Principles- Versus Rules-Based Accounting Standards: The FASB’s Standard Setting Strategy

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ABACUS, Vol. 42, No. 2, 2006
doi: 10.1111/j.1468-4497.2006.00196.x
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ORIGINAL ARTICLE
PRINCIPLES VERSUS RULES-B viersity of Sydne
ASED A
y
CCOUNTING
GEORGE J. BENSTON, MICHAEL BROMWICH AND
ALFRED WAGENHOFER
Principles- Versus Rules-Based Accounting
Standards: The FASB’s Standard
Setting Strategy
In response to criticism of rules-based accounting standards and Section
108(d) of the Sarbanes-Oxley Act of 2002, the SEC proposed principles-
based (or ‘objectives-oriented’) standards. We identify several short-
comings with this approach and focus on two of them. First, the format
(type) of a standard is dependent on the contents of what the standard
regulates. Given the asset/liability approach combined with fair values, we
argue that the combination of this measurement concept with principles-
based standards is inconsistent because it requires significant guidance
for management judgment. Second, we propose the inclusion of a true-
and-fair override as a necessary requirement for any format that is more
than ‘principles-only’ to deal with inconsistencies between principles and
guidance. We discuss the benefits of this override and present evidence
from the United Kingdom’s experience.
Key words: Accounting standards; FASB; Principles; Rules; Rules-based.
According to a widely-held view, U.S. accounting standards are more rules-based
than principles-based.1 This observation stems in large part from the emphasis put
on two aspects of the wording of the typical attestation statement: ‘the financial
statements present fairly, in all material respects, the financial position of X Com-
pany as of Date, and the results of its operations and its cash flows for the year
then ended in conformity with generally accepted accounting principles [GAAP]’
(emphasis added).2 ‘Present fairly’, which indicates a principles-based approach,
is essentially converted to a rules-based approach when it is ‘defined’ in SAS 69
1
The papers in this forum adopt varying positions regarding this view.
2
The FASB’s proposed Statement of Financial Accounting Standards, The Hierarchy of Generally
Accepted Accounting Principles
(FASB, 2005a), would more explicitly codify the rules. It says in
para. A5 it expects to ‘reduce the number of levels of accounting literature under the GAAP
hierarchy to just two (‘authoritative and non-authoritative . . . [and] integrate GAAP into a single
authoritative codification’). The standards adopted by the FASB would be the first level.
George J. Benston ([email protected]) is John H. Harland Professor of Finance, Accounting, and
Economics, Goizueta Business School, Emory University; Michael Bromwich is the CIMA Professor
of Accounting and Financial Management, London School of Economics; and Alfred Wagenhofer is
a Professor of Accounting and Management at the University of Graz.
We appreciate and benefited from comments by Sudipta Basu, David Cairns, Graeme Dean, Thomas
Schildbach and Greg Waymire.
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(.05 a) by reference to Rule 203 of the AICPA Code of Professional Conduct.
This rule states that ‘present fairly’ ‘implies that the application of officially estab-
lished accounting principles almost always results in the fair presentation of finan-
cial position, results of operations, and cash flows’.3 GAAP is specified by SAS 69,
paragraph AU 411, as a hierarchy of conventions, rules and procedures pro-
mulgated by specified authoritative bodies, particularly the Financial Accounting
Standards Board and predecessor organizations (e.g., the Accounting Principles
Board).4 Thus, if the enumerated and codified GAAP have been followed as
specified, presumably the attesting CPAs have done their jobs correctly and
adequately in the eyes of the Securities and Exchange Commission and (probably)
the Public Company Accounting Oversight Board (PCAOB).
Largely because of the Enron Corporation failure, wherein Arthur Andersen
was seen as designing or accepting client-originated financial instruments that met
the technical requirements of GAAP while violating the intent,5 the rules-based
approach has come under fire.6 As a direct result of the misleading accounting
procedures revealed in the investigations of Enron’s failure, the Sarbanes-Oxley
Act of 2002 included a provision, Section 108(d), instructing the SEC to conduct
an investigation into ‘[t]he Adoption by the United States Financial Reporting
System of a Principles-Based Accounting System’. The SEC’s Office of the Chief
Accountant, Office of Economic Analysis, issued a 68-page Report (the ‘Report’)
in July 2003 (SEC, 2003).7 In July 2004, the FASB (2004) responded and in almost
3
The AICPA’s Auditing Standards Board proposed amendment to SAS 69 (AICPA Auditing
Standards Board, 2005) includes this language. Although the statement includes an ‘almost always’
qualifier, it has not been interpreted to allow for an override.
4
If adopted, SAS 69 applied to non-governmental entities would delete the GAAP hierarchy
specified, particularly the statement in paragraph .05 a that gives as the first source—‘Accounting
principles promulgated by a body designated by the AICPA Council to establish such principles’—
and .05 b which includes: ‘Pronouncements of bodies composed of expert accountants, that deliber-
ate accounting issues in public forums for the purpose of establishing accounting principles or
describing existing accounting practices that are generally accepted’. These and other sources
would be replaced by the FASB, which ‘is responsible for identifying the sources of accounting
principles and the framework for selecting the principles used in the preparation of financial state-
ments that are presented in conformity with generally accepted accounting principles in the United
States’ (AICPA Auditing Standards Board, 2005, .08).
5
Andersen actually was charged by the Department of Justice with destroying evidence and was
found guilty in a jury trial in June 2002 of ‘witness tampering’ because one of its lawyers had ‘cor-
ruptly’ persuaded Andersen employees to destroy documents in advance of an SEC investigation.
In May 2005 the Supreme Court reversed that conviction, ruling ‘that the jury instructions failed to
convey properly the elements of a “corrup[t] persuas[ion]” conviction’ (Arthur Andersen LLP,
Petitioner v. United States
, No. 04-368, 31 May 2005, Renquist, J., p. 1). The U.S. Department of
Justice then chose not to pursue the case.
6
Following a detailed description and analysis of Enron transactions audited or participated in by
Andersen, the Examiner in Bankruptcy for Enron (Batson, 2004, Appendix B, p. 167) concludes:
‘The evidence reviewed by the Examiner, and the reasonable inferences that may be drawn from that
evidence, are sufficient for a fact-finder to conclude that Andersen was negligent in the provision of
its professional services to Enron. In addition, the evidence is sufficient for a fact-finder to conclude
that Andersen aided and abetted certain Enron officers in breaching their fiduciary duties to Enron.’
7
Printed in what the web document describes as the ‘smaller’ text size.
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all respects agreed with the SEC Report (in part, no doubt, because the Report
agreed with an earlier FASB [2002] statement and recommended that the FASB be
the sole U.S. standard setter).8 Therefore, the Report, which summarizes much of
the writing on this subject (including submissions by the FASB), provides a point
of departure for an analysis of the ‘rules vs principles’ debate. Given this degree
of unanimity and the reasonable presumption that the Commission approved the
Report, its analyses and recommendations should be taken very seriously.
We begin our analysis by reviewing the SEC’s (2003) Report that suggests a
principles-based (or, as it calls it, an objectives-oriented) approach and the sub-
sequent strategy of the FASB with respect to principles-based standard setting.
Two major shortcomings are discussed in subsequent sections. First, the format of
standards cannot be discussed and decided on without considering the contents
of what the standard should prescribe. Observing that the FASB follows the
asset / liability approach and increasingly adopts fair-value measurements, we
argue that the combination of this measurement concept with principles-based
standards is inconsistent. A major reason is that fair values require many rules to
provide sufficient guidance, they invite manipulation, and they often cannot be
assured by auditors.9 We propose to move back from an asset / liability approach
with fair values to the traditional revenue/expense model, which is better able to
produce trustworthy and auditable numbers.
The second shortcoming is the dismissal of a true-and-fair override that we
argue is a necessary requirement for any standard setting approach. The more
rules the standards include, the more an override provision is necessary to avoid
allowing or even requiring accountants to follow rules by letter but not by
intention. The override gives accountants more professional responsibility for
financial statement content, and its disclosure gives sufficient transparency for
users to understand and, perhaps, challenge its application. We present evidence
on the use of a true-and-fair override from the United Kingdom’s experience
and discuss how International Financial Reporting Standards (IFRSs) cope with
the issue.
The format of accounting standards is not exclusively a U.S. issue, although
the current debate has emerged there in the aftermath of accounting scandals, but
is of international interest because the FASB and IASB have agreed to converge
their standards as much as possible. Recent evidence of convergence is their June
2005 joint exposure draft on business combinations (FASB 2005b; IASB 2005a),
which has even the same numbering of paragraphs.10 Thus, the U.S. debate on
8
Furthermore, the AICPA Auditing Standards Board (2005, p. 5), states that the FASB’s (2005a)
proposed statement, The Hierarchy of Generally Accepted Accounting Principles, is ‘[i]n response
to recommendations in the [SEC’s Report]’.
9
It is interesting to note that when accounting standards (or principles) were controlled by account-
ing practitioners who served on AICPA committees, proposals for fair- and present-value restate-
ments of assets were not taken seriously.
10
However, the IASB draft includes less content, so that some paragraphs are ‘not used’ to preserve
the consecutive numbering with the FASB draft.
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principles vs rules should not be viewed solely from an U.S. perspective but,
rather, from an international one.
THE REASONS FOR RULES-BASED STANDARDS
In October 2002 the FASB issued a Proposal, Principles-Based Approach to U.S.
Standard Setting
. The Proposal’s introduction (FASB, 2002, pp. 2–3) explains: ‘in
the Board’s view, much of the detail and complexity in accounting standards has
been demand-driven, resulting from (1) exceptions to the principles in the stand-
ards and (2) the amount of interpretive and implementation guidance provided by
the FASB and others for applying the standards’. According to the FASB, the
exceptions resulted from the Board having to make compromises with presum-
ably powerful interest groups that prevented it from implementing its desired
principles. The Proposal makes particular mention of FAS 133, Accounting for
Derivative Instruments and Hedging Activities
, the complexities of which resulted
from the Board having to make numerous exceptions from the general principles
promulgated in FAS 133, para. 3. The extensive guidance, it says, results from
having to fulfill the objectives of comparability and verifiability. The Proposal
rejects ‘principles-only’ standards, because these ‘could lead to situations in which
professional judgments, made in good faith, result in different interpretations for
similar transactions and events, raising concerns about comparability’ (p. 9). Com-
parability may be seen as especially important in an international environment, as
there is the danger that local accountants and regulators arrive at differing views
on the interpretation of contentious accounting issues.
In addition, the FASB (and its predecessors) have developed rules-based standards
to meet the demand of major constituents, particularly management and auditors,
who want a clear answer to each and every perceivable accounting issue. The litigious
situation in the United States (and increasingly in other countries) means that the
risk of law suits based on alleged wrong accounting is high and gives accountants
a strong incentive to ask for rules they can adhere to in case of a costly law suit.
As Schipper (2003) points out, rules are likely to proliferate as accountants ask
for guidance that, they hope, will protect them from criticism and lawsuits.
Detailed rules and authoritative guidance also serve standard setters’ and regu-
lators’ objective of reducing the opportunities of managers to use judgments to
manage earnings (and of auditors to have to accept that practice). Standard set-
ters can be and must show that they are active standard setters. Thus, they may
tend to overproduce standards and to write detailed rules covering almost any
conceivable situation.
THE CASE FOR PRINCIPLES-BASED STANDARDS
Despite the demand for rules-based standards, the FASB (2002, 2004) and the
SEC (2003) reject them and have turned to proponents of principles-based stand-
ards, presumably because in the light of the accounting scandals they consider the
costs of rules-based standards to outweigh their benefits. The SEC Report states:
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Unfortunately, experience demonstrates that rules-based standards often provide a
roadmap to avoidance of the accounting objectives inherent in the standards. Internal
inconsistencies, exceptions and bright-line tests reward those willing to engineer their
way around the intent of the standards. This can result in financial reporting that is not
representationally faithful to the underlying economic substance of transactions and
events. In a rules-based system, financial reporting may well come to be seen as an act of
compliance rather than an act of communication. Moreover, it can create a cycle of ever-
increasing complexity, as financial engineering and implementation guidance vie to keep
up with one another. (SEC, 2003, at note 13)11
For these reasons, and based on an example of how corporations (mis)used
the ‘bright lines’ given in APB Opinion No. 16 that specify when a business
combination could be accounted for with the pooling of interests method rather
than the purchase method, the Report concludes that a rules-based system is
not desirable.
Other critics of rules-based standards have pointed out that rules can become
useless and, worse yet, dysfunctional when the economic environment changes or
as managers create innovative transactions around them (Kershaw, 2005, pp. 596 –
7). Moreover, such standards need not reduce earnings management and increase
the value relevance of financial reports in so far as the rules increase managers’
ability to structure transactions that meet these rules while violating the intent
(e.g., Nelson et al., 2002) and real earnings management may overcompensate for
judgmental discretion (see Ewert and Wagenhofer, 2005).
The Report therefore examines what it terms ‘principles-only’ standards, which
it defines as ‘high-level standards with little if any operational guidance’ (at note
13). It then dismisses this alternative, since ‘principles-only standards typically
require preparers and auditors to exercise judgment in accounting for transactions
and events without providing a sufficient structure to frame that judgment. The
result of principles-only standards can be a significant loss of comparability among
reporting entities’ (at note 14).12 The Report does not further consider whether
or to what extent the financial statements of different entities can be more or
less meaningfully compared even when based on common rules or principles.13
11
The Report’s page numbers differ depending on the format in which the electronic version is
printed. Hence, we locate quoted material by the nearest footnote.
12
The SEC Report (2003, at note 15) gives two numbered additional concerns that could be ascribed
to principles-only standards: ‘(2) a greater difficulty in seeking remedies against “bad” actors
either through enforcement or litigation, and (3) a concern by preparers and auditors that regula-
tory agencies might not accept “good faith” judgments’. These are not further discussed. However,
in a section entitled ‘The Role of Judgment in Applying Accounting Standards’, the Report
appears to dismiss (3), as it states: ‘it is simply impossible to fully eliminate professional judgment
in the application of accounting standards’ (p. 15 at note 21). Nor would we wish to, as we discuss
later.
13
See Dye and Sunder (2001, p. 266) for cogent arguments pointing out the shortcomings of
uniformity (the same rule, e.g., expense research and development, yields different results
when one firm’s activities are successful and another’s efforts are a failure) and the benefits
(reporting choice reveals strategies) from allowing financial statement preparers to choose among
alternatives.
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Rather, it offers only two related examples to explain its rejection of principles-
only standards, impairment of long-lived assets and recording depreciable assets
at their historical ‘time of acquisition’ cost. The Report criticizes the lack of
implementation guidance, which leads to a loss of comparability. However, it does
not recognize that, no matter how a long-lived asset is initially recorded, com-
parability is lost as soon as the asset is purchased, as its value in use differs among
users. Over time, both value in use and value in exchange or replacement value
also change and the alterations will differ among companies; furthermore, the
changes often cannot be determined objectively. Consequently, comparability
would only be possible if strict rules for revaluing assets at unambiguously specified
values were used. It is not ‘principles-only’ that is at fault here, but the inevitable
and, indeed, desirable lack of comparability due to different economic environ-
ments. Further, the Report does not recognize that a company’s choice of
accounting measurement or presentation can convey information that is valuable
to investors about the managers’ operational and investment approach and
decisions.
The Report proposes, rather than ‘principles-only’, what it calls ‘objectives-
oriented’ standards, which are said to be optimal as between principles-only and
rules-based standards, apparently because they offer a much narrower framework
that would limit the scope of professional judgment but allow more flexibility
than rules-based standards. ‘Objectives-oriented’ standards are similar to what
the FASB (2004) calls principles-based standards. They appear to be those where
the accounting reflects the economic substance of the accounting problem and is
consistent with and derived from a coherent conceptual framework, from which
there are few exceptions. These standards, the Report asserts, should:
• Be based on an improved and consistently applied conceptual framework;
• Clearly state the accounting objective of the standard;
• Provide sufficient detail and structure so that the standard can be operationalized
and applied on a consistent basis [‘Note 1 of the Report says: “In doing so, however,
standard setters must avoid the temptation to provide too much detail (that is, avoid
trying to answer virtually every possible questions within the standard itself ) such that
the detail obscures or overrides the objective underlying the standard.” ’];
• Minimize exceptions from the standard;
• Avoid use of percentage tests that allow financial engineers to achieve technical com-
pliance with the standard while evading the intent of the standard. (SEC, 2003, p. 5
at note 1)
This is a sensible and desirable list of characteristics and admonitions. Indeed,
it is a wish list to which all standard setters would subscribe. But it begs the ques-
tion as to how much detail should be included in objectives-oriented standards.
Indeed, the Report gives no indication of how such an ‘objectives-oriented’ stand-
ard should or can be derived.
The AAA Financial Accounting Standards Committee (2003) also uses the
term ‘concept-based’ standards and attaches the following characteristics to
them: an emphasis on the economic substance rather than the form of a trans-
action, a description of the particular transaction that is the subject of the standard,
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disclosure requirements, and some implementation guidance in the form of ex-
amples. The Committee says (p. 76): ‘Concept-based standards have the potential
to promote the financial goals of the FASB in ways that rules-based standards
cannot . . . Concept-based standards reflect a more consistent application of the
FASB’s Conceptual Framework and enhance individuals’ understanding of the
framework.’14
We agree with the view that ‘optimal’ standards are somewhere in the continuum
of ‘principles-only’ and ‘rules-only’. In search of a universal, if not an optimal
approach to standards, the FASB has been including more principles in their
recent standards and exposure drafts (some examples are given below), while the
IFRS has added significantly more guidance to their principles-based format in
their recent standards (as shown from the increase from year to year in the
number of pages of the printed version). In the following, we hypothesize two
avenues to correct flaws in this search for improvement to U.S. standard setting:
(a) recognizing that the format of standards is related to their contents and (b) a
true-and-fair override in the standards.
CONTENTS AND FORMAT OF STANDARDS
An assessment of the format of standards, or their underlying philosophical bases,
crucially depends on their regulatory content, that is, on the underlying account-
ing principles they are intended to observe. A major driver of complexity in
accounting standards is the number of exceptions to a basic standard (FASB,
2002); another is the amount of judgment necessary to apply a standard, which
then necessitates rules and guidance. To understand the SEC Report’s objectives-
oriented standards, it is important to consider its underlying accounting measure-
ment or valuation model. We note that although the SEC has not sought to define
or develop an accounting model, the close interdependence between the type of
standard and its contents implies the need to outline such a model when it pro-
vides recommendations regarding the format for standards. While a standard
seeks to implement a particular principle for an accounting problem, its drafters
also should consider and try to avoid potential gaming by opportunistic company
managers and accountants. Gaming specifically results from too much leeway
given to management and accountants. In general, some principles provide more
gaming opportunities than others. The more decision ‘relevant’ and the less ‘reli-
able’ a standard the more difficult it is to provide a standard that does not need
significant guidance and rules.15
The Asset / Liability Accounting Model
The Report adopts the asset/liability model as the fundamental building block of
accounting standards, and emphatically rejects the traditional revenue/expense
14
The Committee also reviews a substantial body of academic research and finds it inconclusive.
15
Bennett et al. (2005) provide a comparative analysis of the standards on research and development
in the U.S., New Zealand and in IFRS.
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model.16 ‘In the asset/liability view the standard setter, in establishing the account-
ing standard for a class of transactions would, first, attempt to define and specify
the measurement for the assets and liabilities that arise from a class of trans-
actions. The determination of income would then be based on changes in the
assets and liabilities so defined.’ In contrast, when describing the revenue/expense
model, the Report states that it gives ‘primacy to the direct measurement and
recognition of the revenue and expenses related to the class of transactions.
Under this approach, the balance sheet becomes residual to the income statement,
and contains assets, liabilities, and other accruals/deferrals needed to maintain a
“balance sheet”
.’ The Report rejects this approach: ‘We believe that the revenue/
expense view is inappropriate for use in standard-setting—particularly in an
objectives-oriented regime’. One reason for this conclusion is that there ‘are a
variety of specific revenue recognition standards . . . for narrowly defined trans-
actions or industries’. The other reason given for rejection of the revenue/expense
approach is that it is necessary to measure wealth at the beginning and end of
periods ‘as a conceptual anchor to determining revenues and expenses that result
from the flow of wealth during the period. Historical experience suggests that
without this conceptual anchor the revenue/expense approach can become ad hoc
and incoherent.’17 The revenue/expense approach is blamed for the inclusion of
deferred revenues and expenses that are incorrectly described as assets and liabil-
ities. The Report concludes: ‘Not surprisingly, an examination of these standards
shows that various inconsistencies exist among the revenue recognition models’.18
However, similar, if not greater, problems arise with the asset / liability approach
under principles-based standards. The reason is that the asset / liability approach
cannot be applied consistently by accountants and managers without such ex-
tensive guidance that it would degenerate into providing rules-based standards.
Although the Report does not clearly specify how assets and liabilities should be
measured, since the economic definition of income is emphasized, it would appear
that fair values should be used.19 Indeed, the FASB (and the IASB) give priority
to fair value measurements.20 The FASB Exposure Draft on Fair Value Measure-
ments
(2005c, issued 2004 and revised 2005) is part of ‘the Board’s initiatives to
simplify and codify the accounting literature, eliminating differences that have
16
The quotations in this paragraph are taken from the SEC (2003) between notes 72 and 78, emphasis
in original.
17
No examples of or references to such historical experience are provided.
18
This statement is supported only by reference to FASB Project Updates, ‘Revenue Recognition’.
In fact, this document does not show or even mention inconsistencies.
19
See also the Report’s observation that it is likely that the FASB will issue more standards with
fair-value measurements (SEC, 2003, at note 100).
20
Evidence of the movement to fair value are the recent drafts with a full fair value approach for
business combinations (FASB, 2005b, and IASB, 2005a) and the fair value option for financial
instruments (FASB, 2006, and IAS 39, as revised June 2005), which is only the first part of a fair
value project of the FASB (see Notice for Recipients of the FASB [2006] Exposure Draft). See
also the discussion paper on measurement at initial recognition (IASB, 2005b).
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added to the complexity in GAAP’ (p. ii). A review of the FASB draft statement
shows that extensive guidance is necessary to reduce the enormous room for judg-
ment in determining fair values—and provides evidence for our conclusions.
Schipper (2003) additionally shows how, for example, application of a principle
governing the fair value of financial instruments presents several difficulties. She
lists and examines the definition of the term ‘financial instruments’, the value
attribute (exit or settlement amount, entry value, net realizable value, value in
use, deprival value), measurement of the value (e.g., bid, ask or midpoint, block
discount, model or present value calculation), and the problem of how sparse
trades and block trades should be handled. Exceptions to the standards can be
dealt with, she says, only by means of rules, which ‘add to the length and complexity
of the standard, and lead to requests for explanations of the breadth of the
exceptions’ (p. 67). Except for assets and liabilities for which relevant and reliable
market prices (on the ‘relevant market’) can be obtained, the values assigned
must be determined from appraisals, present value calculations, or by reference
presumably to similar assets.21 It is likely that these numbers often are both costly
to determine and subject to possible opportunistic manipulation by managers, if
they can be calculated at all, considering the difficulty or impossibility of deter-
mining and measuring intra-firm externalities. Thus, if trustworthy numbers are
useful to investors, very detailed rules for calculating them would have to be
written by the standard setters. This clearly is contrary to the characteristics of the
coherent conceptual framework specified by the Report, particularly its admoni-
tion against excessive detail (SEC, 2003, footnote 1).
A cogent example, discussed by Schipper, is changes that impair the value of
recorded goodwill. The necessity of revaluing the assets gives rise to a series of
questions that complicate application of the standards and require a significant
amount of rules and guidance. Schipper (2003, pp. 64 –5) asks:
at what level in the organization should goodwill be tested for impairment, and how
often? Since goodwill cannot be separately measured, how should the impairment test be
carried out? If goodwill is found to be impaired, how should it be remeasured? The
standard setting issue: How many of these questions should be answered in the standard
and at what level of detail?
Besides the difficulties of measuring fair values, the measurement principle covers
(at least currently) only a subset of balance sheet assets and liabilities. The SEC
Report talks about specifying the measurement for a ‘class of transactions’ (2003
at note 72). This appears to be those that involve assets and liabilities that are
economically similar, which, thus, defines the ‘scope’ covered by a standard. The
Report would have the standard setter identify the assets and liabilities that are
created, eliminated or changed by a transaction or event such that it is not too
narrow or too broad—deemed ‘optimal scope theory’. This implies a need for
detailed rules that define ‘narrow’ and ‘broad’ and how recognizable classes of
21
Some of the complexities of deriving values from models and other measurement issues are
described, rather naively and uncritically, in the FASB exposure draft. For a critical assessment see
Benston (2006).
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transactions that can be distinguished from other classes. The Report gives an
example to illustrate this ‘theory’. The FAS 141 definition of business combinations
is described as ‘near the optimum point on the [objectives-oriented] continuum’:
‘A business combination occurs when an entity acquires net assets that constitute
a business or acquires equity interests in one or more other entities and obtains
control over that entity or entities’ (SEC 2003 at note 86). Thus, there must be
control for there to be consolidation; hence, it is not necessary for the standard
explicitly to exclude equity-method investments. We find it difficult to see how
this illustration helps one understand what the Report means by ‘optimal scope
theory’. The Report does not address whether an objectives-oriented standard
could avoid a bright-line definition of control (e.g., one share more than 50 per
cent, as specified in footnote 5 to FAS 141), even though the Report keeps saying
it wants to do away with bright lines. Perhaps, an objectives-oriented standard
would give considerably more weight to the final phrase of footnote 5, ‘although
control may exist in other circumstances’. Here, a bright line would serve only as
an indicator to judge the existence of control.
A further implication of measurement for a class of transactions is that it generates
the problem of adding the estimated market values of the acquired assets and
liabilities with the historical book values of the acquirer’s assets and liabilities.
What does the sum of these numbers mean in terms of a general principle of
‘representational faithfulness to economic substance’?22 Although this concern
with economic substance would seem to imply measuring assets and liabilities
at their fair values and (presuming zero inflation) net income as the difference
between fair values of net assets at the beginning and end of a period, adjusted for
distributions and additional equity investments, the Report does not explicitly call
for revaluation of all assets and liabilities at the end of an accounting period.
Revenue/Expense Approach
Although the asset / liability approach is consistent with the FASB’s relatively recent
pronouncements, it is inconsistent with its December 1984 Concept Statement No. 5
(Recognition and Measurement in Financial Statements of Business Enterprises),
which describes well the traditional accounting model and declares (pp. 5 – 6):
• A statement of financial position does not purport to show the value of a business
enterprise but, together with other financial statements and information, should pro-
vide information that is useful to those who desire to make their own estimates of the
enterprise’s value . . .
• Earnings is a measure of entity performance during a period. It measures the extent to
which assets inflows (revenue and gains) associated with cash-to-cash cycles substantially
completed during the period exceed asset outflows (expenses and losses) associated,
directly or indirectly, with the same cycles.
22
Indeed, the former G4+1 (a group of standard setters comprising of representatives of the Inter-
national Accounting Standards Committee, Australia, Canada, New Zealand, the U.K. and the
U.S.A; now disbanded) pondered the application of a fresh-start method that would require valu-
ation of the acquiree’s and acquirer’s assets and liabilities at fair value (although only for a uniting
of interest transaction).
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© 2006 Accounting Foundation, The University of Sydney