Accounting academics are involved in a variety of research, but one mission is paramount: to develop sound accounting principles. Accounting is so important to society, whether it be managerial accounting for a firm, government accounting to its citizens, or financial accounting for investors of capital. Researchers are sometimes advised to avoid normative statements on accounting policy, but to deny this mission would be akin to a medical school that has no interest in healing patients. This paper ventures into financial accounting which plays such a critical role in the functioning of capital markets and resource allocation. We provide some recommendations but, more importantly, we provide a framework for researchers to grapple with the issue of what is “good accounting.”
The question of what is “good accounting” absorbs the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) in the US. They struggle with the complexity of writing accounting standards with real dedication, but find themselves continually rewriting past standards – on revenue recognition, leases, pensions, off-balance sheet vehicles, restructurings, to name a few – or withdrawing from proposals – on fair value accounting for mortgages, for example. Some of this comes from dealing with complexity and adapting to changing conditions, and some from working in a political environment. But at the heart of the problem is the lack of an agreed-upon framework to guide standard setting and provide the cohesion and consistency that avoids a scatter approach.
The two boards appear to share this concern and have embarked upon a fresh conceptual framework project. Their endeavor starts with objectives and concepts. They then specify recognition and measurement principles that follow from these notions. “Recognition” determines what goes into financial statements and “measurement” dictates how they are measured. The sequencing of ideas appears to go as follows:
However, the project appears to be getting little traction.1 Our guess is that the Boards’ approach will not be successful, though we wish them well. The underlying concepts of “relevance,” “neutrality,” “faithful representation,” and “comparability” that they propose are admirable and hardly ones to disagree with. But these concepts are too broad to cut through to a solution on a particular accounting issue and do not connect in any concrete way to what users look for in financial reports. In the Recognitions stage, they state definitions of assets and liabilities to which future accounting must conform. This promotes a legalistic approach that ties accounting to those definitions, rather than to the users’ needs, while entrapping preparers in a cobweb of accounting minutiae over interpretation of definitions. Complexity becomes the dominating characteristic. Anchoring accounting to a Hicksian definition of income and a “balance sheet approach” (as tentatively proposed by the Boards) has little resonance with analysts.2
This paper takes a utilitarian approach: we examine accounting policy from the perspective of a user, specifically the fundamental analyst who uses financial statements to value firms. “Fundamental analysis” involves assessing firm value from an understanding of business fundamentals, but those fundamentals are often observed through accounting numbers like sales, profit margins, balance sheet debt, and so on. Indeed, fundamental analysis is sometimes viewed as the processing of accounting information. What accounting helps the fundamentalist and what accounting frustrates her? Is it fair value accounting? Historical cost accounting? Rather than appealing to accounting concepts such as a “balance sheet approach,” or specifying “fair value” or “historical cost” as an (in)appropriate “measurement attribute,” we ask: what does the fundamental investor need? In so doing, we take the view that financial statements are a product and thus the accounting problem is one of product design, tailored to the customer: what does the customer need?3
In the stated objectives in their conceptual framework, the two Boards have the investor very much in mind. We firmly embrace that objective of the Boards to provide information “about the amount, timing and uncertainty of future cash flows” to equity investors and “how those cash flows affect the prices of their equity interests.” But, again, we find this too broad, lacking direction as to the specific accounting that satisfies the objective. One needs to cut to the quick: what is the accounting that the user requires to forecast cash flows?
The answer to this question might be solicited by going to investors and analysts directly and posing the question. Indeed, the accounting Boards have been very keen to get the opinions of analysts. It appears, however, that this approach does not elicit clear recommendations. For example, the leadership of the CFA Institute has come out strongly in favor of fair value accounting, while their rank-and-file working analysts seem to have a different opinion. The Boards’ recent insurance proposals have been controversial among analysts, with some endorsement (largely in Europe) and some strong opposition (largely in the US). We suspect the reason is that analysts use accounting data in very different ways; there is no common platform for carrying out analysis.
We take a different approach. First, we show how accounting numbers connect to valuation, providing a starting point from which to examine accounting issues from an investor’s point of view. This is done, in Section 2, by stating two formal relations, one that connects accounting numbers to price and one that connects accounting numbers to stock returns. These relations come from accounting research, a statement of what research to date has put on the table. So, they also serve as a point of departure for our suggestions for future research at the end of the paper. But, these formal expressions go only so far in directing the actual form that accounting should take. So, in Section 3, we articulate the demands of the fundamental analyst, the consumer of financial reports. This is done by stating a set of principles of “good practice” for fundamental analysis that conveys the type of information that the analyst desires. Finally, in Section 4, we overlay these “good practice” principles on the framework in Section 2 to reach conclusions about the form of “good accounting” that supports “good practice.” The following summarizes how we move from the valuation equations in Section 2 via the principles of fundamental analysis in Section 3 to the accounting principles in Section 4
While the formal modeling in Section 2 is established in past research, the most conditional part of our analysis – to which the reader may take exception – is the statement of “good practice” principles in Section 3. All policy research must start with normative statements and we choose to make normative statements about practice to resolve accounting issues. These principles of good practice are not of our choosing, but rather gleaned from writings on fundamental analysts over many years. They are principles which an analyst can hardly disagree with; indeed, we believe they are commonly accepted. However, the acceptance of our framework largely rests on the reader’s appreciation that these principles make good sense for practice against alternatives that may be offered. The principles stand in contrast to the IASB and FASB approach: rather than specifying desirable “qualitative characteristics” of information a priori, we infer those characteristics from the demand by users. In contrast to the Boards’ concepts, our principles cut to the quick, producing immediate accounting recommendations. One critical issue of accounting policy is the contentious choice of a “balance sheet approach” versus an “income statement approach.” This is resolved within our framework.
We hasten to state that the focus on the equity analyst (and the equity investor) is not the only relevant perspective; there are other users of financial statements, and indeed, the Boards see their task as accounting for all investors. Indeed, the Boards take an “entity perspective” in their conceptual framework, while we take a “proprietorship perspective” where the focus is on accounting to shareholders, the owners. Our analysis is not necessarily definitive, just one that we are able to put on the table – to be evaluated against alternatives that others may offer. When available, we bring the results of research to the issue but, regrettably, research is short on answering normative questions. The gap in relevant research points to research questions, underscoring a secondary goal of the paper: to provide direction to research on accounting policy issues.
