The Institutions That Make Accounting Policy

7/31/2019 The Institutions That Make Accounting Policy

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The Institutions That Make Accounting Policy:

The International Dimension

Just as the world would be a simpler (if less interesting) place everyone spoke the

same language, so the international world of business would be a simpler place to operate inif accounting policies were uniform throughout the world. The problems of preparing

consolidated financial statements by parent companies that have overseas affiliates and the

measurement of foreign income for tax purposes would both be simpler. The use cc

accounting information for management control purposes, across national boundaries would

be simplified and so would international lending, investment appraisal, and ihe auditing of

the financial statements of multinationals.

The process of reducing variations among national accounting practices-the process of

harmonization, as it is called-has indeed made progress since serious work started on it as re-

cently as 1967. Considering the differences that exist between the accounting objectives of

countries at different stages of development and with different legal systems, perhaps the sur-

prising thing is that any progress at all has been made in so short a time.

There are many different ways of classifying countries when considering their

accounting needs. One obvious distinction is between the democracies and the authoritarian

regimes that rule much of the world. This distinction does not correspond neatly ,to a

division between free enterprise and centrally controlled economies, for there are

democracies (e.g., India) with a large part of the economy in the hands of state-owned and

state controlled enterprises, and there are communist countries (e.g. Hungary and

Yugoslavia) that leave scope for same free enterprise. The significance of this distinction

for financial reporting lies in the role of private investors and the capital market. The-

, willgenerally be much more important in free enterprise economies, and financial reporting will

play a correspondingly more important part there in the allocation of resources.

Another obvious distinction is between the developed countries of North America,Australia, Europe, and Japan and the less developed countries of Africa and Asia. Hereagain, the difference is one of degree rather than of kind. All countries are developing (orretrogressing), and accounting has its part to play in that development in all of them. Mostof the less developed countries have only in this century shaken off their status ascolonies, and few of them are democracies as we understand the word. The distinction

between democracies and autocracies is not unrelated, therefore, to the distinction between

the more developed and the less developed nations.A third basis of classification is the nature of a country's legal system. Primarily, thedistinction is between the common law systems of the Anglo-Saxon countries and theirformer colonies and the civil law systems of Western Europe. In civil law countries, there isgenerally more emphasis on following prescribed rules and forms, end financial reportinggenerally follows the tax code much more closely than in the common law countries. Nodiscussion of accounting policy would be complete without some consideration of itsinternational dimension. But before .considering the problems of harmonization, it is worth-while to look at how accounting standards are set in three developed countries besides theUnited States. Britain, Canada, and West Germany each presents a different model of thestandard-setting process, and each of them is different from the U.S. model. Two of those

countries are members of the European Economic Community; (EEC), in which formal


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harmonization is a requirement of adherence to the' Treaty of Rome, which brought theCommunity into existence.

Great Britain and Ireland

The official accounting standard setting body in Great Britain and Ireland is theAccounting Standards Committee (ASC). Established originally in 1970 by the Institute ofChartered Accountants in England and Wales (the English Institute), the Institutes ofChartered Accountants in Scotland and Ireland joined the committee later the same year, andthree other professional bodies of accountants joined in 1971 and 1976. Since 1976, it hasfunctioned as a joint committee of the Consultative Committee of Accountancy Bodies(CCAB).

The ASC resembles the Accounting Principles Board much more than it does theFASB. Under its present constitution, which was revised in 1982, its membership may vary

between la and 22 members. They are nominated by a nominating committee representing thesix CCAB bodies, and formal appointment to ASC is made by the CCAB. A small number ofnon accountants may, since 1982, serve on the ASC. All members serve part time and areunpaid.

Like most standard-setting bodies, the ASC has due process procedures throughwhich affected parties can communicate their view on ASC proposals to the committee.Exposure drafts are widely disseminated. The committee is also provided with a ConsultativeGroup, not unlike the FASB's Advisory Council, which meets with the chair of ASC notfewer than three times a year.

Up to five places on the committee are reserved for users of financial statements,drawn from industry and financial institutions, who need not be members of the CCAB

bodies. At all times there is at least one member from each of the six CCAB bodies. As of

July 1, 1984, the committee had 20 voting members, from the following areas.

Public ractice 7Industr and commerce 6Users 4

Nontradin ublic sector 2Academic 1

20

There are two striking differences between the positions of the ASC and theFASB. One is that statements of standard accounting practice (SSAPs) issued by theASC must have the approval of the governing councils of all six CCAB bodies before

they can take effect. This procedure is not only cumbersome and time-consuming, butit raises serious questions about the wisdom of giving veto powers to council memberswho may not have given much thought to the Complex technical issues that ASCmembers have to grapple with.

The second difference between the ASC's and the FASB's positions relates toenforcement. As Britain has no body corresponding to the SEC to give the ASC its

blessing and authority, the committee has had to look to the Stock Exchange and thedisciplinary powers of the CCAB bodies over their members for such enforcement

power as it has. Members acting as auditors are required to ensure that significantdepartures from ASC standards in financial statements are disclosed and are justifiedif their concurrence in the departure is stated or implied. The Stock Exchange makes ita condition of listing that, when an auditor qualifies his or her report in respect of adeparture from an ASC standard, the company must explain its reasons for the


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departure to its shareholders. These disciplinary measures have not been entirelysuccessful in giving the ASC the authority that it needs to be effective. As yet,enforcement remains an unsolved problem for the ASC.

The ASC must, of course, work within the limits set by the British CompaniesActs, principally the acts of 1980 and 1981. The 1981 act was promulgated in part to

incorporate the EEC's Fourth Directive into British law. In so doing, a number of fun-damental accounting concepts have been given statutory force. These include theaccruals concept, the presumption that a company is a going concern, the requirementthat only "realized" profits be included in the income statement, and the requirementthat accounting policies be applied consistently from year to year. The only one ofthese concepts that could create a problem for the ASC is the "realized profit"concept, which has yet to be defined.

British accounting standards are promulgated by the ASC in the form ofStatements of Standard Accounting Practice (SSAPs). For all practical purposes, theyare like the FASBs statements of financial accounting standards (SFASs), though theyhave been considerably less numerous. In its first 10 years, 1970-80, the ASC issued 18

standards. In the FASB's first 10 years, from mid-1973 to mid-1983, the Board issued 72standards, and a number interpretations in addition.

Since 1984, the ASC has introduced a subsidiary type of pronouncement called astatement of recommended practice (SORP). SORPs give guidance on specific topics thatare not thought to warrant the issue of a full-blooded standard. Compliance with SORPsis encouraged but is not mandatory (even in the limited UK sense), and noncompliancedoes not have to be reported on by auditors. There is also a subcategory of SORPs calledfranked SORPs." These relate to problems peculiar to specific industries and aregenerally produced by working groups drawn from the industries concerned. Preparationof these statements is overseen and reviewed by the ASC, which gives its approval beforethey are issued by the industries concerned.

Although, broadly speaking, British and U.S. accounting standards are inagreement with each other, there are some significant differences between them. Threeexamples of these differences are given below:

United States Britain

Comprehensive tax allocation Partial tax allocation (SSAP 15)

(APB Opinion 11) Some development expenditures may

be capitalized (SSAP 13) be capitalized (SSAP 13)

R&D expenditures to be written The "inflation accounting" standardoff when incurred ,SFAS 2) recognizes changes in specific prices

The "inflation accounting" only (SSAP 16)standard recognizes changes in

both specific prices and the

general price level (SFAS 33)

Canada

In Canada, the formulation of generally accepted accounting principles is theresponsibility of the Accounting Standards Committee of the Canadian Institute ofChartered Accountants (CICA). The committee, which in 1984-85 had 22 members, re-sembles the Accounting Principles Board that functioned in the United States from 1959

until 1973, since the members divide their time been the work of the committee and theconduct of their practices. Its voting rule is also the same-recommendations, as its


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pronouncementsare called, require a two thirds majority of the members as a conditionfor issuance. Being composed of part-time, unpaid members and relying for much of itsstaff work on the support of members' firms, the committee is able to function on a

budget that is a small fraction of that of the FASB.Since the passage of the Canada Business Corporations Act of 1975, the

recommendations of the CICA have been given virtually the force of law, because theyare enforced by the government as regulations made under the Act.

West Germany

It is not clear that the concept of "generally accepted accounting principles" hasmuch meaning in West Germany, for there legal acceptability takes the place of generalacceptance, and the influence of the tax law is dominant. The German StockCorporation Law of 1965 requires that company financial statements be prepared inaccordance with principles of orderly accounting. One German authority explains the

position in this way:The German understanding of accounting principles is not quite comparable to what

is mean in Britain. . . . In Germany this set of basic norms is generally referred to asprinciples of orderly bookkeeping or accounting (GOB). There are three mainsources of these requirements: company, commercial, and tax law and regulations. . .. Income Tax Regulations in particular leave no doubt whatsoever that the terminvolves the keeping of books required by other laws, and makes it quite clear thatall tax allowances, including the carry forward oflosses, will be disallowed if thetax audit reveals that principles have not been adhered to. There is, however, the

problem that these principles are neither defined non codified. One has rather tocollect them from the body of various laws, especially the company law and even fromdecisions of several tax cases in whichthese principles have been furtherelucidated. Theconsequence is that commercial accounts are much orientated towards tax calculation.Since the Saxon Income Tax Law of 1874 there is the paramount principle(Massgeblichkeitsprinzip)that commercial and tax statements should agree. . .

As the author of his passage goes on to point out, to maximize the benefit from tax allowances,whatever accounting treatment is most favorable to the taxpayer for tax purposes will dictatethe treatment to be adopted for financial reporting purposes also.

Where conformity between tax accounting and financial reporting is required,accounting policy has in effect, been handed over to the tax authorities. There is no room for anFASB or a body like it. The qualitative characteristics by which accounting information is

judged in the Anglo-Saxon world are hardly likely to carry much weight in such a system. It

has yet to be seen how this system can accommodate an overriding commitment to thedisclosure of a "true and fair" view that is now being imported into German company law tobring it into line with EEC's Fourth Directive.

International Accounting Standards

International accounting standards are not exclusively the concern of any oneorganization, for governments have not been willing to leave this matter entirely to privateinitiative. The International Accounting Standards Committee (IASC) is unquestionably thevoice of the private sector in this field; but it does not have the field to itself. The Organizationfor Economic Cooperation and Development (OECD), made up of highly developed countries,has prepared a Code of Conduct for Multinational Enterprises, which includes, among other

things prescriptions for financial disclosure by multinationals. At the urging of the developingnations, the United Nations has formed an Intergovernmental Group on International


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Accounting Standards and Resporting. This initiative on the part of the UN reflects theconcerns of developing countries about the activities of multinational companies in theirterritories and their desire to improve their capacity to control those activities. They see theIASC as being dominated by the developed nations, and especially by the United States UnitedKingdom. This view of the IASC is not entirely Unfounded. We shall return to this matter

shortly

The International Accounting Standards Committee (IASC)

The original agreement to establish the international Accounting StandardsCommittee was signed in London on June 29, 1973, by representatives of the professionalaccounting bodies of Australia, Canada, France, West Germany, Japan, Mexico, the

Netherlands, the United Kingdom, and the United States. The committee had grown out ofthe Accountants International Study Group, made up of representatives of Canada, the UnitedKingdom and the United States, which had held periodic meetings since 1967 and publishedseveral papers on comparative accounting topics before it disbanded in 1977.

The purpose of IASC is "to formulate and publish in the public interest, basic

standards to be observed in the presentation of audited accounts and financial statements and

to promote their worldwide acceptance and observance." Members of the commitee are all

professional bodies, not individuals; when they become members of the committee, they

undertake to "use their best endeavors to ensure that published accounts comply with these

standards or that there is disclosure of the extent to which they do not. . . ."2

At the end of 1985, there were 71 nations represented on the Committee, several ofthem by more than one professional body. Membership of IASC is identical with themembership of the International Federation of Accountants (IFAC), a worldwide organizationof 97 accounting organizations (at the end of 1985). The full membership of IASC meets onlyonce every five years, at the time of the World Congress of Accountants, and most of itswork is done by a board selected by the council of IFAC. The IASC board is drawn from 13countries. Countries selected to serve on the board may be represented on it by more than one

person, but each country has only one vote.International accounting standards are initially developed by steering committees

made up of representatives from three to five countries, not all of which need have seats onthe board. Exposure drafts are widely circulated for comment throughout world. The finalissuance of an international standard requires approval by at least three-quarters of themembers of the board.

The IASC board meets regularly with a consultative group representing preparers and

users of financial statements, and the group participates throughout the process of issuing aninternational standard. It includes representatives of worldwide organizations of stockexchanges, chambers of commerce, financial executives, financial analysts, trade unions, andthe World Bank. The consultative group also has observers from the secretariats of OECDand the United Nations Center on Transnational Corporations.

As of July 1, 1985, IASC had issued 24 standards, the last 2 (IAS 23 and IAS 24) tobe implemented on July 1, 1986. These standards do not override the national standards ofmember countries. When national standards conflict, as they often do, the IASC has adifficult task picking its way through those standards to minimize the conflict. When conflictremains, and a national standard is less onerous than the international standard, it is theresponsibility of the national accounting bodies to use their best endeavors to bring their

nationalstandards into linewith the international ones.


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The United States is unique in having a standard-setting body, the FASB, that isindependent of the professional accounting bodies and because of the structure of the IASC,the FASB is not a member of it. In developing its own standards, the FASB must, of course,consider their international implications. But not being a signatory to the IASC agreement, ithas no formal obligation to make its standards conform to the IASC's.3

Some Doubts About International Harmonization

On the face of it, the harmonization of standards across countries would appear to bebeneficial to all concerned. Indeed, the arguments for harmonization across countries aremuch the same as the arguments for having accounting standards within a single country.These arguments are discussed in Chapter 9. yet serious doubts have been voiced that theneeds of the developing nations may be in danger of being sacrificed or at least subordinatedto the needs of the developed nations, and especially to the needs of the transnationalcorporations that have their headquarters in North America, Western Europe, and Japan. 4

These doubts arise in part from the orientation of financial reporting in the financiallydeveloped countries toward the needs of investors and creditors. When it is said, in. thedeveloped countries, that financial information should be useful for decision making, what ismeant is that it should be useful to investors and creditors in making their decisions. Criticsof harmonization in the developing nations argue that these countries have few indigenous

private investors. Economic activity is, to a considerable extent, in the hands of governmentagencies, and financial information should be geared primarily to their needs rather than tothe needs of private investors.

This criticism of harmonization has a good deal of substance. It is not so clear that doubtsabout the different needs of private investors in more developed and less developed countries

are well founded. For example, Washington SyCip, of the Philippines, has argued thatcountries with high rates of inflation should not be tied to historical cost accounting butshould have more frequent recourse to asset revaluations than is common in countries withmore stable economies. However, experience of double-digit inflation in the United Statesand Europe has been enough to show that the deficiencies of historical cost accounting arenot confined to the developing countries.

Situations can certainly be found in which differences of economic organizationamong countries make an accounting standard that is appropriate in one country inappropriatein another. SyCip's example of groups of companies, on the Japanese model, for whichconsolidated accounts are not appropriat-, may be such case. But accounting standards are notmeant to force truly diverse situations into a uniform mold. The need to have different rules for

different situations is a general need. It applies between developed and developing countries;but it applies to other kinds of differences as well.

Summary

Just as accounting standards within a single country attempt to eliminate arbitrary andunnecessary differences in the accounting methods used by different companies, so in the inter-nal field, efforts are being made to eliminate or reduce acting differences across national

boundaries. Because some of thosedifferences reflect differences in legal systems, in politicalsystems and in stages of economic development, the. progress of harmonization is slow anddifficult.

Before discussing harmonization, we looked at the, institutions that set accountingstandards in Britain, Canada, and West Germany. None of these countries has a body at all


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like the FASB. There are significant differences in accounting standards even within theEnglish-speaking world.

Several organizations are involved in the process of trying to formulate internationalstandards, IASC, the EEC, the OECD, the UN being the main ones. One of the majordifficulties in reaching agreement on international standards results from differences between

the needs of the more developed and those of the less developed countries of the world. Theirneeds are different in important respects, and one should not assume that accounting policiesthat are appropriate for the United States are necessarily appropriate for, say, India orIndonesia. This is because the objectives to be served by financial reporting may be different.We shall consider those objectives in the next chapter.

BAB 4

Usefulness for Decision Making:

The Objective of Financial Reporting

In April 1971, at the same time as the AICPA was setting up the Wheat Committee to study the

Accounting Principles board and the means for establishing accounting principles, the Institute

also commissioned a second group, the Trueblood Study Group (named after its chairman, the

late Robert M. Trueblood), to consider the objectives of financial statements. The Study

Group's report, Objectives of Financial Statements, was published in October 1973, 18

months after the Wheat Report. By that time the FASB had come into existence and

looked to the Trueblood Report for direction. After a period of study and discussion,

the board issued its own Tentative Conclusions on Objectives of Financial Statements of

Business Enterprises in December 1976, and a definitive statement, Objectives of

Financial Reporting by Business Enterprises, in November 1978. This- Statement of

Financial Accounting Concepts No.1 was the first installment of the Board's

Conceptual Framework of Accounting. It was followed in December 1980 by a

statement of objectives for nonbusiness organizations, the fourth installment of the

conceptual framework.

The change in title from the Board's tentative statement of 1976 to its concepts

statement of 1930 is noteworthy, for it signaled an expansion of the Board's horizons

from financial statements to financial reporting. This change established that the

Board saw financial statements as a part, but only a part, of the apparatus forconveying financial information to its users.

Perhaps the most important conclusion reached by the trueblood Study Group was that"the basic objective of financial statements is to provide information useful for making eco-nomic decisions." It seems barely credible now that such a conclusion could ever have beenconsidered controversial. Yet when the FASB made a survey of reactions to the TruebloodGroup's objective in 1974, only 37% of the respondents approved the objective, and only 35%thought the Board should adopt another Trueblood objective1 calling for the provision ofinformation useful to investors and creditors for predicting, comparing, and evaluating potentialcash flows to them in terms, of amount, timing, and related uncertainty."2

jThe FASB's View of Objectives


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The FASB has unequivocally chosen usefulness for decision making as the primaryobjective of financial reporting, and its elaboration of this objective in Concepts Statement No.1 will be discussed shortly. But it is first worth asking why a statement of objectives isnecessary at all. On this point, the opening paragraph of the Trueblood Report is quiteunconvincing:

Accounting is a social system much like language and law. As such, it tends to evolve by

adapting to its environment; but evolutionary changes may occur which are incompatible or

even in conflict with current notions of what the objectives of this system ought to be an

explicit statement of objectives, therefore, is essential to rational development.3

If this means that the evolution of accounting to meet some social need can be

constrained by an explicit statement of objectives, absent restrictions placed on the behavior of

accountants by some regulatory agency, it seems quite unlikely to be borne out by events. No

one can suppose that the behavior of those who prepare financial reports or those who usethem, if left to themselves, will be much influenced by a statement of objectives.

The principal beneficiary of statement of objectives is the FASB itself, for in charting

its course it needs to know where it is heading. Agreement on the objectives of financial

reporting must be the starting point for a conside ation of the kind of reporting that is

needed and of the accounting standards to whid that reporting is to conform. It makes no

sense to set standards for a product until the purpose of the product has been defined. For

example, in setting safety standards for aircraft, it makes a difference whether the purpose

of the aircraft is to carry freight or passengers. The standards of potency set for drugs by

the Food and Drug Administration are presumably different depending on whether a drug

is sold over-the-counter or is obtainable by prescription only.

The purpose of a product is, above all, to meet the needs of those who use it. The

FASB would have done well to frame its objectives statement by addressing directly the

needs of the users of financial reports and those of the other parties to the reporting

process. It has chosen not to do that but to approach the matter more obliquely. A

summary of the Objectives of Financial Reporting by Business Enterprises follows. The

objectives have been numbered for ease of reference in the ensuing discussion. The

paragraph number after each objective refeis to Concepts StatementNo.1:

1. Financial reporting should provide information that is useful to present potentialinvestors and creditors and other user in making ration investrnent, credit, and similar

decisions. The information should be comprehensible to those who have a reasonable

understanding of business and economic activities and are willing to study the

information with reasonable diligence [Paragraph 34].

2.Financial reporting should provide information to help present and potential investors

and creditors and other users in-assessing the amounts, timing, and uncertainty of

prospective cash receipts from dividends or interest and the proceeds, from the sale,

redemption, or maturity of securities or loans. The prospects for those cash receipts are

affected by an enterprise's ability to generate enough cash to meet its obligations when

due and its other cash dividends and may also be affected by perceptions of investors and


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creditors generally about that ability, which affect market prices of the enterprise's

securities. Thus, financial reporting should provide information to help investors,

creditors, and others asses' the amounts, timing and uncertainty of prospective net cash

inflows to the related enterprise [paragraph 37].

3. Financial reporting should provide information about the economic resources of anenterprise, the.claims to those resources (obligations of the enterprise to transferresources to other entities and owners' equity), and the effects of transactions, events,and circumstances..that change.resources and claims to those resources [paragraph 40].

4. Financial reporting should provide information about an enterprise's financialperformance during a period. Investors and crediturs often use information about the pastto help in assessing the prospects of an enterprise. Thus, although investment and creditdecisions reflect investors' and creditors' expectations about future enterprise

performance, those expectations are commonly based at least partly on evaluations of pastenterprise performance [paragraph 42].5. the primary focus of financial reporting is information about an enterprise's

performance provided by measures of earnings and its components [paragraph 43].6. Financial reporting should provide information about how an enterprise obtains andspends cash, about its borrowmg an repayment of borrowing, about its capitaltransactions, including cash dividends and other distributions of enterprise resources toowners, and about other factors that may affect an enterprise's liquidity or solvency[paragraph 49].7. Financial reporting should provide information about how management of anenterprise has discharged its stewardship responsibility to owners (stockholders) for-

the use of enterprise resources entrusted toit [paragraph 50].8. Financial reporting should provide information that is useful to managers and directors

in making decisions in the interests of owners [paragraph 52]

All the objectives listed are concerned with decisions, directly or indirectly. Nos. 1and 8 refer explicitly to decision making, by investors and creditors in No. 1 and bymanagers in No. 8. No. 4 refers indirectly to decision making. No. 2 is no more than anexpanded version of No. 1. Nos. 3 and 6 are hardly. Objectives at all, for they simply callfor information about economic resources and cash flows, without considering who mightuse the information or for what purposes. Nos. 5 and 7 are concerned with performancemeasurement, No. 5 with the enterprises performance, and No. 7 with that of management.Performance measurement is necessary, of course, as an inpu-, to decision making.

The significance of decision making as the central objective of financial reporting willbecome apparent later, when we consider the qualitative characteristics that accounting

information should have. The relative desirability of different characteristics can be judgedonly in the light of the needs the information is to serve. Hence, the choice of decisionmaking as the principal need to be served influence the criteria by which the FASB appearsto believe that accounting information and accounting standards should be judged. As weshall note shortly, not everyone agrees about the primacy of decision making. But even someof those who do agree on that point may think that the Board's statement unduly elevates the

predictive uses of financial reporting above the reportinguses. A key phrase in the Board'sstatement is "to help investors, creditors, and others assess the amounts, timing anduncertainty of prospective net cash inflows," and there is a danger that, by placing this "upfront" in its list of objectives and giving the appearance, intentionally or otherwise, ofemphasizing the predictive use of accounting at the expense of the reporting use-in the natureof things, one can only report about the past-the Board is giving the wrong signals. However,


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if the order of the listed objectives is not of special significance, and if the statement isjudged.as a whole, a balance between the forward-looking and backward-looking uses ofaccounting is maintained.

The FASB's statement of the objectives of financial reporting is not without its critics.One group of critics asserts that the statement is too narrow and that, by focusing almost

exclusively on the interests of investors and creditors, it fails to recognize the concerns ofseveral other sectors of society, even of other groups with a stake in the productivity o ourfreeenterprise economy, such as labor and the tax authorities. We shall return to this criticismlater.

In part, the FASB anticipated that criticism in its statement of its TentativeConclusions on Objectives of Financial Statements of Business Enterprices, issued in 1976.It referred to the diversity of uses that financial statements could serve, and it argued that itwas.necessary to focus on only a few of them.

To identify investors' and creditors' needs as the focal point of financial statement

information greatly narrows the range of economic decisions and varied needs for

specialized information that general purpose financial statements must try to satisfy, thereby

increasing the possibility that the statements can reasonably satify the narrower range of

needs.4

That observation should have been included in the Concepts Statement. But if it hadbeen, the Board's critics might well have replied that even if it is true for general-purposefinancial statements, there are other means of finaneial reporting, and the statements ofobjectives should have been drafted broadly enough to encompass them and their uses. That iswhat a British study group did in The Corporaie Report5 in 1975, and that precedent issufficiently interesting to warrant further discussion later.

But, viewed in its totality, the world of financial reporting is indeed full of diversity-diversity of reportirtg entities, means of reporting, and of groups with an interest in thereporting process. Eachgroup has its own interests and its own needs.

Roughly 17 million business tax returns are filed with the Internal Revenue Serviceeach year. Of these, about 2,750,000 are filed by corporations, 1,500,000 bypartnerships, and12,750,000 by sole proprietorships. Of the 2,750,000 corporations, only about have s t o c kthat is publicly traded and only about 10,000 we subject to the jurisdiction of the Securities andExchange Commission.6 Yet it is this relatively Small number of SEC-regulated companiesthat most people have in mind when financial, reporiing issues are discussed. The reason, ofcourse, is simple those 10,000 companies dominate the business world.

Although privately held corporations, partnerships, and propietorships are not subject to

SECjurisdiction and therefore do not have to comply with its rules of disclosure, any financialstatements they issue that are prepared in accordance with generally accepted accountingprinciples (GAAP) must conform to FASB standards. Thus, many of the accounting policyissues discussed in this book are of as much concern to them as they are to publicly ownedcorporations. However, the FASB bas already exempted small businesses from some of itsdisclosure rules, and increasing pressure is put on it to relieve privately held concerns from asmuch as possible of what is often called "standards overload."

Not all of the private sector of the U.S. economy seeks to make a profit. A

considerable segment of the private sector consists of charitable, educational, religious, and

healt orientedi institutions that exist to provide services on a nonprofit basis. And beyond the

private nonbusiness sector is the public sector, made up of state and local government units

and, of course, the federal government. There is considerable debate about how different the


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accounting policies of nonprofit organizations, public and private, should be from those of

profit-seeking organizations, and something will be said about this later.

The Nature of Financial Reporting

All of this book is concerned with financial reporting. That is, however, an all-embracing term, and it will be useful to Iook at its component parts. Figure 4-1 presents whatthe FASB calls "the information spectrum." On the left are the basic financial statements ofreporting entities, and the notes thereto. Financial statements are oniy one of the means ofconveying information about enterprise financial performance. Whether they are the mostimportant means is a matter of opinion.

Accountants distinguish sharply between the financial statements proper (includingthe notes thereto) of a reporiting entity and the suplementary information that accompaniesthem. An important example of such supplementary information is the current cost numberscalled for by the FASB's Statement 33 (Accounting and Changing Prices). Another

example is the information about oil and gas reserves that oil- and gas-producing companiesare required to disclose under ement 69. The distinction between information that is given inthe primary statements and what is given as supplementary information is almost certainlymore important to accountants than to anyone else. The primary statements are audited; thatis, someone has exercised independent judgment to attest that the statements fairly presentthe enterprise's position and performance in accordance with generally accepted accounting

principles. The supplementary information is not audited, but it is reviewed by the company'sauditors, and if they had reason to question the veracity of the information they would say so.To the users of financial reports, information is information however it comes to them, andits source is significant only because it conveys something about the reliabiIity of theinformation. The absence of an auditor's opinion seems to make little difference to the

amount of attention that is paid to financial information such as quarterly reports that areissued as "unaudited."

The general-purpose external financial reporting that is covered by the lefthand threecolumns of the spectrum in Figure 4-1, and which for the most part is effected ihroughcorporate annual and quarterly reports, is supplemented by other information conveyedthrough other channels; 10K reports filed with the SEC, information contained in

prospectuses and registration statements, and press releases issued by management areexamples of what the spectrum calls "other financial reporting." The righthand space in thespectrum, "other information" used in investment, credit, and similar decisions, coversgeneral economic intelligence, more specific industry or entity intelligence (such asinformation about new products), information on political conditions in territories whereinvestments may be made (including, of course, the United States), and much else.

The Parties to Accounting Policy

Who are the parties to accounting policy? There arc at least five different groups, withdifferent interests, different needs, and therefore different points of view on policy issues.These are as follows:

1. Investors and creditors2. Managers

3. Auditors

4. Regulators

5. The public at large


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The largest and supposedly the most important of the first four groups is the vast bodyof investors and creditors who provide the capital that nurtures the economy. Investors andcreditors, it has already been noted, need information if they are to make investmentdecisions rationally. Much of that information will have to be provided by accountants.

The investors and creditors who are the principal users of acg information are by no

means a homogeneous group, tlneii interests and needs are therefore quite diverse. In the,:ace, common-stockhQl

-ders_haye_more interest in profit than creditors do, for they willshare in it to a greater On the other hand, creditors normally have a greater

_t in financial position than in rof~itability, for it is to that thev look for thesettlement of their claims. This differenceatCV W v m m u u . . - - - - - _ ew.phasis leads to a differencein the importance the two s are likely to attach to the quality of conser-atism in fi? reports.Conservative accounting suits lenders. It has less to those who hold stocdoctrine ofconservatism an important part in the thinking of accountants, and more 'te said about itlater.

Cammon stockholders are themselves a heterogeneous class. ive investors, who "buy andhold," have less interest in ::cial reporting than those who actively trade; and the holdofdiversified portfolios of securities have different intereststhose who bear the greater risk of holding only one or two . Thus, a regulatory agency thathas the interests of 0,bnvtors" at heart will not be able easily to identify what those Amme!leStS are.

The word supposedly was used above in describing_ LnN~estors acti: creditors as themost important rou of Rejsons con:F:.?d wit accounting policy, because of the widely heldview qrLa: accounting po icy questions are actually, more often than am. resolved in theinterest of the second group, the manaQers ~o control the resources entrusted to them binvestors: They are e peop e who decide what accounting policies an enterprise will follow(to the extent that discretion is left to them by tbe regulators), and it would not be surprisingto find that any:.licts of :nterest that might arise between investors and =a:nagers were usually resolved infavor of the managers 7 For - ts; -nple, if management bonuses are based on, profits, it is

pcESible that capital expenditures might be written off over a kr.;er rather than a shorterperiod of time, to keep currenL pnr:its, and therefore curre;at bonuses, higher than theywould76 Making Accounting Poll , icy

otherwise be. If the bonuses had been based on the price of a company's shares, or on the priceof its shares in relation to some market average, it is possible that management might t--'-: a

longer view. Anyt-hing that rnakes the goals of investors ar.d thegoal_s ofrnana};tzs_congruent with each Qtltexv. Adiminis= the_ danger that ._ accounting (and other)issues will be decide= to the ~detrim_ent of_.o_ne.group and in favor o__f_the_other.

.

AUditorsVdre -the third

gr(1Itp 7 who have an l,n,tp,rec in accounting policy. They do notrr.ak, accounting policy; it is the managers of a:: enterprise who deci le how its affairs are to ~-

_ presented in its financial statements. The responsibility of the auditor is to report whether thestatements fairly present its financial position and the results of its operations; if in theiropinion the statements do not do so, tne auditors must repor. accordingly to the stockholders. Incases of extreme disagreement with the way a company's affairs are presented in its financialstatements, they may disavow an opinion altogether. However, such extrer.le cases are rare.

Normally, any dissatisfaction expressed by the auditor to the management over hov. the


13/17

company's affairs are to be prIesented will result in revision of the offending statements toallow the auditor to give a "dean' opinion.

Auditors earn their fee by putting their reputations on the line when they sign an auditreport. 'heir interests, regarding accounting policy, are complex and conflicting. The more workan, auditor can get, to do and the higher the fees charged,. the more he or she prospers. That

points in the direction of wanting~more complex regulations that require expert professionaladvice for their interpretation and implementation, and more and more required disclosure,especially by publicly owned companies and especially if the information disclosed is requiredto be reported on by independent auditors. Undoubtedly the increased complexity of accountingrequirements (and taxation) in recent years has been a major cause of the growth of the publicaccounting profession. But on the other hand, the audit function carries with it heavy potentialliabilities if audited statements turn out to contain misrepresentations and stockholders andother- are misled by tf:em. That catases auditors to favor clear-cut reoorting requirements, factsrather thanThe Objective of Financial Reporting 77

ts, and, when judgments have to be made, judgments I lk- past rather than about the future.tors form yet another group that has an interest in acg pnlic-y, for they play a large part informulating it. We ~Sa; d something about them when we considered the said something aboutthem when we considered the tions that make accounting policy, of which the two most nt arethe SEC and the FASB. But here, too, it is not v cynical to note that, although theii first concernshould and no doubt is, the public interest, they caru-LA be ex.; to be oblivious of their owninterests. Regulatovs thrive a--_ulation, and deregulation does not come easily to them. :heother hand (there is always an other hand), their regus, in the long run, have to be acceptable tothe regulated to the politicians who oversee them, for regulations on acting policy that cannot

be defended will not survive indefs. What makes them detensible is a large part'o3`wha't`thi~~is about. -

Other Views on ObjectivesThe FASB has been criticized, as we have already noted, for w: n4 its attention on theconcerns of investors and creditors -`y !l,~ uisregmdin everyer.e else Hrhn- ha$_ a 5_ta.ke in,--i--.-:ess ent~rises. It should, of course, be noted that the FASB il~ con ls dered the reportingobjectives of nonbusiness organi;=c.c.~ns in a separate document.7 But that does not placate thel,ecitics who say that the interests of society in the business sector. ~~liivuld not be identifiedwith the interests of investors and ceditors. One such critic expresses his concern in this way:78 Making Accounting Policy

"Iltese critics are misdirecting their fire, for their quarrel is not witi: accountin,but with

our present form of society. To sat

isfy them, it would be necessary to change society's systems of rewards and incentives,

and its system of determining the relative values of goods and services, which of course

leaves the needs of the poor unsatisfied and the needs of the well-to-do amply catered for.

If that is a deficiency, it is not the fault of accounting but of the (relatively) free-

enterprise system under which we live. It is the task of accounting not to change -the

svstem but to reflect it.

---J Yet to say that is not to condone the neglect by the FASB of several aspects of

financial reporting by business enterprises that have broader significance beyond the

interests of investors and creditors. One does not have to want to change society to see

that, in comparison with the list of reporting objectives set out in The Corporate


14/17

Report' in Britain in 1975, the FASB's list has some deficiencies. None of its objectives

goes as fa-r, for example, as the following:

Assessing the effectivenPSS of the entity in achkyj vectives established

previously by its management, i ts meml2els or owners or y society. This includes

but is by no means limitcd to conipliance with stewardship obligations.Ct

Assessing the capacity of the entity tc make future reallocations o: iis resources, for

either economic or social purposes cr for both.

Evaluatim: the economic function and performance of the entity in relation to society and

the national interest and the svcial costs an ne rts attributable to the entity.

AttestinQ tn c**,li,nce. y~ith taxation r2gl,tinns, cQman__y law, contractual and other

legal obligations and requirements (particularly when independently verified).'

What principally distinguishes these objectives from those on the FASB's list is their

continual reference to the social significance of business behavior and to the social

performance as distinct from the private performance of business enterprises. The study

group that prepared The Corporate Report did not, for the most part, say how their

proposals were to be implemented; but they did make suggestions for innovative addi-

The Objective of Financial Reporting 79

Wnal statements to be published by business enterprises, noa statement of value added, an

employment report, and a s'atement of future prospects. These new statements would

z_ :east throw some light on the social performance of the busi-e_s sector.

':'uji Ijiri has mounted quite a different kind of attack on the F.A.SB's list of objectives,

by rejecting de80 Making Accounting Policy

the accountee that bears the cost of providing the information; and in the absence ofregulation, it would be the accountoz's judgment as to what is "fair" that would prevail.

In the typical business situation in which ownership is divorced from management, the

accountor is in a much stronger position to protect his or her interests than the

accountee is. It is hardly surprising, therefore, that in the FASB's framework usefulness

to the accountee is ---iven precedence.

Moreover, ML:; :t usefulness and fairness b: i; compatible qualities? Information that

is ui,fair to the uccounto or the accountee, in the sense that it does not "fairly present" a

picture of financial posi-,Ion or performance, is likely to be misleading; and if it is

misleading it is unlikely to be as useful as it might otherwise be. Usefulness, in fact,

implies fairness. It is not helpful, therefore, to discuss usefulness and fairness as though

they were opposing quaiities.

Financial Reporting Objectives for Private Noribusiness Organizations

The purposes and characteristics cf the business and nonbusiness segments of the

private sector* are usually sufficiently different to maIce their financial reporting

objectives different. However, as the FASB points out,

the line between (them] is not always sharp since the incidence and relative importance

of those characteristics in any organization are different- This suggests that, for

purposes of d(%voloping financial reporting objectives; a spectrum of organizations

exists, ranging from those with clearly dominant nonbusiness characteristics to thosewith wholly business characteristics."


15/17

At one end of the spectrum are organizations, such as nonprofit hospitals, that derive

their capital from bond issues and their revenue from charges for services to patients.

Because their sources of capital and revenue are like those of a business, they'The discussion here will not coverpublic nonbusiness organ'vations, such as local andstate governrnen_t;units, and public au'. iorities, such as the Tennessee Valley

Authority. The Objective of Financial Reporting 81

w= a many of the characteristics of a business. At the other end ? organizations, such aschurches, that rely almost wholly on aritable contributions, have no capital, provide servicesfree , et charge, and therefore have virtually none of the characteris-_~cs of a business. In

between these two extremes are other in_-.::urions, such as universities, whose revenues consistof fees charged for services, endowment income, and charitable con_:1-utions. They do havecapital funds but no ownership inter` ne major distinguishing characteristic shared by all private -=:~.business organizations is that

profit sePkin~ is not their _--111cipal motivation, and profitability has no place among tf~e 7t-nor_mance me-- asures by which such organizations may be _ ~ed. Indeed, some of them,

such'as charitable foundations, z+cist to give money away and might be judged to be more suc-e_ssful the larger their deficits.

.he principal differences between business and nonbusiness _-;anizations are to be found notin the way they use resources -_::,in how they obtain them. They both use resources to pro:.::eand distribute goods anc services and they both need :o p_onomize in the use of thoseresources. To that extent, manv c: :he indices of efficiency that are used in business can also be-ed to judge nonbusiness organizations. The methods used by --nbusiness organizations toobtain resources, on the other -3-d, are different, at least in part, from those used by their

_`::ness counterparts. As already noted, many of them obtain re-:enue from membership duesor charges for services; but usually some of their revenue is obtained from persons who expect

no direct benefit or a disproportionately small direct benefit in return. This fact naturallyinfluences the kind of fima:.cial information that those who provide resources expect to aeceivefrom the organizations they support.

.he objectives of financial reporting by nonbusiness organi=-_~ons are summed up by theFASB as follows: . .

Financial. reporting by nonbusiness organizations should provide information that is useful to

present and.potent_ial resourceprovaders and other users in ma_l:_ing.rational decisions.

about .the_allozation of resources of those organizations.,

.

cision usefulness as the -i-:^ purpose of accounting and putting in its place what he

:~ "accountability." i'Ijiri ~~ e accounting relationship as a .oartite one, involving the

accoun_to_O/the ac- o te , and the

i-- -ountant, He regards the FA s view~f~bjectives as being ~:e_aviIy biased in _favor of

the account_ee (the user of accounting s.:crmation), with little concern for the accountor

(the provider of the information). In the central position that the FASB's Qa--iecvork

assigns to decision usefulness, Ijiri would put fairNess.

~- a decision-based framework, the objective of accounting is to -r-ovide information

useful for economic decisions. It does not maaer what the information is about. More

information is always pceferred to less as long as it is cost-effective. Subjective infor-~hon is welcome as long as it is useful to the decision maker.


16/17

~- an accountability-based framework, the obiective of accounting z :, provide a fair

system of information flow between the ac`r_.^.cor and the accountee. . . . Based on the

underlying ac=T_ntability relation, the accou_ntee has a certain right to know; at ~ same

time this framework recognizes that the accountor also ats a right to protect privacy.

More information about the accounaar is not necessarily better. Better perhaps from thestandpoint of :be accountee but not necessarily so from the overall accountabil~t-s

relation. Subjective information can seriously damage the inst of the accountor, ev=_n if

it may be highly useful to the. ac,-`' -,j^;:ee.1Z

,"'.zis approach does provide a useful reminder that the user a:,ounting information is not

the only party to an account-elationship. And it is impossible not to approve of fairness :

cesirabIe quality of the relation-,'nip. But it is doubtful that

a relationship would exist at all if the usefulness of the ation provided were not at itscenter. It is almost always

Performance is measured in terms of profitability or cash flows to investors. Yet the

correspondence between investors and societal welfare is roblematic unless we are willing to

assume the social ap:iinality of existing distributions of resources in society, equilibda in all

markets in the economy, exogenous independent and equally important preferences for all

people and simultaneously _ :o ! deny tne problem of social choice and the theory of second

beSt.e

82 Making Accounting Policy

^ Financial reporting should provide information to help _present andpo. _nt_ial resource

providers and other users in ssc4- the se,-Nic-s that a nonbusiness or~anization rovides and iU nhility cor anue to _providethose services.

3

Financial reporting should provide information that is useful :, present and potentialresource providers and other users in z:-sessin~ how mana~~,s ~f,o lhnay~fior~ ,'iavedisc argec! their stPWc rQSI?ID responsibilities about other aspects e t err performance.-

Financial reporting should provide information about the economic resources,obliQations, and net resources of an obliKation, an te ~effecs of transactions, even;g,and cir_cumstanccs that change resources and interests in those resources.Financial reporting should provide information about the performance of anorganization during a period. Periodic measurement of the changes in the amount andnature of the net resources of a nonbus

rness>,.,.-:r,nes...~..

s organization and information about the service efiorts and accomplishmentsof an organization together represent the information most useful in assessing its pc-rformancu.

1_ Financial reporting should provide information about how _an oro nization obtains andspends cash or other liq_uicLreso.uiigs, about its borrowing and repaymentof~orrowing, and about other factors that may affect an organization's liquidity.

Financial reporting should inciude explanatin_ns and inter retatons to helR usersunderstand financial information provided."


17/17

There are really only four objectives here to be served by the provision of financialinformation, and all are addressed to the needs of the users of that information-the needsof the accountees, in Ijiri's terminology. The first listed objective is concerned withdecisions about the provision of re_somrces to nonbusiness or ' tions by the resource prayide_rs _ard others. The second is concerned w-itfi-f~e assess-~ m o-f the servicespro-

vided-by the organizations. The third is concerned with stew ardshi with theassessment of the performance of the managers of nonbusiness organizations. And thefifth'is concerned with the performance of the organizations themsP_tves.The other three"objectives" merely call for information, without specifying what purpose, if any, theinforTnation is to serve.

The Objective ofFinancial Reporting 83

Summary

Before one can judge the quality of a product, one must consider what purposes

the product is intended to serve. The same is :=.ie of accounting. The FASi3's view

is that the primary objective of financial reporting is that it should be useful for

maki~-~g decisions by investors and creditors and, secondarily, by r. ,anagers. Someconsider this objective too narrow, in that it _;--:,-,res broad social objectives, and

some consider it unfairly _ _:aed W favor of the users of infonnation.

The nature of financial reporting was considered. It does not only of financialstatements, important as they are, but :=:cludes much other information as well.

Five principal groups were identified as having an interest in accounting policy:i:-vestors and creditors `.tanagers

Auditors Regulators Tbe pubiic at large

7 he interests of these groups are not always congruent. Those -...-ho formulate

accounting policy, like the FASB, face a con::ant challenge to try to satisfy all

parties.

The nrivate nonbusiness sector, wluch does net exist to seek :rofits, has different

financial reporting needs from the business sector. The differences between the

business and non^usiness sectors were considered. At the same time, it must be

noted that the nonbusiness sector is quite heterogeneous, $Ind ' `

some parts of it have many of the characteristics of a business.' In the discussion

of accounting policy throughout thisbook; :: is undoubtedly the role of profit and

profit measurement that . :istinguishes between accounting for business .and

accounting :or nonbusiness organizations. That leaves large areas of common

interest to the two types of organization. One such nota~le area is the desirablecharacteristics that accounting infor-nation should have. As the FASB found when

they considered amendments to the two earlier Concepts Statements (Nos. 2 -nd s)

on qualitative characteristics and elements, which had b:-en

Documents

The Institutions That Make Accounting Policy