Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Accounting Standard Setters Capitulate to Financial Economics

The International Accounting Standards Board and the US Financial
Accounting Standards Board have issued preliminary drafts of the first
two chapters of their proposed joint Conceptual Framework for
Financial Reporting. This available at the FASB
web site.

The draft document appears to me to represent the triumph of
financial economics over traditional accounting. For example:

  • The document describes the principal objective of financial
    reporting as follows “To help achieve its objective, financial
    reporting should provide
    information to help present and potential investors and creditors and
    others to assess the amounts, timing, and uncertainty of the entity’s
    future cash inflows and outflows (the entity’s future cash
    flows). That information is essential in assessing an entity’s ability
    to generate net cash inflows and thus to provide returns to investors
    and creditors.” In its subsequent discussion of this issue, the document
    goes on to say “The Boards’ eventual consideration of those
    matters might result in a conclusion that adding a discussion of
    forecasts to the framework would be consistent with the focus on
    users’ interest in the amounts, timing, and uncertainty of an
    entity’s future cash flows” This is in sharp contrast to
    the existing framework document of the IASB which places primacy on
    “information about the financial position, performance and
    changes in financial position of an enterprise.”
  • The document strengthens the importance of neutrality and
    completely does away with the notions of ‘conservatism’ and
    ‘prudence’ in a hard hitting paragraph: “Neutrality
    is incompatible with conservatism, which implies a bias in financial
    reporting information. Neutral information does not color the image it
    communicates to influence behavior in a particular direction. For
    example, automobiles might be produced with speedometers that indicate
    a higher speed than the automobile actually is traveling at to
    influence drivers to obey the speed limit. But those
    ‘conservative’ speedometers would be unacceptable to drivers who
    expect them to faithfully represent the speed of the
    automobile. Conservative or otherwise biased financial reporting
    information is equally unacceptable.”
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