The significance of conceptual- primacy to the process of developing a conceptual-framework for financial reporting By One-Mamba This short paper shall assess the significance of conceptual-primacy to the process of developing a conceptual-framework for financial reporting. Furthermore, we shall explore how conceptual-framework producers, such as the Financial Accounting Standards Board (FAST) and the International Accounting Standards Board (SAAB), have treated conceptual-primacy, and seek to determine whether or not they have made the correct choice in their treatment.
Conceptual-primacy are concepts that are used to define other concepts, and in doing so provide unity and prevent the set of concepts from being internally inconsistent’ (Johnson, 2004). With this definition we can affirm that conceptual-primacy is pivotal to the development of a conceptual-framework. This is because, if conceptual- frameworks are intended to ensure a consistent basis in setting standards; uniformity in reporting and reducing the need for fundamental debate each time a standard is issued; then this would not be possible if there are disputes regarding the interpretation of the framework itself.
Thus conceptual-primacy narrows the scope for deviation in interpreting standards and such is absolutely fundamental to the development of a conceptual, framework. With conceptual primacy, there is only one economic reality but it may be reflected in the accounts in one of two ways, from either the Balance Sheet (B/S) (Asset and Liability view) or Profit & Loss (P) (Revenue and Expense view). This creates a dilemma regarding which view we should bestow conceptual-primacy to. Conceptual-framework producers have chosen the B/ S view. Our interest is to examine why this is the case, and scrutinize the arguments in regards to this choice.
According to senior project managers of both FAST and SAAB, ‘The IBIS view is grounded in a theory prevalent in economics: ‘that an entity income can be objectively determined from the change in its wealth plus what it consumed during a period’ (Hicks, 1946!. This view is carried out in definitions of liabilities, equity, and income that are based on the definition Of assets that gives “conceptual primacy’ to assets’ (Halley G. Bullet, 2005). However, many commentators refute the claim that the B/S view is consistent with Hicks and claim that the works of Hicks has been misconstrued.
Both the FAST and the SAAB inappropriately justify their “B/S view’ of income determination based upon the published work of Nobel laureate economist J. R. Hicks. Hick’s actually rejects the “asset and liability view” because the resulting income measurement includes one-time windfalls’ (Jameson, 2005). Such windfalls could distort the interpretation of results, and such lead to misinformed decisions, thereby not serving as useful information for decision-making, the very purpose of financial reporting.
Furthermore many academics avow that, ‘they support the use of accounting hurry by standard setters and practitioners, provided that the theories they choose are considered in their entirety, and do not have their elements cherry-picked opportunistically to suit the standard setters’ immediate objectives (Michael Bromidic, 2010)’. Here a question is posed, regarding if the B/S view was adopted off the strength of misconstrued economic theory? This provokes us to ponder if the B/S view would have still been adopted; if there was greater clarity and understanding over the works of Hicks.
Away from the debate regarding the B/S views academic conceptions, is a impel compelling argument over why conceptual-framework producers have made the correct decision over conceptual-primacy and it is succinctly present by Oscar Gelling, who wrote: have not been able to define income without using a term like asset, resources, source of benefits, and so on. In short, meaning can be given to assets without first defining income, but the reverse is not true. That is what mean by conceptual primacy of assets. No one has ever been successful in giving meaning to income without first giving meaning to assets (Gelling, 1992).
Therefore if conceptual-primacy concepts are used to define other concepts, hen the founding concept should not need another concept for adequate explanation. Accordingly the P&L view cannot possess conceptual-primacy for how do you define income without the inclusion of assets? For the proponents of the view, this question is likely to be the hardest to answer. Moreover, The advantage of the B/S view is that it includes all changes in assets and liabilities in one statement and produces one “bottom line” for explaining the change in net assets/equity arising from non-owner transactions.
It does not require any judgment as to determining which renovations and events that affect financial position are excluded from the financial performance of the reporting public entity. These items, as at the financial reporting date, represent increases or decreases in the net resources of the entity and are, therefore, part of surplus/deficit’ (Béchamel, 2009). It is important to note that many of the most vocal proponents of the view are preparers of accounts.
This begs the question, why would these preparers oppose the B/S view, which does not require any judgment as to determining which transactions and events can be excluded from the performance of the company. For this would limit the discretion available to the preparers in composing the accounts, and such would limit their scope to manipulate the presentation of the company’s performance. Perhaps here we see further the appeal of the B/S view as it effectively narrows the scope for manipulation from account preparers; therefore opposition from preparers would naturally be expected.
In this approach, assets are the primary starting point for determining all of the other elements. Liabilities are defined with reference to being claims on existing or future assets. This approach then uses the definitions of assets ND liabilities to determine revenue and expenses (Béchamel, 2009). However this is contested by Ron Paterson of Ernst & Young ALP who said, “Assets and liabilities do not form a natural starting point for devising recognition rules; the balance sheet is the result of the accounting process, not the starting point” (Leistering, 2005).
This view suggests that conceptual- primacy should not be given to the B/S view because it is the by-product of the activities that leads to the making of the balance sheet. ‘Under this approach, the balance sheet becomes residual to the income statement, and notation assets, liabilities, and other accruals/deferrals needed to maintain a “balance sheet” (Commission, 2002). Ron Paterson is not the only Ernst & Young employee to voice his opinion as Professor Robert Matt of then Ernst & Ernst, saw the B/S view as an attempt to bring about a fundamental change in accounting from the (as he saw it) dominant P view.
This ‘balance sheet’ view would lead ultimately to current value accounting, something he vehemently opposed. Although this concern was later proven to be ill founded as conceptual-framework producers have made clear that they have no intention of moving towards current value accounting (Gore, 1992). It seems that the great appeal of the IBIS view can be perceived to be its simplicity. We determine income and expenses simply through the changes to our assets during a particular period.
What comes in and out during this period will comprise the basis of our financial reporting; such simplicity really is required particularly in the current environment shaped in the backdrop of the financial crisis. It can be argued that complex assets and transactions permitted the scope for irresponsible actions to take place during the crisis. Moreover, one need only reflect to the days of Enron where large-scale frauds and irresponsible actions went undetected due to the complexity of the accounting.
However over simplicity may lead to troubles of its own, as ‘proponents of the P&L view believe that limiting surplus/deficit to changes in assets and liabilities often mismatches revenue and expense and can lead to distortion of the measure of surplus/deficit. They note that it is imperative to exclude those gains and losses caused by random events, such as floods or fires, and those gains and losses resulting from rearrangements of financial instruments cause unnecessary fluctuations in reported surplus/deficit.
This issue overshadows the effect of including deferrals in the statement of financial position’ (Béchamel, 2009). The B/S view may not capture everything when reporting on the performance of an entity, nor at times may it adequately match income to expenses, in the correct accounting period. Partly because it avoids having strange items on the Balance Sheet, I. E. Items that may be debits or credits but do not seem to have the economic characteristics of an asset or a liability, such as deferred tax assets/liabilities.
However this simplicity provides clarity and transparency to the true performance of the entity. Thus it makes accounts far more understandable and thus more useful to the eventual users of the accounts. To conclude, the P view is supported because accruals/matching is central to their view of accounting and results in smooth earnings numbers that, they argue, allow a better representation of economic reality. However the drawback of this is that it affords preparers of accounts, greater discretion over what to include and exclude in their reporting and such widens the possible scope for abuse.
Whereas the IBIS view is simple and straightforward and reduces the scope available for discretion by account preparers. It is with this insight we assuredly conclude that the conceptual-framework producers like the FAST and SAAB, have made the correct choice in their treatment of conceptual-primacy, and it is right to bestow primacy to the Balance Sheet (8/ S) (Asset and Liability view).