FASB and IASB Joint Conceptual Framework

FASB and IASB Joint Conceptual Framework

Introduction.

Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) began simultaneously and individually issuing preliminary views to seek public comments by 3rd November 2006 for a joint FASB/IASB project to develop an Exposure Draft of an improved Conceptual Framework for Financial Reporting by Business entities. The FASB for example on the 6th of July 2006 issued its accounting series No. 1260- 001, Preliminary Views - Conceptual Framework For Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information. The FASB adopted the view that the Conceptual Framework was necessary in order to provide direction and structure to financial accounting and reporting given that its mission cannot be fulfilled without a sound and unified conceptual underpinning that provides direction and the means for deciding whether one solution to a financial reporting issue is better than others. The FASB also decided to carry out the project jointly with the IASB owing to the fact that the IASB has also recognized that its conceptual framework needs improvements. In addition, both the FASB and the IASB have common goals for the future standards that they set - one of the goals being that they require future standards to be principles-based rather than rulesbased. Therefore, having a common conceptual framework that is up to date, internally consistent, and complete would help the boards achieve that goal. A number of problems exist with the adoption of a common conceptual framework.

The objective of this paper is to discuss the problems the FASB and the IASB have had in developing a new joint Conceptual Framework. The paper will also be looking at the different approaches to measuring assets using fair value, the advantages and disadvantages with each approach, as well as the controversies inherent in the fair value approach and why both boards are hanging on to the fair value approach despite the controversies.

Problems Faced by the FASB and IASB in developing a unified Conceptual Framework

Both the FASB and IASB recognize the fact that certain gaps in their existing framework need to be filled. The joint project consists of eight phases including: (i) objective and qualitative characteristics; (ii) elements and recognition; (iii) measurement; (iv) reporting entity; (v) presentation and disclosure; (vi) purpose and status; (vii) application to not-for-profit entities in the private sector; and (viii) finalization.

Despite the benefits of a common Conceptual Framework, the IASB and FASBs' pursuit of the common framework is pregnant with a number of challenges and controversies. There are different views on whether the framework should apply only to the private sector or should it be applied to a broader set of entities including those of the public sector. In addition, different views also exist as to whether the Framework should apply to areas where some existing accounting standards preceded the concepts that support them. There are also different views of the status of the Framework in the GAAP hierarchy.

As concerns the applicability of the framework to Not-For-Profit Organisations, national standard setting partners to the IASB are concerned with the timing of the boards' consideration of application of the revised frameworks to not-for-profit entities in the private sector and whether the revised framework should cover not-for-profit entities in the public sector as well. For example, Australia and New Zealand Standard setters have sector neutral frameworks, which have been used over many years for setting sector neutral accounting standards based on these frameworks. It is therefore going to be difficult for the national standard setting bodies in these countries to adopt the new Conceptual Framework in both the public and private sector since it may bring about a lot of distortions to the existing frameworks as well as existing accounting standards.

Some IASB constituents consider the extension of the new framework to the public sector very important. However, the experience of Australia and New Zealand make the definition of concepts that can be applied to an environment where the prime objective is not profiteering provides great challenges to the boards. McGregor and Street note that development of sector neutral concepts requires standard setters to start thinking in terms of an asset having utility to an entity due to its capacity to provides goods and services in meeting the entity's service delivery objectives rather than focusing solely on he ability to generate future cash flows.

Another important challenge has been the timing of consideration of Not-for-Profit Phase. When the boards began the joint project, the not-for-profit phase was postponed to the end. The applicability of the new framework to not-for-profit entities would only be considered when concepts have been established for private sector entities. McGregor and Street note that out of 21 members comprising the IASB and FASB, only one IASB member spoke openly in favour of speeding up the discussion for not-for-profit issues. Standard setters in Australia, Canada, New Zealand and the U.K have responded and expressed concerns about the implications of the framework project for not-for-profit entities and have called on the IASB and the FASB to consider the not-for-profit entities simultaneously with private sector entities throughout the project. However, their views were rejected by the boards. Following their first rejection the national standard setters responded by requesting IASB/FASB to consider not-forprofit institutions at the end of each phase of the joint project. However, this second request was as well rejected. Chapter 1 of the common framework covers the objective of financial reporting. Accordingly, the overall objective of financial reporting is expected to remain the same in the common framework as in the respective frameworks of both boards, that is, financial reporting should have a general purpose rather than focus on meeting the information needs of specific interested parties, and should provide useful information to present and potential investors, creditors, and others about: the economic resources of an entity; the claims to those resources; the effects of transactions and other events and circumstances that change resources and claims. However, on the 2nd of November 2006 the UK Accounting Standards Board (ASB) issued a response to the 6th July 2006 IASB/FASB preliminary views document on the objectives and qualitative characteristics of financial reporting. The response highlights a number of issues including the following:

·                       “a focus on decision-useful as the objective of financial reporting, with an emphasis on
future cash flows and no reference to stewardship;

·                       the need for further work to be done in determining who should be the primary user

·                       the proposal to replace reliability with faithful representation, which could lead to
problems when combined with no specific reference to substance over form and reliance
on the component of “verifiability” and

·                       the proposal to apply the objective to financial reporting, not just the financial statements,
but deferring what constitutes financial reporting until a later phase of the project”.

A monitoring group comprising the standard setters from Australia, Canada, New Zealand and the UK also issued a report highlighting the application of the preliminary views document to not-for-profit entities and three key issues were raised in the report:

·                       That there was insufficient emphasis on accountability/stewardship;

·                       That there was a need to broaden the identified users and establish an alternative primary user group; and

·                       That the pervasive cash flow focus was inappropriate.

The report also notes that there is potential risks that the scope of financial reporting may be narrower than necessary to satisfy the needs of users in the not-for-profit sector.

Different Approaches to Measuring Assets Using Fair Value

An interesting issue in the new conceptual framework is the issue of fair value measurement of assets and liabilities in the balance sheet. Both boards have been moving towards replacing historical-cost with fair value. In particular both the FASB and the IASB are extending fair value measurements, which were in the past limited only to financial assets and liabilities to include all assets and liabilities irrespective of whether they are financial or not. This section of the paper will be looking at the different approaches to measuring assets using fair value. According to Rayman (2007: 213) citing FASB (2006, par. 5)
    “fair value is the price that would be received to sell an asset or paid to transfer a
    liability in an orderly transaction between market participants at the measurement date”.
A similar definition is provided by the IASB in IAS 39 Financial Instruments, Recognition and Measurement. Accordingly:
    “fair value is the amount for which an asset could be exchanged, or a liability settled,
    between knowledgeable, willing parties in an arm's length transaction”. (IAS 39. par.
    9).

There are three main approaches to valuing assets using fair value. this include the quoted price in an active market, using the price of substantial assets as a proxy and using a valuation technique. (Epstein and Jermacowicz, 2007).

IAS (39 par. 48A) deals with the establishment of the fair value of financial assets. This paragraph stipulates that the best evidence of fair value is the quoted prices in an active market. If the market is not active, IAS (39 par. 48A) requires that an entity should establish the value of the financial asset using a valuation technique. A valuation technique enables the entity to establish what the transaction price of the asset would have been on the measurement date in an arm's length exchange motivated by normal business considerations. Valuation techniques include using recent arm's length market transactions between knowledgeable willing parties, if available, reference to another financial instrument that is substantially the same, discounted cash flow analysis and option pricing models. (IAS 39, par. 48A). IAS (39, par. 48A) further stipulates that if there is a valuation technique commonly used by market participants to price the instrument and that valuation technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, the uses that technique. It is also required that the valuation technique makes maximum use of market inputs and should rely as little as possible on entity-specific inputs. The technique should also incorporate all factors that market participants would consider in setting and should be consistent with accepted economic methodologies for pricing financial instruments. (IAS 39, par. 48A).

Controversies of the Fair value approach

Despite the benefits of the fair value approach, there are some controversies inherent in the approach. Fair value requires that an asset should be recognized at the price at which it can be exchanged between knowledgeable parties in an arm's length transaction. However, this is controversial given the fact that the asset may be exchanged at a price significantly higher than or lower than or higher than what is recognized today as the arm's length price. IAS (39. par. 55a-b) stipulates that gains or losses on financial assets or liabilities classified at fair value should be recognized through profit or loss. This implies that an entity will have to be continuously reviewing the asset's value to see if it has increased or reduced. In addition, the valuation techniques used may not truly reflect market conditions. For example, the discount rate that may be applied in a valuation technique may not be relevant for the firm, which may make it difficult to arrive at the true fair value. Another controversy with fair value is that although it is claimed that it improves the value relevance of the balance sheet, it seems not to be the case in practice. Book values of equity continue to be significantly different from market values. Hann et al. for example, provide evidence that while fair-value accounting improves the credit relevance of the balance sheet, it does not improve its value relevance. In addition, Hann et al. also suggest that fair value impairs both the value and credit relevance of the income statement and the combined financial statements unless transitory gains and losses are separated from more persistent income components.

Why the IASB and the FASB are hanging on to the Fair Value Approach.

Both the IASB and FASB acknowledge that HCA-based financial statements obscure real financial position and the results of operations of a firm and provide ample room for manipulation. Often the historical book value of assets and liabilities has only a remote association with market values, which in turn provide bright lines for management to manipulate reported earnings and to hide their lack of real accomplishment. Fair value accounting on the other hand measures and records current values of assets and liabilities in the balance sheet therefore making the book value to be approximately equal to the market value. This in turn increases the value relevance of the balance sheet items The basic premise underlying the FASB' s decision is that fair value of financial assets and liabilities better enables investors, creditors and other users of financial statements to assess the consequences of an entity's investment and financing strategies