. Tbe EuropeanCommission is reportedly (Guerrera Eind Normztn 2002) proposing tb at tbe U.S. aban-

don G P in favor of tbe more flexible IAS, wbicb empbasizes 'substance over form' inaud itors' inspection of tbe accounts. A concepts-based approacb likely will lead to greateragreement in standard setting between tbe F SB and I SB eind tbus promote interna-tional barmonization.

RE V IE W O F RE L T E D C D E MI C RE SE RCH

Tbe academic accounting literature is somewhat limited with respect to direct researchon tbe issue of concepts-based vs. rules-based standards for fineincial reporting. However,several studies sbed light on issues related to tbe benefits and costs of tbese two approaches;we summarize a representative sample of tbese below. Some of tbis researcb relates toaud its of fuiEincial statements ratb er tban to tbe setting of standards. Tbe Committee be-lieves that th e tension and potential conflict between auditors and tbe ir clients are inher-ently sepeirable from, bu t not always distinctly different from, tbe tension nd potentiedconflict between p reparers md users of financiil statem ents. A ltbougb auditing tensionssbouid not dictate tbe form and content of accounting s tandards , we believe tbat inferencesabout standard se tting can be drawn from tbe literature on auditing.

Preparers Rea ction to Concepts-Based and Rules-Based StandardsTbe primeiry responsibility for financial reports lies witb management. Academic

litera ture provides abundemt evidence tba t manag ers, witb or witbout tb e knowledgeand/or consent of tbeir auditors, both interpret rules and structure transactions to acbieve

desired accounting trea tm en ts. Tbere is an extensive em pirical/arcbival accounting lit-erature (e.g.. Watts and Zimmerman 1986) addressing tbe incentives of managers tomake financial reporting choices and decisions in tbeir own best intere sts Tbese stud -


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Evaluating Concepts Based vs. Rules Based Approaches to Standard Setting 77

A recent study specifically addresses th e effects of brig ht line vs. conceptueil stan-dirds using survey da ta ga thered from 253 au dit partners on the ir experience with 515attem pts at eam ings msinagement by their clients (Nelson et al. 2002). This study re-

ports tha t managers are more likely to attempt eam ings managemen t with transactionstructuring when precise standards govern the accountingleases, equity vs. costmethod, consolidations, and so forththan when standards are more flexible. Corre-spondingly, aud itors are more likely to permit eamings management attempts throughtransaction structuring to stand when governing rules are precise and the transactionstructuring is consistent with the rules.

Nelson e t a l. (2002) find tha t when the standard provides no bright line for man-agers to use in transaction struc turing, they a re less likely to engage in costly transac-tion structuring. However, with such concepts-based standards, managers are morelikely to justify eju-nings managem ent attem pts by convincing the auditor of their in-

terpretation of the imprecise rules. Auditors xe

more likely to permit such eam ingsmanagement attempts to stand when the accounting is governed by more flexible orsubjective standards.

In related research, Cuccia et al. (1995) use experimentsd methods to examine re-porting aggressiveness in th e tzix area . They study whether professioneil tax practitio-ners are more or less aggressive with vague, verbal standards than they are undermore precise, quan titative or numericil stand ards. The authors find th at tax practitio-ners are equally aggressive under both types of steuidards but that the form of theiraggression varies. Tha t is, with vaguely worded stan dard s, the practitioners use th elatitude inherent in the regulation to justify aggressive reporting . With numerical stan-dards, they instead u se the latitud e available in assessing eviden tiary support to justifyan aggressive reporting position. The authors conclude that when practitioners haveincentives to report aggressively, modifications to standards to make them more strin-gent and quEintitative may prove ineffective in reducing the aggressiveness of the re-porting. Although there are significant differences between tax p reparers and auditorsand their respective relations w ith their clients, these resu lts likely have implicationsfor the effects of financia l accoimting stand ard s.

osts Incurred to Structu re Transactions

Dye 2002) examines transaction structuring by modeling analytically the manager'sfinancial reporting process as one of classification meinipulation. That is, for many s tan-

deu-ds, there is a generally preferred outcome, such as operating rather than capitallease treatment, and classification manipulation results in more firms attaining thepreferred accounting treatment than would otherwise be the case \mder GAAP. Heconcludes that such manipulation reduces the effectiveness of rules in a standard todistinguish among true economic differences in transactions. Rather, classificationminipulation leads to a sh dow standard th at simply dem arks the boundary betweenthose firms th at are or are not willing to pay the cost needed to structure a transactionto secure the more favorable classification. In other words. Dye 2002) provides supportfor Nelson et al.'s 2002) conclusion th at rigid s tand ards will increase mauiagers' abilityto msmipulate financial reporting outcomes opportunistically, and thu s w eaken the ef-

fectiveness ofthe standard.EmpiricEil research provides evidence th at managers structure transac tions to avoidbalance sheet recognition Examples include Bowman (1980) and Ely (1995) on leases


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ConclusionsOverall, resvilts ofthe academic literatu re indicate tha t the two different approaches

to accoxinting stand ards alter n either th e incentives nor the ability of management torepo rt opportunistically; only the n atu re and characteristics of opportunistic repo rtingvary depending on the na ture of the standa rd. This research provides some evidenceth at th e rigid ( bright line ) or flexible na ture ofthe governing accoimting standard isimportant, bu t genei-Jilly less im por tant thsin incentives faced by both m anagers andauditors. Finally, the literatu re provides some evidence tha t precision in the wording ofconcepts-based stan dards h as some effect on financial reporting decisions.

IMPLEMENTATION OF CONCEPTS BASED STANDARDSFASB members and staff asked th e Committee to undertake the ta sk of recasting

two standards, SFAS No. 8 and SFAS No. 133, as concepts-based standard s. We presentour recasting of SFAS N o. 87 in the Appendix; see the AAA web site (http://www.aaa-edu.org) for the recasting of SFAS No. 133. In completing this task , the Committee bothenumerated desirable charac teristics of concepts-based s tand ards and provided insighon imp lementation issues. We discuss these two issues in tvim.

Chara cteristics of Concepts B ased StandardsThe Committee first determined characteristics that a concepts-based steindard

should possess. Our list of character istics is as follows.1) In a concepts-based standard , the economic substance , not the form, of a given tran s

action should guide its financial reporting . The FASB's Conceptual Framew ork de-fines the classification and measurement of economic transac tions and , accordingly

should serve as the foundation for financial reporting that refiects the economiesubstance of a transaction.2) A concepts-based standard should include a description of the particu lar transac

tion tha t is the subject ofthe stan dard. This description should include the underlying economics ofthe trsmsaction in order to provide a common, explicit understand ingof these economics.'

3) A concepts-based standard should include a general discussion ofthe mapping between the economics of a treinsaction smd the financial statements, using the Conceptuzil Framework to guide classification and m easurem ent issues associated withthis mapping.

4) A concepts-based standard may include implementation guidance, most likely inthe form of examples th at illu stra te application ofthe standard's general principlesto typical transactions covered by the standard . In these implementation examplesit may be necessary to make choices that are based on practicality rather thanexplicitly on the concepts. We believe this is accep table, but should be noted as suchin the discussion ofthe example.

5) In a concepts-based standard, the Board should be careful when creating names foconcepts, even if they enhance th e readability ofthe standard. The names may alreadyhave connotations for readers th at differ from the concept tha t the Board heis in mind.If it is unavoidable to use such neunes, the Board should articu late their definitions.

Storey and Storey (1998, 86) highlight the imp ortance of having common prem ises when developinconceptual statements in their FASB monographThe Framework of Financial Accounting Concepts and


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8 Accounting Horizons March 2003

6) Concepts-based stand ards should Include disclosure requirem ents related to a de-scription ofthe economics ofthe transaction being reported, the assumptions madein the reporting, and ny supporting information that will facilitate understandingboth the economics and the reporting.

Issu es Associated w ith a Conceptual Approach to Standard S ettingThe Committee found the task of recasting current standards as concepts-based

standards to be both engaging and challenging. In this section, we simimarize issuesthat arose during our process of revising the stand ards .

As noted previously, approaches to standards setting can be depicted as a continuimi,with purely rules-based standards on one end and purely concepts-based s tandards onthe other. One primary issue the Committee encountered wsis where on this continuumto place the revised standards. That is, to what exten t should concepts-based s tandardsrepresen t ideal standard s that reflect the imderlying economics ofthe transactio n ina pure fashion? Given the academic orientation of most ofthe Committee's members,our na tural inclination is to advocate tha t conceptual standards reflect the economicsas purely as possible.

We encountered several issues when tak ing an economics-based approach for re-writing the two stand ards. First, we encountered th e issue tha t the reporting for onetransaction depends on the reporting for other transactions, such as assets and liabili-ties. In rew riting standards, problems arise due to the fact th at not all of a firm's eco-nomic assets an d liabilities etre recorded. For assets and liabilities th at are recorded,not all a re recorded a t fair value. Such recognition nd measurement issues for a ssetsand liabilities lead to problems with writing economic-based conceptual standards . For

example, if all of a firm 's assets eind liabilities were recorded a t fair va lues, th ere wouldbe no need to distinguish between derivatives tha t were used to hedge vs. not used tohedge, between fair value and cash flow hedges, between separate and embedded de-rivatives, or even between derivatives tha t are used for hedging and other instru-ments th a t can act as hedges. One should simply record all derivatives at fair valuewith changes in fsiir v lue recorded in income. Our point here is not necessarily anendorsement of fair va lue accounting, rath er , it is simply to point out the issu es associ-ated with refiecting true economics in rew riting stan dards as conceptual standard s.

A second issue is th at many rules in the current stsmdards appeeir to eirise rom hepracticality of dealing with constituents' concems, rather than arising rom he underlying

economics ofthe transaction. The transition rules and corridor approach to recognizingunreahzed gains and losses in SFAS No. 87 are examples of such rules. A question arises asto the extent to which conceptual standards should include such concessions to practical-ity. That is, to what extent should conceptual standards initially include practical consid-erations and gradually move to refiect the underlying economics vs. imposing an imm ediatechange to an economics-based standard? We do not have an answer to this question, butraise it as an issue that needs to be considered. The Committee's approach to revisingSFAS No. 87 more closely refiected the immediate transition to economics-based standards ,without regeu d to practical concems of constituents.

A third observation rela tes to th e effect of a conceptueil approach on the need for

standards related to specific transactions. It is possible tha t some individual stan dardswill be straightforward applications o fthe concepts in the FASB's Conceptual Fram e-work. For example, accoimting for pensions may require only a relatively straightfor-


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concepts-based standard on pensions will add little. Here a concepts-based pension s tan-dard need only define pensions in term s of elements ofthe Conceptual Framework andprovide illustra tions of appljdng the framework On a related point, a move to concepts-based stan dards allows for some combination of current stan dards . For example, SFASNo. 87 on pensions and SFAS No. 106 on other post-retirement benefits potentiallycould be combined into a single conceptual stand ard .

Finally, all of these observations raise the issue of whether th e F SB should take apiecemeal or a one-shot comprehensive approach to rewriting standards as concepts-based rather tha n rules-based. In a piecemeal approach, the F SB writes all new stan-dards as concepts-based standards. All past rules are rewritten one by one. Such anapproach may be necesssury due to practical considerations. However, the Committeeraises two issues related to th is approach. Firs t, the order in which the recasting of oldstandards is done is important in order to avoid having to go back and re-recast a stan-dard due to issues tha t arise in recasting another standard. Second, it may be necesseiryto undertake a comprehensive re-thinking ofthe Conceptual Framework before under-taking revision of individual standards. For example, in the extreme, if a concepts-based approach is intended to refiect purely the economics of transactions, the idea ofwhat constitutes assets, liabilities, and equity of the firm and the measurement basisfor these elements needs to be reconsidered.

The Committee realizes that the FASB constantly reconsiders such issues. How-ever, we believe a more comprehensive re-think ing o fthe Conceptual Framework maybe needed prior to undertak ing revision of current stsmdards. One approach to accom-plishing th is goal would be to have a separate project on conceptueil standard settingtha t is distinct from the process of setting current stand ards .

O N L U D I N G O M M E N T S

In closing, the Committee believes consideration of a concepts-based approach tostandau-d setting should be given priority. As indicated, the Committee's experiencesuggests that this process will not be easy and that many issues will need to be re-solved, but we believe undertaking such a project will improve standeird setting. Werecognize, consistent with evidence in accounting research, that the implementationand enforcement of concepts-based accounting stemdards may be daunting because theynecessarily rely on the joint efforts of management, the board of directors, and theauditors to apply professional expertise and judgment to achieve unbiased financialreporting. However, the tensions between and among the companies, their auditors,investors, and regulators are not specific to the nature of the standards as concepts-based or rules-based. Standards, iii whatever form, cannot solve these conflicts. Webelieve that issues of incentives and monitoring should be addressed separately andshould not determine th e n ature of accounting s tandards.

With concepts-based standards , the importance of professional judgment and thedesire for unbiased reporting is paramount. However, as noted by Mason and G ibbins(1991), professional judgm ent is important in all cases. In d iscussing th e issue of profes-sional judgm ent, they quote from the Introduction to ccounting Recommendations tothe CICA Handbook: no ru le of general application can be phra sed to suit allcircum stances...that may arise, nor is there any su bstitu te for the exercise of profes-sional judgm ent in the determination of what constitutes fair presentation or good prac-tice in a particula r case. The Committee encourages the FASB to provide explicit


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APPENDIX Conceptual Approach for SFAS No. 87, Em ployers Accou nting for Pen sions

Overview and Background C omm entsThere are two m ain economic aspects to the accounting for pensions. The first is to

recognize the current period pension expense and the second is to recognize the totalunfunded obligation for pension benefits as ofthe end ofthe reporting period.

In reformulating SFAS No. 87 from a rules-based to conceptual standard, we fo-cused on capturing economic substance over form and maintaining consistency withthe FASB s Conceptual Framew ork. We believe that the principles underlying SFASNo. 87, as wr itten, generally are consistent with the Conceptual Framework.

However, the detailed rules provided in SFAS No. 87 (e.g., corridor amortizationand recognizing a minimum liability amount) are not appropriate to a conceptual stan -dard . Many of these riiles appear to be compromises aimed at m aintaining certain de-sired characteristics ofthe financial statements unrelated to th e economic substance ofthe transactions. The impetus for other detailed rules appears to be the Board s concernregarding transition accounting at the time ofthe issuance ofth e stemdard. We do notconsider transition accounting to be a pertinent concem in a concepts-based standarduid so we eliminate the rules related to transition accounting. We expect that anycumulative effect of an accounting change will be reported as such in the year of trans i-tion.

We shortened SFAS No. 8 substantially and rewrote it with minimal detailed imple-mentation guidance because we believe that there is a reasonably common and ac-cepted definition of pensions benefits, unlike otber transactions such as derivatives.Additionally, the goals ofthe FASB with respect to pension reporting are quite straigh t-forward and consistent with the Conceptueil Framework. We do, however, retain mostof the disclosure requirements of SFAS No. 87. We consider these disclosures to be ofprimary importance to investors in understanding th e accounting for pensions. We con-clude tha t a shortened and simplified standard accomplishes the financid reportinggoals for pensions.

We believe tha t under a conceptual approach to stemdard setting, the standfu dshould encompass all post-employment benefits and not ju st those related to pensions.We do not perceive an economic or philosophical difference between pension benefitsand, for example, health care benefits. However, because ofthe purpose of this exercise,

we felt tb at the focus should remain on SFAS No. 87 is written, so we did not includeother post-employment benefits in the reconstituted standard.We also note that certain inconsistencies arise in converting an ex isting standfird

such as SFAS No. 87 into a conceptual standard due to the connections between thesubject standard and other existing standards. For example, SFAS No. 87 refers toSFAS No. 34 on Capitalization of Interes t Costs, among others. We do not address suchspecific relations, recognizing that if all standards are rewritten as conceptual, suchinconsistencies should disappear.

We rely on the Conceptual Framework for the definition of both an asset and aliability in determining whether the pension plan assets and the unfunded pension

obligation should be carried on the statement of financial position. The chainge in thenet pension asset or liability should be reported in income.Tbe first section ofthe existing standard, tbe Simimary, states tbat SFAS No. 87


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Statement 87(paragraph s)

Summary(6)

(35)

(10-14, 39)

Introduction(1-5)

Scope (7, 8,9)

Suggested TextJ omm ents

A Objective of Statem entThe objective of this statement is to provide standards for therecognition and disclosure ofthe employer's compensation cost forpension benefits for the reporting period and of the employer'srelated liability for employees' pension benefits as ofthe end ofthereporting period.

Pension benefits constitute one element of employee compensationand, as with other forms of compensation, the cost of thatcompensation is to be accrued eind recognized as an expense in theperiod incurred.

For pension costs that have been accrued but not funded, acorresponding liability for the unfunded obligation is to berecognized on the balance sheet. An employer with an overfundedpension obligation has an asset for the amount overfunded.Absent convincing evidence to the contrary, the term s of the planth at define the benefits an employee will receive (the plan's benefitformula) provide the most re levant and reliable indication of howpension costs and obligations are incurred.

The Board recognizes that computation of the current period's

pension expense and ofthe end of period pension obligation requiresthe use of estim ates as well as the prediction of events over whichthe employer has lit tle or no control. Actuarial assum ptions includediscount rates and probability of payment. The necessity of makingand incorporating such estimates and predictions does not diminishthe importance of recognizing the cost and obligation in order toreflect on the financial statements of the firm, the economicimplications euid consequences for the employer of providing pensionbenefits for employees.

istory of pension accounting not appropriate for inclusion in body ofstandard perhaps relegate to an appendix or eliminate

B Scope and D efinitionsPension plans in the U.S. are governed by many laws andregulations. Generally these require that pension plans be fundedby the employer and that the assets funding the pensions betransferred to the pension trus tee . Pension plans take many forms.Frequently, pension benefits provide for periodic payment to retiredemployees or to their survivors, but they may also include lumpsum payments or other t ^es of benefits. AU such plans are includedwithin the scope of this standard. Statutory funding requirementsshould have no effect on the recognition of the cost and liabilityassociated with pensions.


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Evaluating Concepts-Based vs. Rules-Based Approaches to Standard Setting 85

(12)

(16, 21, 24)

(22)

(36)

(15-53)

Likewise, an employer s obligation to provide pension benefits m aytake a variety of forms and may be fin nced in different ways. ThisStatement applies to any arrangem ent tha t is similar in economicsubsteuice to a pension plan regardless ofthe particular terms ofthe plan or the form offinancing. his Statement applies to a w rittenplan as well as to a plan whose existence may be implied from awell-established but perhaps unwritten practice of payingpostretirement benefits.

Pension b enefits. Pension benefits are part ofthe compensationpaid to an employee for services. Generally, but not always, theamount of benefit to be peiid depends on a number of future events(including, for exam ple, the employee s yea rs of service , theemployee s compensation, how long the employee and any survivor

lives) that are incorporated into the computation of the benefit.The total am ount of the promised benefit can only be estimated.

Pension service) cost. This is the current period cost of theemployer of providing pension benefits to employees for th e servicesrendered during the period. The actuarial present value of thesebenefits is generally determined by the terms ofthe plan. This costmay include several additional components, including but notlimited to: the impact of pleui amendments, including retroactiveenhancements; and changes in actuarial assumptions related toemployees (e.g., age at retirem ent, years of retirem ent).

Pen sion financing) cost. The current period financing cost ofthe pension plans includes the interest cost on the gross liabilitynet ofthe chemge in the fair marke t veilue ofthe plan assets, adjustedfor contributions and disbursements.

Net Pension obligation asset). he accumulated liability oftheemployer for the employees pension benefits less the fair value ofplan assets.

These paragraphs provide both detailed definitions of terms, includingcomponents of periodic net pension cost and measures ofthe accumulatedpension obligation, an d detailed rules as to the accounting for the cost andthe liability. S ome of these terms are not consistent with the ConceptualFramework. In addition, the Committee finds that several of the termstogether with the required accounting treatment are inconsistent with theunderlying economics o f providing pension benefits for employees. TheCommittee points specifically, as examples of uneconomic treatment to theprovisions in 25) for amortization ofthe cost of retroactive benefits, to 29)on nonrecognition of gain or loss, to 32) fo r required amortization of anunrecognized gain or loss when that gain or loss exceeds a 10 percentthreshold to 36) for the minimum liability com putation, and to 37) forthe recognition of an intangible asset to offset the minimum liability in 36).

We eliminate both the detailed terminology and the detailed reporting rules.


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5 4 C. Disclosure RequirementsThis standard requires the employer to provide disclosuresnecessary for understanding the source and amounts ofthe reportedpension cost and pension obligation. The underlying assumptionsused in the computations are integral to such an u nderstanding.These disclosures must include but a re not limited to:a. A description of the plan including employee groups covered,

type of benefit formula, fim ing policy, and the nature and effectof significant matters affecting comparability of informationfor all periods p resented.

b. Actuarial present value of benefits a ttributed by the plan sbenefit formula to services rendered by employees du ring thereporting period including the key assumptions behind the

computation (the service cost component).c. Assumptions and computations supporting the financing costcomponent of pension cost.

d. Actuarial present value of all benefits attribu ted by the p lan sbenefit formiila to employee service rendered prior to the currentreporting period.

e. Actuarial present value of all vested pension benefits as of thereporting date.

f. Description ofthe plan asse ts as ofthe reporting date includingthe tjrpes of assets held and the ir fair marke t value.

g. chedule reconciling the change in the fair m arke t value of planassets from the previous reporting date, including, but notlimited to the following:i) actual return on plan assetsii) employer s contribution during the periodiii) benefits paid to employees dur ing the periodiv) realized gains and losses on plan assets during the periodv) unrealized gains and losses on plan assets during the period

h. Am ount of pension cost deductible for federal income taxpurposes.

i. Key actuarial assumptions.

Effect of changes in actuarial assumptions on the current periodpension cost and the end of the period pension liability.k. Expected impact of statutory funding requirements on liquidity

and financ ial position.

55-75 We exclude these paragraphs because they provide detailed rules foremployers with two or more plans for annuity contr cts and other lifeinsur nce comp ny contracts for defined contribution plans for multipleemployer plans etc. ll of which we believe re covered conceptu lly in theabove paragraphs.


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Plan assets Assetsusually stocks, bonds, and other investments^that have been segregateand restricted (usually in a trust) to provide benefits. Plan assets include amounts contributeby the employer (and by employees for a contributory plan) and eimounts eamed from investin

the contributions, less benefits paid.Service Employment taken into consideration under a pension plan. Y ears of employment beforethe inception of a plan constitute an employee s past service; years thereafter are classified irelation to the particular actuarial valuation being made or discussed. Years of employmen(including past service) prior to the date of a particular va luation constitute prior service; yearof employment following the date o fthe valua tion constitute future service; a yetir of employmeadjacent to the date of valua tion, or in which such date falls, constitutes current service.Service cost The actuarial present value of benefits attributed by the pension benefit formulato services rendered by employees during tha t period.Vested benefit obligation The ac tuaria l present value of vested benefits.

Vested benefits Benefits for which the employee s right to receive a present or future pensionbenefit is no longer contingent on remaining in the service of the employer. (Other conditionsuch as inadequacy of the pension fund, may prevent the employee from receiving the vestebenefit.)

KEFERENCESAmerican Inst itute of Certified Public Accountants (AICPA). 1999. Audit Committee Communi

cations. Statement on Auditing Stand ards No. 90. New York, NY: AICPA.Bowman, R. 1980. The debt equivalence of leases: An empirical investigation. The ccounting

Review 55 (April): 237-255.Canadian Ins titute of Chartered A ccountants (CICA). 2002. Introduction to accounting recommendations. In CIC Handbook. Toronto, Canada: CICA.

Cuccia, A., K Hackenbrack, and M. Nelson. 1995. The ability of professional standard s to miti-gate aggressive reporting. The ccounting Review 70 (April): 227-248.

Dye, R 2002. Classifications manipulation and Nash accounting standa rds. Journa l of Account-ing Research 40 (September): 1125-1162.

Ely, K 1995. Operating lease accounting and the market s assessment of equity risk Journal of ccounting Research 33 (Autumn): 435-458.

Engel, E., M. Erickson, and E. Maydew. 1999. Debt-equity hybrid securities. Journal ofAccount-ing Research 37 (Autumn): 249-274.

Financial Accounting Standards Board (FASB). 1982. Acco unting for Sales o f Real E state. NorwalkCT: FASB.. 1998. Accowrefing/or Leases. A Cod ification. Norwalk, CT: FASB.

Finnerty, J. 1988. Financial engineering in corporate finance: An overview. Financial Management (Winter): 14-33.

Gibbins, M., S Salterio, and A. Webb. 2001. Evidence about auditor-client managem ent negotiation conceming client s financial reporting . Journal of ccounting Research 39 (December):535-563.

Guerrera, F., and P. Norman. 2002. Brussels attacks accounting rules in the U.S. FinancialTimes (February 21): 1.

Hackenbrack, K., and M. Nelson. 1996. Auditors incentives and their application of financiaaccounting standards. The ccounting Review 7 (January): 43-59.

Hronsky, J., and K Houghton. 2001. The meaning of a defined accounting concept: Regulatoryh d th ff t dit d i i ki A i O i ti d S i t


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