The relevance of reliability: an update on the FASB and IASB joint conceptual framework project.

The first line in Concepts Statement No. 1 (CON1)--issued by the Financial Accounting Standards Board (FASB) in 1978--that forms the underpinning for FASB's Conceptual Framework (CF), reads: "Financial reporting is not an end in itself, but is intended to provide information that is useful in making business and economic decisions."

However, seven Concepts Statements, over 150 Statements of Financial Accounting Standards (FAS) and over 500 Emerging Issues Task Force (EITF) consensuses, FASB Interpretations, Technical Bulletins, FASB Staff Positions (FSP) later--besides additional guidance from the American Institute of Certified Public Accountants (AICPA) and regulatory accounting pronouncements (RAP)--one may wonder if financial reporting has become an end in itself. It's also worth pondering whether the litany (some would say "cacophony") of financial reporting information required by current standards has outlived its usefulness.

FASB Chairman Robert Herz acknowledged in the November issue of Financial Executive that "complexity impedes transparency." He also noted it is everyone's job--the FASB's, as well as preparers and auditors--to "get this beast under control." Part of such a taming effort will likely be the joint CF project of the FASB and the International Accounting Standards Board (IASB).

Insights from standard-setters and CFO-preparers follow.

Purpose and Goal of the Joint Conceptual Framework Project

The CF's of the FASB and IASB, initially developed over 20 years ago, are still helpful to standard-setters, but "are not good enough," says Halsey Bullen, FASB senior project manager for the CF project. He notes the CF is "very thin" in the areas of recognition criteria, measurement and disclosure, and adds that changes in the business world have to be reflected. Also, says Bullen, "the two frameworks [FASB and IASB], while very similar, aren't the same," and the two boards are working on joint standards projects as part of the effort toward international convergence. Having a converged CF would facilitate writing converged standards.

Early on, the joint project team found "cross-cutting issues" or systemic problems in various standard-setting projects that reflected limitations of the current CFs. Bullen emphasized the team is not trying to reinvent the wheel, and that a fair number of concepts will carry forward. For example, he says, FASB and IASB have agreed on the objectives of financial reporting, which will be similar to CON1, The Objectives of Financial Reporting.

Bullen makes reference to the Invitation to Comment, Selected Issues Relating to Assets/Liabilities with Uncertainties," posted on FASB's website since September 30, with comments due Jan. 3, 2006, as being a good example of a cross-cutting issue. "We ran into problems about uncertainties on a number of standard setting projects and knew this would come into play as we discuss definitions of assets and liabilities, recognition criteria and measurement," observes Bullen. There are a variety of opinions on how to deal with uncertainties, he says.

Overall, the joint project team is working toward issuing the first two chapters of a joint CF covering objectives and qualitative characteristics of financial reporting (currently the subject of CON 1 and CON 2), as an initial draft for comment in the first quarter of 2006.

However, he adds, the group will not wait for that first phase of the joint CF project to be completed before beginning the next phases, including the elements of financial statements (assets, liabilities, revenue, expenses and more), which are currently covered in CON 6.

Principles-Based Standards and Simplification

Will the CF project address the proliferation of accounting standards? Bullen believes that that topic is more the focus of FASB's codification project; however, he believes simplification may become more evident as new standards are written, particularly if a "principles-based" or "objectives-oriented" approach is taken. The CF would be one of the primary underpinnings in a principles-based approach.

One key difference between the FASB's and IASB's CF is that FASB's CF was written to guide it in issuing standards, but was not explicitly intended to help preparers and auditors. In contrast, IASB places its CF higher in the "hierarchy" of accounting standards, and expressly designed its CF not only for its own use, but also for preparers and users of financial statements. Bullen notes that reconciling this difference about where the CF stands in the hierarchy is still to be determined.

FASB anticipates issuing a final standard entitled Hierarchy of Accounting Principles by the end of 2005, moving the authority of generally accepted accounting principles (GAAP) fully to FASB from previously being a function of the American Institute of Certified Public Accountants' (AICPA) auditing standards. However, as noted in the Exposure Draft (ED) of the proposed hierarchy standard, although the CF meets the same characteristics as the highest category of accounting standards, it currently does not constitute GAAP per se.

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Although the Securities and Exchange Commission (SEC) recommended the CF be elevated and designated as authoritative literature, once improvements to the framework have been completed, FASB does not believe the CF is ready to be so elevated at this time.

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A related point of contention has been the hierarchy ED's position that would remove the option under AICPA Rule 203 to diverge from GAAP under certain circumstances. Adding to the mix are statements by the SEC that conformity with GAAP alone may not be sufficient in order to adequately communicate the substance of transactions.

Arnold Hanish, executive director finance and chief accounting officer for Eli Lilly and Co., believes it is time to elevate the concepts statements. "If you head down the path of principles-based accounting, you would think concepts should hold a prominent position in the hierarchy," he comments. Hanish serves as vice chair of FEI's Committee on Corporate Reporting (CCR) and is a member of the Public Company Accounting Oversight Board's (PCAOB) Standing Advisory Group (SAG).

Andy Thrower, CFO of SSP Industrial Group, agrees. He comments that particularly among smaller companies and private companies, "there is a lack of knowledge about the concepts statements--what they say or don't say." Indeed, he says he is "very much an advocate of principles-based accounting, and you don't get there until you elevate the fundamentals on which the standards are based." Thrower chairs the Standards Subcommittee of FEI's Committee on Private Companies (CPC) and is a member of FASB's Financial Accounting Standards Advisory Council (FASAC).

Some believe FASB has taken a cart-before-the-horse approach, issuing standards or proposed standards that appear to represent a sea-change in approach--such as proposed standards on revenue recognition and fair value measurement--which they believe should be undertaken after the CF project is further along. They believe key elements of the CF should be thoroughly discussed by FASB constituents, broadly understood and generally agreed upon before issuing such standards. However, Bullen notes, FASB has many constituents who want specific answers on specific issues, referencing the steady stream of FSPs the FASB staff has issued, in part, in response to such demands.

Thrower has some concerns that the current CF project is so focused on convergence with IASB "that completion of the CF will not get focus." He says that "measurement attributes are simply listed in concepts statements, but what's missing is guidance as to which is appropriate."

Bullen says, "It's hard to imagine the SEC issuing a standstill order to stop writing standards until the principles are all fixed." On one of the most controversial subjects, revenue recognition, he adds, "The view FASB is looking at right now for revenue recognition is very well grounded in the principles in the existing conceptual framework, based on the definitions of assets and liabilities."

But, here, too, there is some disagreement. Alan G. Levin, Pfizer Inc. CFO, stated in the Report of the 2005 Annual Financial Accounting Standards Advisory Council (FASAC) Survey: "There are conflicts between the conceptual guidance in Concepts Statements 5 and 6--revenue based on changes in assets and liabilities versus the requirement that revenues must be earned and realized/realizable."

FEI President and CEO Colleen Cunningham, also a FASAC member, stated in the same report, "While I continue to have hesitations about the current asset-liability approach being considered, I believe there is an absolute need for a comprehensive standard [for revenue recognition] to address the significant inconsistencies in the existing guidance and accepted practices. However, I believe the CF project must be sequenced prior to revenue recognition."

Cunningham added, "I believe that it is critical that the FASB continue to move ahead ... and focus on a comprehensive review and update of the CF ... There are several pervasive issues (for example, whether fair value is a relevant and reliable measurement objective in the absence of market-based inputs and whether control should be defined in the context of legally enforceable rights and obligations or expected risk and rewards that are not legally enforceable) that should be addressed by the board at the conceptual level prior [to] ... the standards level.

"Some of the pervasive issues associated with the current environment (for example, differential accounting standards) may be largely resolved if all constituents can get grounded in a consistent CF for financial reporting."

The Relevance of Reliability

Much of the debate around current issues, such as fair value measurement, revolve around what was previously viewed, particularly with reference to CON 2, as a "tradeoff" between the primary qualitative characteristics of relevance of information and the reliability of that information (incorporating if the information was verifiable, and if it was a "faithful representation" of what it purported to represent).

In the current CF project, Bullen says, the two boards are moving toward a sequential approach to applying the qualitative characteristics, recommending that relevance be considered first, and then other qualities, including faithful representation. Some constituents are very concerned about FASB's proposed fair value measurement methodology and the credence it would accord non-market-based fair values. Issues of reliability and questions about auditability abound, particularly in the post-Sarbanes-Oxley age, where certifications of financial information are required under increased threat of criminal penalty.

Hanish says that as we move down the path toward fair value accounting, "it makes it more difficult to step back and truly say these numbers are verifiable and auditable," and that he doesn't believe the auditing standards have kept pace with the FASB's direction around fair value accounting. He believes there is more than one approach to come up with the fair value of many assets and liabilities.

"From my perspective, it gives me a great deal of concern and trepidation of being second-guessed by auditors and the SEC." The $64,000 question to Hanish, is: "Who are the users to whom FASB is directing these disclosures?" He adds that accounting standards can't be written for every particular situation or industry. Also, users' needs differ. "Some focus on EBITDA (earnings before interest, tax, depreciation and amortization)," says Hanish. However, he adds, his industry (pharmaceuticals) is valued based on what's in the pipeline.

The rules have become so complex, argues Hanish, and "the need to ensure that you have extremely competent staff, particularly for a multinational company, to make sure you don't miss any of the rules or misinterpret them, is tremendous." He also says that auditors have a hard time keeping up with the standards themselves because of the degree of complexity.

"I think the FASB has to work hand in hand with the Public Company Accounting Oversight Board (PCAOB) to make sure whatever comes forth is auditable and verifiable," states Hanish. He believes there needs to be much more dialogue between FASB and PCAOB during deliberations.

"There needs to be a movement back to simplicity," says Hanish. "Anything the FASB can do to simplify the world of accounting is going to be a giant step forward."

Contributed by Edith Orenstein ([e-mail]), Director of Technical Policy Analysis, Financial Executives International (FEI).