From compromise to concept? – a review of ‘other comprehensive income’

This paper reviews how ‘other comprehensive income’ (OCI) entered financial reporting by tracing major Financial Accounting Standard Board (FASB) and International Accounting Standards Board (IASB) projects that required direct entries to equity and describing recent efforts to make sense of the practice. It was the fixation on net income that brought about departures from all-inclusive income, which were repeatedly made over the years without decidedly devoting attention to developing a conceptual basis. OCI was used as a compromise to incorporate current values in the balance sheet, while retaining historical cost principles in the income statement. When the practice was labeled as OCI, it became institutionalized without a clear meaning. A sense-making of the practice then replaced the debates on the adequacy of using OCI and standard setters have realized that additional layers of theory became necessary to explain, for example, reclassification adjustments. Yet, the IASB has made clear in its recent Exposure Draft of a revised conceptual framework that it does not intend to pursue a fresh start in performance reporting that appears to be needed conceptually. Instead, practical considerations, primarily on International Financial Reporting Standards adoption in Japan, seem to lead to another ex-post rationalization of OCI, this time around a conceptually vacuous use of the relevance characteristic.     

On the Definitions of Income,Expenses and Profit in IFRS

This paper makes two contributions. First, it demonstrates that income and expenses are incorrectly defined in the IASB's conceptual framework, and it proposes alternative definitions. Second, the paper identifies that, in part as a consequence of these incorrect definitions, and in part because there are two, conflicting concepts of profit in IFRS, there is, first, no definition of profit in the Framework and, second, inconsistency and needless complexity in the concept of profit in IAS 1. The issues raised in this paper contribute to the current IASB projects on the conceptual framework and on financial statement presentation.     

The Return of Stewardship,Reliability and Prudence – A Commentary on the IASB’s New Conceptual Framework

Abstract

In March 2018, the IASB published its revised conceptual framework including notable changes to the chapters on the objective of financial reporting and on qualitative characteristics. The IASB put more emphasis on stewardship as part of the decision usefulness objective, reintroduced prudence as an aspect of neutrality and introduced a tolerable level of measurement uncertainty (as a successor to reliability) as part of faithful representation. The present paper discusses the substance of and reasons for these changes in light of the history of the IASB’s work on conceptual frameworks. The paper also explores the possible impact of these changes on the IASB’s future standard-setting by looking at the other chapters of the IASB’s new framework. This paper finds that the more pronounced role of stewardship and the reintroduction of prudence do not seem to entail a revised conceptual thinking of the IASB in the other chapters, while the introduction of a tolerable level of measurement uncertainty provides the IASB with a conceptual tool with the potential to substantially affect future standard-setting debates. However, its positioning as part of faithful representation is questioned and an alternative arrangement of qualitative characteristics suggested.     

Mixing fair-value and historical-cost accounting: predictable other-comprehensive-income and mispricing of bank stocks

Other comprehensive income (OCI) items are often considered to be transitory (Chambers et al. 2007; IASB 2013; CFA2014). In this paper, we show that a significant portion of OCI, namely unrealized gains and losses (UGL) from available-for-sale (AFS) debt securities, is non-transitory: a negative correlation between accumulated unrealized gains and losses in the current period and next period UGL is predicted, and we show that this correlation is economically and statistically significant. This correlation is due to a mix of accounting methods of measurement of income from fixed-income securities: UGL are recognized based on fair values, whereas interest income is measured based on historical cost. We document that (1) this negative correlation helps explain a previously unexplained negative correlation in other comprehensive income (OCI), and (2) investors seem to price total UGL disregarding (or not understanding) the predictable, accounting-driven component of UGL.     

Gaps in the IFRS Conceptual Framework

Abstract

The stated purpose of the IFRS Conceptual Framework is to assist the IASB to develop Standards that are based on consistent concepts, and also to assist preparers to develop consistent accounting policies when Standards either do not apply or allow a choice of accounting policy. Yet, the Framework actually does surprisingly little to help the IASB (or preparers) determine which assets, liabilities, income and expenses should be recognised, and how they should be measured. The Framework’s focus on assets and liabilities implies that the accounting can, and should, be determined from the balance sheet. Yet, many current financial reporting requirements focus initially on the income statement, and so they are not so much derived from the Framework as instead in need of being reconciled back to it. At its heart, the problem here is that, while the Framework states that accrual accounting provides a better basis for assessing past and future performance than cash-based information, it does not explain why. To do so would require a conceptualisation of how entities’ business models are employed to create value, and of the strengths and limitations of accounting data in enhancing investors’ understanding of that value-creation. The lack of explanation of the purpose and informational objectives of accruals, how they relate to business models and how they cause the income statement and the balance sheet to interact are gaps in the Framework. Filling those gaps would provide a more robust, and natural, way for the IASB to develop recognition and measurement requirements in its Standards.     

Comprehending Comprehensive Income

Comprehensive income (CI) contains a mixture of realised, unrealised, temporary, persistent and recyclable elements. How, when and where these elements should be reported in income and equity have been issues intensively debated (and changed) by international regulators over the last 20 years. This article traces the major threads of the debate and places changes within the context of empirical academic research. Our contention is that the recent IAS 1 (AASB 101) Presentation of Financial Statements, effective 1 July 2012, has benefited from past academic research that focused on the value relevance from disaggregation and presentation of unrealised other comprehensive income (OCI). We conclude by outlining the equity posting and recycling to profit or loss (P&L) issues and assert that, because of the inconsistent nature and complexity of OCI, it would benefit from further research.     

Why is there inconsistency in accounting for liabilities in IFRS? An analysis of recognition,measurement, estimation and conservatism

We report that International Financial Reporting Standards (IFRS) are inconsistent with respect to the recognition and measurement of liabilities, both in the conceptual framework for financial reporting and in accounting standards themselves. We demonstrate that this arises in part because the International Accounting Standards Board (IASB) does not make a conceptual distinction between the process of measurement, which requires a currently observable measurement attribute, and the process of estimation, which is inherently subjective. The IASB employs only the logic and language of measurement, while actually requiring entities to report both measurements and estimates in financial statements. Our contribution is to identify and interpret this conceptual conflict, to demonstrate that this has particular relevance to accounting for liabilities, and to draw implications for accounting research and policy with respect to recognition, measurement and conservatism.     

Harmonization and the Conceptual Framework: An International Perspective

The release of CLERP 9 (Commonwealth of Australia, 2002) requires the Financial Reporting Council and the Australian Accounting Standards Board to adopt International Accounting Standards (IAS) en bloc as domestic reporting standards by 1 January 2005. This article considers the current and future role and direction of the conceptual framework (CF) under the CLERP proposals and a potential IAS reporting environment after January 2005. It is argued that Australia, which has been a major innovator on CF issues, may suffer a major setback if the International Accounting Standards Board's CF is adopted in January 2005. Furthermore, while the International Accounting Standards Board (IASB) has been aggressively pursuing a set of global accounting standards, it remains unclear whether the IASB will, or can, develop an internationally relevant and generally accepted CF which can guide the development of a globally compatible set of accounting standards.     

Is Comprehensive Income Value Relevant and Does Location Matter? A European Study

Abstract

This paper investigates the relative and the incremental value relevance of Comprehensive Income (CI) and Other Comprehensive Income (OCI) across European countries after the mandatory adoption of the International Accounting Standards Board (IASB) standards. This topic, which has already been analysed in other countries, drew the attention of academics and practitioners in Europe after the issuance of International Accounting Standard 1-revised, which requires entities to prepare a statement of comprehensive income (SOCI) in which both CI and OCI components are disclosed. The investigation of the value relevance of accounting amounts is important in order to evaluate their usefulness, because it highlights whether they reflect information investors use in making economic decisions. This study analyses a sample made of all the European listed entities of countries belonging to the EU at the date of issuance of EU Regulation 1606/2002. Our analysis involves a period from 2006 to 2011 and includes 16,511 firm-year observations. Our results show that Net Income (NI) is more value-relevant than CI, even though the total OCI of the period adds relevant information to those already disclosed in other accounting items such as NI and Book Value. In this regard, we found that the coefficient of the total OCI of the period is lower than that of NI, a result to be expected because of its transitory nature. Our findings also suggest that the requirement to issue an SOCI has not produced a significant change in the value relevance of both CI and the total OCI of the period leading to the conclusion that its location does not affect the value relevance of these items. Finally, we found significant differences in the incremental value relevance of the total OCI of the period across European countries, differences that seem to be caused by the countries' characteristics, such as the source of funds (credit/equity and insider/outsider) and the legal systems.     

What is a Conceptual Framework for Financial Reporting?

ABSTRACT

Despite more than forty years of exploration into constructing a conceptual framework (CF) for financial reporting the question ‘What is a CF?’ has not been adequately answered. The result is that those who construct CFs are not guided by a clear concept of a CF and communication about CFs is undermined by differences in understanding what it is. There has been a failure to undertake conceptual enquiry into the nature of a CF or into the expressions used in describing it. This paper addresses this failure by undertaking such a conceptual enquiry. Existing explanations of CFs are examined and found to be inadequate. What is wanted from a CF is identified and explained and this is used to prescribe what should be understood by the expression ‘conceptual framework’. A new characterisation of CFs is given that should assist any future construction of new CFs. Problems that may be faced by those who seek to construct a CF are identified.     

Why Do Analysts use a Zero Forecast for Other Comprehensive Income?

Accounting theory and accounting researchers stress the importance of clean surplus accounting and comprehensive income to corporate valuation. However, casual observation suggests that sell-side equity analysts routinely ignore other comprehensive income (OCI) in their forecasts and instead focus on forecasting earnings (before OCI). Using a sample of analyst reports, I first confirm that analysts normally omit forecasts of OCI or comprehensive income from their reports, consistent with analysts forecasting OCI as zero. I then predict and find that a zero forecast for OCI generally produces lower forecasting errors than alternative time-series models, such as a random walk or AR(1) model, suggesting a rational reason why analysts take this approach. Finally, I predict and find that although analysts’ point forecasts of future OCI are usually zero, their implied cost of equity estimates are consistent with analysts forecasting a positive variance for OCI.     

The Purpose of Financial Reporting: The Case for Coherence in the Conceptual Framework and Standards

This paper proposes a basis for progress in the development of the conceptual framework (CF) as a foundation for developing accounting standards. This topic has gained increased prominence following the IASB's (2013) release of its Review of the Conceptual Framework for Financial Reporting (RCFFR) proposing changes to the CF. In this paper the broad socio‐economic environment is seen as determining the primary purpose of General Purpose Financial Reporting (GPFR), which, in turn, establishes the high‐level properties of a CF suitable to meet that primary purpose. This is to support market stability and efficiency through the provision of an account of the financial position and performance of an entity that accords with economic reality. The case is made that the primary purpose of a CF is to provide the principles for the development of accounting standards that will result in GPFR that is useful. This requires theoretical coherence. The CF should drive the standards and if standards depart from the CF principles, such departures should be justified. This proposal is consistent with the position adopted in the RCFFR. However, in contrast to the RCFFR, this paper accents the purposive approach and links the formation of standards directly to the CF. This approach implies that standards are subordinate to CF principles; therefore compliance with standards should not provide a basis for compromising the faithful representation of economic reality. From the purpose identified for GPFR, the paper argues for a default presumption in favour of Fair Value Accounting, a retreat from the asset/liability approach, and a re‐casting of the income statement to focus on operational flows.     

Fair value accounting and the present value fallacy: The need for an alternative conceptual framework

The major functions of company accounting identified by the IASB and the FASB are (1) reporting on ‘the custody and safekeeping’ of the company's resources and (2) reporting on ‘their efficient and profitable use’. The joint IASB/FASB project for improving the conceptual framework for financial reporting is directed towards better performance of both functions within the conventional ‘accrual’ system of accounting through the use of ‘fair value’. Although the disclosure of fair values is a development to be welcomed, the requirement that changes in fair value should be reported as ‘gains’ or ‘losses’ appears to rely on the ‘Hicksian’ concept of income as a theoretical ideal.The object of the present paper is to establish that this concept is fundamentally flawed by what may be called the ‘present value fallacy’. Even in an economic utopia of perfectly competitive markets (with no discrepancies between objective market values and subjective present values), the concept of income or profit as value growth can be seriously misleading.If the prevailing Hicksian conceptual framework is discarded in favour of an alternative based on Fisher's theory of income, the two major, but incompatible, functions of financial reporting can be carried out independently and without compromise. The conventional ‘hybrid’ system of accrual accounting, in which backward-looking measures of volume and forward-looking measures of value are mixed together, would be replaced by a ‘segregated’ system in which they are kept strictly apart. A logical extension of Fisher's theory suggests the disclosure by agent/managers of the return on investment that they are planning to deliver to their principal/owners. This type of ‘decision-useful information’ is vital for the efficient operation of capital markets and for removing the accounting incentive to short-termism.     

资本管理会计:现代企业会计的理念创新

国际会计准则理事会的《财务报告概念框架》基于资产负债观,间接计量权益,声明财务报告的设计不反映企业价值,传承以期初资本余额界定资本保全和利润计算参照点的粗略不当概念。有鉴于此,本文发掘论证了《簿记论》的资本损益观,创新提出了资本管理会计的资本成本损益观;建议以企业期末资本的原值,即应回收历史成本,精准科学地界定资本保全概念和损益计算参照点;建议以管资本为主,系统、科学、全面地区别和运用历史成本会计与现时价值会计;建议健全现代企业会计与财务会计和管理会计的一体化协同机制,并以企业资本管理作为转型升级的核心目标;建议基于企业期末资本的净值原值比,设计资本成本回报率,作为企业会计评价的主要核心指标。     

Implications for the Conceptual Framework Arising From Accounting for Financial Instruments

This article describes some of the issues faced by standard setters in developing guidance on accounting for financial instruments and the implications these issues have for the conceptual framework (CF). The objective is to outline issues, not necessarily to resolve them, and to consider the implications they have for further developing the conceptual framework.
Given the current trend of harmonization and convergence of accounting practice towards international standards, it seems reasonable to assume that any policy implications will be most relevant to the CF inherited by the International Accounting Standards Board (IASB). ¹ Unless otherwise stated, references will be made to International Accounting Standards (IAS).     

Gestaltungsformen der Bilanzierung von Versicherungsverträgen: ein kritischer Vergleich von Deferral / Matching- und Asset / Liability-Ansätzen

On 31 of March 2004 the IASB issued the IFRS 4 (Insurance Contracts), which is a stepping stone to the second phase of its project on insurance contracts. The new standard deals with limited improvements to accounting practices for insurance contracts, without requiring major changes that may need to be revised in phase II. In the second phase of the project a recognition and measurement model is expected to be finalised which differs significantly from the traditional approach to accounting for insurance contracts. It will be an asset / liability-approach that requires an entity to identify and measure directly the rights and obligations arising from insurance contracts. The resulting assets and liabilities should be measured at their fair value. In contrast to the asset / liability-approach, the traditional approach to accounting for insurance contracts, referred to as deferral / mat-ching-approach, emphasises the measurement of income. Both approaches and their corresponding implications on the balance sheet and the profit and loss statement are analysed in detail.     

On the IASB comprehensive income project: an analysis of the case for dual income display

The IASB is presently involved in a project on reporting comprehensive income. Since the IASB accounting model mixes two income determination systems, namely, historical cost accounting and fair value accounting, an interesting question pertains to whether the display of comprehensive income should reflect the existence of these two paradigms. This article scrutinizes, from both the points of view of accounting theory and a valuation perspective, the typical arguments made by proponents of historical cost net income and comprehensive fair value income. It finds that claims for exclusive reliance on a single concept of income are untenable. The analysis provides arguments in defence of an income display that explicitly features both income concepts. Such a dual income display would correspond to a categorization of comprehensive income that is currently investigated in the IASB performance reporting project. However, given the importance of summarization in financial analysis, as is most extremely reflected in the focus on the earnings per share (EPS) number, the case for a dual income display should also be considered at the highest level of summarization of financial performance reporting. In other words, mandatory publication of two EPS numbers, one for net income, and one for comprehensive income, should be considered. Possible effects on perception and actual use of financial reports that should enter such a consideration are suggested as topics for experimental research.     

A Conceptual Framework for Accounting for Public-Benefit Entities

There is a renewed impetus in the International Accounting Standards Board (IASB) and the International Public Sector Accounting Standards Board (IPSASB) to develop a conceptual framework for financial reporting for both private sector and public-benefit entities. This article takes stock of some of the key issues related to this endeavour with particular emphasis on what the objectives should be and whether it is possible to have one conceptual framework for all entities.     

Discussion of Barker and Teixeira ([2018]. Gaps in the IFRS Conceptual Framework. Accounting in Europe, 15) and Van Mourik and Katsuo ([2018]. Profit or loss in the IASB Conceptual Framework. Accounting in Europe, 15)

Abstract

I provide comments on two papers, Barker and Teixeira ([2018]. Gaps in the IFRS Conceptual Framework. Accounting in Europe, 15) and Van Mourik and Katsuo ([2018]. Profit or loss in the IASB Conceptual Framework. Accounting in Europe, 15), in this issue, which were presented at the EAA-IASB research forum in Brussels. The paper accepts the shortcomings of the updated IASB conceptual framework and argues that these are in large part due to the origins of the document. It points out that the original US project was an attempt to make standard-setting more consistent and involved creating principles which would explain existing standards. Constituents have subsequently resisted attempts to make the framework theoretically sound because they fear this will encourage too much innovation. Standard-setters prefer incremental change, so continue to work with a model created to resolve a problem of the 1970s. I suggest that since standard-setting has been professionalised, the more significant need to is to define what information investors find useful. This may involve providing more granular information about the entity’s business model.     

The IASB and FASB Stumble over the Annuity Method of Depreciation

Abstract

In their leases ED issued in May 2013, the IASB and FASB used the annuity method of amortization while at the same time disavowing that they were doing so.