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Accounting has evolved over the past four decades. Many different regulatory bodies have been formed over the years whose aim has been to clearly define accounting and income for the betterment of financial accounting. In this article I try to analyze the different accounting frameworks that have been formed over the years by different regulatory bodies and in what way have they helped the standard of accounting.
The concept of income is very vague and it is very difficult to define it. On the other hand Accounting is a very broad concept and there are many definitions given to it over the years. In simple words accounting can be defined as-:
It is the art of communicating financial information about a business entity to users such as share holders and managers. The communication is generally in the form of financial statements that show in money terms the economic recourses under the control of management-Wikipedia.
For the better understanding of accounting and its different standards different regulatory bodies came up with the concept of Conceptual Framework.
Financial Accounting Standard Board (FASB) was the first regulatory body which came up with their conceptual framework in the 1970's and they are still today developing it. The definition of conceptual framework given by them was-:
A coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature functions and limits of financial accounting and financial statements. Lecture 4.
It is clear from the above definition that the basic idea of creating a conceptual framework is to regulate or keep a check on accounting methods. While FASB were still in the process of developing their conceptual framework, other regulatory bodies like ASB (accounting standard board) and IASB (international accounting standard board) came out with their conceptual framework. Their conceptual framework was more or less a mirror image of the FASB's conceptual framework and the definition given by them was the following-lecture 4
- ASB - Sets out the principles that the ASB believes should underline the preparation and presentation of general purpose financial statements... A coherent frame of reference to be used by the board in the development and review of accounting standards.
- IASB - This framework sets out the concepts that underline the preparation and presentation of financial statements for external users.
The main idea or objective of the conceptual framework was to provide important accounting information to its user i.e. shareholders, creditors etc and also to regulate or keep a check on different accounting standards followed by firms. The information thus provided should be helpful to the present and potential investors as well as to the creditors and other users so that they can make proper decisions with respect to the firms. The information should satisfy certain criteria's before being passed to the users, some of them are the following-: lecture 4
- Undestandibility- the information should be easy to understand by its users, it should not be complicated.
- Comparability- the information should be such that it could be compared with other information to make it easier for the users to make a decision.
- Relevance-the information should be current or relevant to the present market situation. Relevant information is mainly used by the investors.
- Reliability-the information provided should be trusted and so it should be reliable. Creditors of the firms are interested in reliable information.
After looking at the objective of the conceptual framework, can we really say that it was useful to develop a conceptual framework? Or has it really helped in the daily accounting standards? Or was it worth it to spend so much time and money on its development? Well, to answer such question we should analyze the usefulness of conceptual frameworks. The foundation of FASB's conceptual framework is to facilitate decision on complicated accounting standards or to reach conclusion on complex issues. FASB also claims that conceptual framework reduces the need of many detailed standards and debate. But does it really help to reach the right conclusion, conceptual framework may show the right direction but to reach the right conclusion is up to the individual. Each individual has a different way of interpreting the conceptual framework therefore it cannot grantee that everyone will come to the same conclusion.
The main problem with the FASB's conceptual framework is that at no point does it clearly define Income. It came up with the idea if income and called it comprehensive income. FASB defines comprehensive income as the equity of the business enterprise during a period from transactions and other events and circumstances from non owner recourses. So FASB required you to give the income statement in the following manner-
- Comprehensive income=revenues-expenses+ gains-losses
- Change in equity=comprehensive income+ investment by owners(IO)- distribution to owners(DO) lecture 4
FASB said that anything that affects our balance sheet is reported in the comprehensive income, it uses the balance sheet approach to calculate the comprehensive income. FASB's Conceptual framework was in no terms perfect since it did not define income at any point therefore all its other definitions were inconclusive. For example-:
- Assets-are probable future economic benefits or controlled by a particular entity as a result of post transactions or events.
- Liabilities-are probable future sacrifices of economic benefits arising from present obligation of a particular entity to transfer assets to provide services to other entities in the future as a result of past transactions or events.
These definitions given in FASB's conceptual framework were very vague and did not solve any purpose. For example- the definition of asset does not clarify whether a cost is an asset or a liability (advertising, R and D, wages). Also definitions of ASB's asset and liabilities were similar to FASB's and didn't solve any purpose.
Schuetze (1991) in Zeff and Dharan-The definitions of FASB's assets is very vague and open ended that it does solve any of our problems.
Therefore in July 2001 FASB/IASB/ASB concluded that the definitions were deficient and inconclusive.
As said before the concept of income is very broad and one cannot define income perfectly. FASB and IASB came up with different approaches for valuation of income and its treatment in our financial statements.
IASC (International Accounting Standard Committee) issued an interim standard on financial instruments. It issued an exposure draft 62 and approved the publication of IAS 39 in 1998 which became effective in 2001 (lecture 2). It adopted a mixed measurement model which meant that some financial instruments will be measured at historical cost while some would be measured at their fair value. Classification of the financial instruments was the basis on which they were to be measured. Original IAS 39 said that financial assets were to be viewed at fair value except those you held till maturity (ones which you are never going to sell). On the other hand financial liabilities except derivatives are to be valued at amortize cost. Changes in the fair value held for trading purpose go through the Profit and Loss account and ones which are not held for trading can either be shown in profit and loss account or can be taken directly to equity. But once a financial instrument was classified it cannot be changed. IASC later revised IAS 39 for a better classification of financial instruments. The classification was as follows-:
- Either Financial assets or liabilities can be valued at fair value through the profit and loss account.
- Assets can be available for sale.
- Loans and receivables
- Held till maturity
All of the above classification can be valued at fair value and can be shown in the profit and loss account. So the purpose of revised IAS39 was to give a choice to the firms for valuation of the financial instruments but at the same time encourage valuation at fair price.
But this method had a drawback. If the firm decided to show its liability in P/L account what interest rate should it show? Do they show the interest rate they are actually paying or the rate that is actually implied on the fair value? Also prudential supervisors, security companies, insurers expressed concern that FVPL (fair value profit and loss) option might be used inappropriately. Therefore the revised IAS 39 went to the EU (European Union) for its consideration and the EC (European commission) proposed the adoption of an amended version of IAS 39 on 19th of November 2004. The proposed amendments were as follows-:
- To remove the fair value option for liabilities. Therefore it did not allow showing liabilities at fair value.
- Also amended hedge accounting.
IASB considered these amendments and on 15th June 2005, IASB issued its final amendment to IAS 39 that was to restrict the use of the option to designate any financial asset or liability to be measured at fair value through profit and loss account. In other words if you have a liability it must be at amortized cost unless that liability is in conjunction with the asset. This important amendment to IAS 39 came into effect on 1st January 2006.
Another important valuation method proposed by the regulatory bodies was that of Deprival value or Current cost. In UK the companies act allows a variety of valuation bases. FRS 15 (Financial reporting standard) was one such rule in the UK; it said that companies should value assets at current cost/deprival value. The true significance of measuring the value at current cost is that it reflects the greatest loss the entity could suffer if hypothetically it would be deprived of the asset. So we can say that deprival value is amount of the loss which a business would suffer if the asset was lost or destroyed however it assumes the manager takes optimal actions. ASB completely believed that deprival value is the correct way to think about the value of fixed asset but this was not true, since it is not always sure what the replacement cost of an asset will be and also sometimes there is no second market for the asset. Couple of other standards of the ASB which are no longer in existence but tried to ask the correct accounting question are FRS 11 and FRS 15. Both the standards provide the framework for assets valuation and revaluation. FRS 15 gave the option that either a company can revalue its asset or it can show it at historical cost but with the condition that if the company chooses to show its asset at historical cost then that number should never change and if it chooses to revalue then it should do so every year. Revaluation gain should be credited to the revaluation reserve which means it should be show in STRGL (Statement of recognized gains and losses) and there is no change in the profit and loss account. Revaluation loss on the other hand has to be recognized wholly in the profit and loss account if it is caused by clear consumption of economic benefits or in other words companies future cash flows have diminished. In the absence of evidence of clear consumption of economic benefits the loss will be recognised in the STRGL until the carrying amount reaches the assets depreciated historical cost.
IASB came out with a revised FRS 15 standard that reflected IASB's fair valuation agenda for the valuation of assets, it was called IAS 16. The only difference between these two standards was that where FRS 15 asked the question as to what caused the change in the value of asset, IAS 16 does not. The ultimate aim if IASB was that all fair value changes go through the income statement.
All the different standards given by IASB, ASB and FASB aimed at a better, clearer and easier way of accounting and the path to achieve that was through the conceptual frameworks of these different regulatory bodies. Elements of the financial framework included balance sheet, income statement, cash flow statement, statement of changes in equity etc and these statements provided the users with information about the economic resources of an enterprise, the claim to those resources and the effects of transactions. To conclude the conceptual frameworks aim is to provide information about the financial position, performance and changes in the financial position of the enterprise that is useful to a wide range of users in making economic decision.
But does the conceptual framework really help the users? FASB's conceptual framework nowhere defines income or tells how are we suppose to measure it. Also FASB's approach to recognize assets and liabilities was not conclusive. Nowhere in its framework does FASB tell us how to measure; it does give a number of measurement bases but does not tell which one to prefer. At the same time FASB's conceptual framework does not tell us which statement has more priority, income statement or the balance sheet, this in turn raises the question of comparability, since there is no measurement system it becomes difficult to compare. The main problem with FASB's conceptual framework is that it says that the concept will evolve as accounting develops? But shouldn't it be the other way around?
Other regulatory bodies like IASC and The Canadian institute of chartered accountants more or less copied FASB's conceptual framework. Also conceptual frameworks are being developed by Australia and New Zealand which are similar to FASB's conceptual framework. The British (ASB) started to develop their conceptual framework in 1970 and issued the final ASB statement in 1999. Their framework had 8 chapters compared to the 6 of FASB, but was similar in many ways to the FASB's conceptual framework. The only difference being that ASB relied on deprival value for the valuation of the firm, which after a lot of opposition by firms was changed to mixed measurement system.
Therefore now we can say that even after having the right intention a conceptual frameworks falls short of what it should really achieve. The conclusion which can be given to the conceptual framework of all the regulatory bodies can be-
- What the conceptual framework is trying to achieve is unachievable. Income cannot be defined. All accounting problems cannot be solved through the conceptual framework. It may improve accounting but it is the second best solution. (lecture 4)
After a lot of discussion FASB and IASB together decided a new joint agenda project to revisit their conceptual framework. The goal of this joint project is to build on the two existing frameworks by refining, updating, completing and converging them into a common framework.