Unreliable Accounts

1. Unreliable Accounts: How Regulators Fabricate Conceptual Narratives to Diffuse Criticism, by Karthik Ramanna, https://doi.org/10.1515/ael-2021-0002.

2. The Social Value of FASB, by Gregory B. Waymire and Sudipta Basu, https://doi.org/10.1515/ael-2021-0001.

3. Exploring the Relevance and Reliability of Fair Value Accounting, by Yoshitaka Fukui and Shizuki Saito, https://doi.org/10.1515/ael-2020-0086.

4. The Pluralistic Foundations of Conceptual Veiling, by Julia Morley, https://doi.org/10.1515/ael-2021-0049.

5. Unreliable Accounts: Governing behind a Veil, by Paul F. Williams, https://doi.org/10.1515/ael-2021-0107.

6. Unreliable accounts: How regulators fabricate conceptual narratives to diffuse criticism – A response to Karthik Ramanna, by Colin Haslam, https://doi.org/10.1515/ael-2020-0088.

7. “Unreliable Accounts: How Regulators Fabricate Conceptual Narratives to Diffuse Criticism” by Karthik Ramanna: A Comment on Ideological Capture, by Vera Palea, https://doi.org/10.1515/ael-2021-0054.

8. The Politics of Accounting Standards: A Comment on Ramanna’s “Unreliable Accounts: How Regulators Fabricate Conceptual Narratives to Diffuse Criticism”, by Steven K. Vogel, https://doi.org/10.1515/ael-2021-0088.

Perhaps the present effort will fail. But some day it may succeed. (Y)ears from now a kindred soul may find in my crude researches some clue to the solution. He is the audience for whom I write.

Underhill Moore

As quoted by William O. Douglas (1950) ^[1]

1 Introduction

The Financial Accounting Standards Board (FASB) has lasted for nearly 50 years since replacing the Accounting Principles Board. Perhaps its most important achievement is its Conceptual Framework (CF) consisting of eight Concepts Statements that address foundational issues in financial accounting and reporting. Ramanna (2022) studies a specific change in that framework – FASB’s (2010) decision to de-emphasize reliability of financial reporting in favor of representational faithfulness.

Ramanna (2022) argues that FASB’s de-emphasis of reliability, and especially verifiability, will ultimately degrade financial reporting quality in practice. Financial data verification arose historically because accounting data play a fundamental role in stewardship and contracting (e.g., Ball, 1989; Ijiri, 1975; Jensen, 1983; Sunder, 1997). Because managers have pay and promotion incentives to overstate the firm’s performance (e.g., Watts & Zimmerman, 1986), reports of earnings and net assets produced under the broad constraint of Conservatism are less likely to be biased upwards (Basu, 1997; Basu & Waymire, 2019; Braun, 2019; Ewert & Wagenhofer, 2012; Gao, 2013; Mora & Walker, 2015; Sterling, 1967; Watts, 2003).

We agree with the thrust of Ramanna’s (2022) criticism of FASB’s views about reliability. Hence, we seek to complement Ramanna’s essay by exploring additional fundamental questions about what FASB does and how FASB does it. We pose three specific questions that require further investigation to say something concrete about FASB’s long-term social value as an institution. First, has FASB generated value for its intended beneficiaries? Second, has FASB’s CF increased knowledge about accounting and financial reporting, or has our knowledge stayed the same or even regressed? Finally, what is the opportunity cost to society of FASB? That is, would it be a net social benefit or cost if FASB ceased to exist?

Some caveats apply to our remarks. We offer no new theory of FASB’s economic function, nor do we provide any new evidence on the consequences of FASB’s accounting standards. While we hope that our discussion will spur new theoretical developments and suggest new directions for empirical testing, we merely raise some basic questions on the social value of FASB, about which we currently know very little. Any value to this exercise will surface through the future efforts of scholars who take up our questions.

We consider whether and how FASB standards and Conceptual Framework have created private value for the primary intended beneficiaries of accounting regulation in the next section. We then consider the broader impact of FASB on accounting knowledge that might also benefit future generations of financial statement users. We consider last the opportunity cost of FASB – i.e., would the world be harmed if FASB ceased to exist? We conclude in a final section.

2 Has FASB Generated Private Value for Its Intended Beneficiaries?

While FASB can serve many “stakeholders,” the primary intended beneficiaries of FASB’s accounting standards are investors who hold publicly traded equity and/or debt securities in corporations regulated by U.S. federal securities laws (FASB, 2010, OB2).^[2] Investor protection is the centerpiece of the U.S. Securities and Exchange Commission (SEC)’s regulatory mission: “For more than 85 years since our founding at the height of the Great Depression, we have stayed true to our mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.”^[3] SEC’s standard-setting power under the Securities Exchange Act of 1934 was delegated to FASB on its creation in 1973, as it was to FASB’s predecessors (the Committee on Accounting Procedure and the Accounting Principles Board) when they operated. It seems reasonable to ask whether FASB’s work has benefited the investors that U.S. federal securities laws were designed to protect.^[4]

A necessary condition for FASB standards to benefit investors is that FASB has a comparative advantage in supplying accounting standards. This could happen if managers and auditors acting as shareholders’ agents have weaker incentives and/or know less than standard-setters or if there are coordination benefits from mandatory accounting standards that exceed those from voluntary accounting norms. Our conclusion is that the available evidence provides at best weak support for the claim that FASB standards generate positive economic value for its primary intended beneficiaries.

FASB’s institutional form was suggested by an American Institute of Certified Professional Accountants (AICPA) committee from the early 1970s headed by Francis Wheat that focused only on the process used to set accounting standards (Davidson & Anderson, 1987; Zeff, 2015). The Wheat Committee (AICPA, 1972) recommended that the Accounting Principles Board (APB), a group consisting of 20 part-time members who retained regular external jobs, be replaced by FASB, which would employ seven full-time members. A second AICPA committee chaired by Robert Trueblood focused solely on the broad conceptual basis to be used in determining accounting standards (Zeff, 2016), since the APB had been criticized for not setting its rules using a coherent theory. The Trueblood Committee (AICPA, 1973) recommended that FASB develop a conceptual framework to guide its standard-setting activities.

The process and the goals pursued by FASB followed from the work of the Wheat and Trueblood committees. FASB’s standard-setting process includes numerous “due process” rules intended to make standard-setting more transparent and more independent of entrenched interests. As Dennis Beresford, a former FASB Chair, noted in 2013: “At inception, the major concern about the new FASB was whether it could be truly independent of the business community, auditors and regulators, and most importantly the SEC … (T)he board has been able to achieve reasonable independence and has not become subservient to the SEC, the business community, or the accounting profession” (Heffes, 2013, 36). Contrarily, Fogarty, Hussein, and Ketz (1994) and Gipper, Lombardi, and Skinner (2013) survey a large literature that concludes that politics pervades FASB standard setting.^[5]

FASB’s due process rules encourage its members and staff to have extensive, direct, and ongoing interaction with external constituencies who are affected by FASB standards. These interactions can have both favorable and unfavorable effects. On the positive side, parties affected by FASB rules are likely more aware of FASB activities and their potential effects since FASB publicizes its agenda and deliberations long before a new rule is passed. At the same time, FASB uses rhetoric to frame its behavior in ways that impair understanding of why FASB has adopted one rule over an alternative (Young, 2003, 2014). For example, FASB claims, “The FASB Conceptual Statements are intended to serve the public interest by setting the objectives, qualitative characteristics, and other concepts that guide selection of economic phenomena to be recognized and measured for financial reporting…”^[6] Lobbying by potentially affected parties likely shapes FASB standards to favor some constituents over others (cf. Horngren, 1973; Watts, 1977; Watts & Zimmerman, 1978, 1986; Zeff, 1978, 2005; Leuz, Pfaff, and Hopwood 2004). Erb and Pelger (2015), who also study the dropping of reliability from the conceptual framework, argue that FASB staff and some board members exploited confusion about the meaning of “reliability” among constituents and other board members to opportunistically redefine the term away from verifiability, and thus justify increased fair value reporting.

FASB’s standard-setting output has been prodigious. By July 2009, FASB had issued 168 Statements of Financial Accounting Standards (SFASs) as well as many interpretations and technical bulletins to clarify implementation of specific standards. Effective July 1, 2009, FASB’s Codification Project redefined U.S. Generally Accepted Accounting Principles (GAAP) as identical to its new Accounting Standards Code. As of January 2022, FASB has issued 200 “Accounting Standards Updates” (ASUs) in place of the former SFASs as well as written guidance from sub-committees like the Emerging Issues Task Force and the Derivatives Implementation Group.^[7]

Assessing the social costs and benefits of accounting standards is an exceptionally difficult task. Schipper (2010) provides a comprehensive analysis that identifies numerous difficulties and limitations of any empirical analysis on this issue. Empirically measuring the effects of FASB standards requires complex empirical analysis extending beyond the effects of a single standard or group of standards. That is, measuring the value of FASB output requires consideration of the cumulative effects of the standard-setting institution across all, or at least most, standards that apply to firms subject to FASB mandates.^[8] Subject to the above limitations, we believe that the best evidence available so far on the cumulative effects of SFASs is provided by Khan, Li, Rajgopal, and Venkatachalam (2018) – hereafter KLRV.

KLRV measure the abnormal common stock returns around dates when FASB passed new SFASs. Their sample covers 138 standards (of 171 including three revisions to previously adopted rules) promulgated by FASB during the years 1973–2009 that were broadly applicable to U.S. public firms. KLRV (2018, 210) conclude: “We find insignificant stock market price reactions (on average) on event dates related to the passage of 104 of the 138 standards. When we aggregate the event dates across all standards, we obtain a statistically insignificant negative abnormal return of −0.07 percent. From all this, we infer that, on average, a new standard is a value-neutral event for shareholders.”^[9]

This finding is important because it suggests that FASB has had a trivial cumulative average effect on the wealth of one of the main intended beneficiaries of investor protection under FASB rules – the shareholders in publicly traded enterprises required to prepare financial statements under U.S. GAAP.^[10] However, this tiny effect is consistent with Zimmerman’s (2013, 888) trenchant diagnosis, “EFRQ [external financial reporting quality] has on average at best a second-order effect on firm value of U.S. publicly listed companies and improvements in these firms’ EFRQ have a third-order effect on firm value.” The small negative effect is consistent with U.S. public company CFOs viewing FASB standards as arbitrary rules that have to be complied with rather than as a vehicle to inform investors (Dichev, Graham, Harvey, & Rajgopal, 2013).^[11]

Given all this, it seems relevant to question what FASB perceives to be the benefits that result from their standards. Beginning in 2009, the Financial Accounting Foundation (FAF), which oversees FASB, implemented a post-implementation review (PIR) process to evaluate the effects of new FASB standards (Blouin & Robinson, 2014). This process requires consideration of relevant academic research, an evaluation of whether the objectives for financial reporting were met by the standard, and the gathering of survey evidence from parties affected by new standards. FASB had previously sponsored and published academic research in the form of 28 Discussion Memoranda (1973–1991) surveying academic research on a new agenda item and 23 Research Reports (1973–1993) mainly authored by academics (Zeff, 2021). Both series were stopped as FASB members showed little interest in academic research (Dyckman, 1989). Burton and Sack (1991), both former SEC Chief Accountants, wrote at this time, “While the FASB has sponsored a limited amount of academic research, encouraged research by financial statement preparers and used its own staff to undertake research, it still does not appear that research outputs have had a substantial impact on the pronouncements of the Board which remain primarily the result of a political bargaining process.”

The PIR process is an attempt to reengage with academic researchers, but FASB still comes nowhere near quantifying the net benefits of the standards they mandate or showing even qualitatively that their benefits exceed the associated implementation and litigation costs.^[12] Accordingly, we recommend that academic research extend KLRV (2018) to directly address why FASB accounting standards might increase net benefits to corporate investors and quantify more precisely the magnitude of such effects.

FASB might generate net benefits for others who interact with corporations subject to FASB rules, but this would seem to be an unintended consequence. Researchers should also test whether a public interest, and specifically an investor protection, rationale actually explains FASB behavior better than alternative views. Investors in equity and debt securities might not be the actual intended beneficiaries of FASB standards. For example, FASB acts as an agent of the SEC and might seek to promote the survival of the SEC’s regulatory power, which need not align with the interests of equity and debt investors and others affected by SEC disclosure and reporting rules (Moe, 1990; Weingast, 1984). Palmon, Peytcheva, and Yezegel (2011) and Zeff (2014) study how the SEC interacts with FASB and argue that the SEC often exerts considerable pressure on FASB.^[13] The Sarbanes-Oxley Act of 2002 (SOX) gave the SEC the power to approve FASB’s budget, which it used to take the power to nominate, interview and review potential FASB members in early 2007 (Leone & Johnson, 2007).^[14] Palmon et al. (2011, 180) conclude, “The issues addressed by the FASB, the speed at which the FASB responds, and even its position on certain issues can at times be solely attributed to SEC pressure.”

More broadly, FASB’s authority is also subject to the U.S. Treasury and other federal agencies whose rulemaking rely on GAAP and who often object to proposed standards (cf. Horngren, 1973). The SEC was delegated its power by Congress, which overrules or threatens FASB when its standards could hurt large political donors, and often uses FASB and accountants as scapegoats for economic crises created by bad fiscal and monetary policy.^[15] Palmon et al. (2011) argue that the SEC (and by extension, Congress) may use FASB to deflect any criticism that the SEC (or Congress) is beholden to private interests by pointing to the independent standard-setting body (i.e., FASB).

Both the SEC and FASB claim to serve the public interest, and no doubt some employees of each agency believe in this mission. Although there is a long tradition of viewing altruistic motives as being purer than self-interested motives, Smith (1776) argued that self-interested motives can produce unintended benefits under market competition, which in part may explain how capitalist economies have generally created greater wealth than communist economies (Maddison, 2001). Oakley (2013) identifies instances where altruism is pathological, i.e., that it harms its intended beneficiaries.^[16] Could altruistic FASB members unintentionally hurt investors and other stakeholders by mandating ex-post poor accounting standards?

Moreover, public choice economics argues that some regulators are self-interested (e.g., Buchanan & Tullock, 1962; Frye & Shleifer, 1997; Olson, 1965) and succumb to lobbying and other rent-seeking activities (e.g., Kreuger, 1974; Tullock, 1967) because they do not face market competition. If regulators like the SEC are captured by the regulated (e.g., Mahoney, 2001; O’Connor, 2004; Partnoy, 1999; Smith, 1776; Stigler, 1971), then regulation is unlikely to be effective. Similarly, if regulators are ideological, then they might issue lots of regulations, but their ultimate effectiveness is likely doubtful. Mahoney (2003) compares how well competing theories based on public interest, public choice, and political ideology explain which U.S. states adopted “blue-sky” securities laws between 1911 and 1931 and when they did so.^[17] He finds that the public choice and political ideology theories fit the data better than public interest theory. Political ideology is a leading explanation for regulatory switching between Democrat and Republican presidencies, including at the SEC, in recent years. For example, Republican SEC Chairman Christopher Cox was a strong advocate for the SEC accepting IFRS by 2014, but his Obama-appointed Democratic successor, Mary Schapiro, did not endorse IFRS and the convergence project has languished.

Bischof, Daske, and Sextroh (2020) examine the roles of ideology and special interest lobbying in influencing Congressional intervention in accounting regulation, focusing on two public debates regarding fair value accounting in 2008–09 and stock option expensing in 2003–04. They find in both cases, like Mahoney (2003), that political ideology dominates when economic consequences are at the forefront of public debates, but that special interests dominate political intervention when technical issues are being considered.^[18] Since investors are primarily affected when economic consequences are large, the FASB Conceptual Framework seems least useful as a guide to FASB action when it is arguably most important. Unsurprisingly, laws passed in the immediate aftermath of a crisis often include provisions whose ultimate consequences differ from those envisioned because they were adopted quickly without sufficient critical analysis and due diligence study (e.g., Bainbridge, 2011; Romano, 2005; Waymire & Basu, 2011).^[19]

3 Has the Conceptual Framework Improved Thinking About the Foundations of Accounting?

The FASB Conceptual Framework (CF) provides guidance to standard-setters for resolving specific accounting policy questions and a basis to justify their actions. In the preamble to SFAC 8 (FASB, 2010), FASB says, “The Board itself is likely to be the most direct beneficiary of the guidance provided by Concepts Statements.” More generally, the CF is a theoretical statement about the economic value of financial accounting and reporting that can be used by other current and future organizations in making accounting policy decisions. Thus, it is critical to assess what impact FASB has had on accounting knowledge. Jiang, Wang, and Wangerin (2018) and Chakravarthy (2019) document that board members frequently cite the CF to support their votes on specific standards. Further, voting by Board members has become more homogeneous after the CF was put in place. But, has the CF helped us think more clearly about the foundations of accounting and financial reporting, or could the CF have caused accounting knowledge to regress (e.g., Baxter, 1953; Sunder, 2010)?

A contentious assumption of the CF is that the Balance Sheet is more important than the Income Statement. This has been termed the Asset-Liability approach to accounting policy versus the previous Revenue-Expense approach based, for example, on Paton and Littleton (1940) (Dichev, 2008). FASB’s use of the Asset-Liability approach extends back to a 1966 paper by Robert Sprouse, an early Board Member and Vice-Chairman during 1973–1985, who led the FASB CF project. As summarized by Basu and Waymire (2010, 123), Sprouse (1966) makes two main claims: (1) “accounting’s foundation lies in the traditional balance-sheet identity that Assets = Liabilities + Equities,” and (2) “if the balance-sheet identity is valid, it implies that balance-sheet accounts that are inconsistent with specific definitions of assets and liabilities are fallacious. Sprouse’s key assertion is an “if-then” proposition that acceptance of the balance-sheet equation implies that it is the starting point for identifying a valid accounting system.”

Dichev (2008) criticizes the FASB’s use of the Asset-Liability approach as inconsistent with most firms’ business models, which are focused mainly on the design and execution of successful product market strategies.^[20] Dichev argues that a “balance sheet orientation of accounting standard-setting is flawed” … because it is “at odds with the economic process of advancing expenses to earn revenues, which governs how most businesses create value, and which represents how managers and investors view most firms” (Dichev, 2008, 453). O’Brien (2009) is likewise skeptical of the CF and argues that accounting is based on foundational concepts that are at odds with the CF; these “inconvenient” concepts include stewardship, reliability, and earnings that must be expunged from the accounting lexicon to make the CF consistent with the standards that are actually promulgated by the Board in recent years.^[21]

Contrarian views of FASB and its CF have also been offered by Young (2006), Penman (2007), Palmrose (2009), and Williams and Ravenscroft (2015). Young (2006) criticizes the FASB and its CF because it is based on hypothetical (i.e., “made up”) users of financial statements rather than actual humans with differing investing goals and cognitive limits that constrain actual use of accounting data. Penman offers a balanced analysis of fair value accounting versus historical cost accounting and concludes that fair value is weakest when the value of a firm stems from the use of assets rather than changes in the prices of assets that can be traded in active markets (Penman, 2007, 42). Palmrose (2009) emphasizes the science of accounting and the idea that the increasingly complex standards written by FASB have encouraged an overly technical focus that is far removed from the foundations of accounting.^[22] Williams and Ravenscroft (2015) argue that the FASB CF is incoherent because decision usefulness cannot be clearly defined and measured; thus, they advocate a return to standards based on accountability concepts that would be more logically defensible (e.g., Ijiri, 1983). Braun (2019) and Basu and Waymire (2019) argue that the dismissal of conservatism and downplaying of historical cost in FASB (2010) stems from a deep misunderstanding of their role in generating new information for financial markets and operating efficiencies within firms.

Even more fundamentally, Demski (2007, 154) dismisses the CF saying, “… the framework remains irreparably flawed. The foundation of qualitative relevance and reliability (or relevance and faithful representation) does not comport with economic fundamentals. This follows from a straightforward application of the Blackwell Theorem. Moreover, transactions are endogenous and other information is ubiquitous.”^[23]

Demski’s view echoes an early critique of the CF’s user primacy emphasis by Dopuch and Sunder (1980, 14–15):

The extraordinary emphasis of the recent pronouncements regarding objectives of financial accounting on user primacy can probably be traced to inappropriate applications of single-person decision theory in a multi-person context … This model, developed by the physical scientists and engineers for the control of mechanical or inanimate systems, is inappropriate for social systems, where the object of control is not an unchanging chemical process but a human being with learning capabilities … A user-primacy notion in the selection of objectives of financial accounting which ignores how firm managers are likely to adjust their behavior to the new information system (and how this adjustment in management behavior will affect the interests of the so-called users) represents a very short-sighted view of the whole problem.

The major takeaway from these papers is that, despite language to the contrary, the FASB CF is not rooted in the fundamentals of accounting as it has evolved over several millennia (Basu, 2015). This is the major point implicit in Ramanna’s (2022) analysis. A central feature of accounting based on the double-entry system is that it has evolved as a means for assessing business performance through profit measurement (Ijiri, 1975). This self-contained system can easily be tailored to a given firm’s transactions (Littleton, 1953, 1956; Terrill, 1955) and, along with principles for revenue and expense measurement, yields profit measures that can be compared across time for the same firm or between firms at a given moment in time. These measures guide firms whose very reason for existence is to produce profits more effectively than can be done through a series of market transactions between sub-contractors (Alchian & Demsetz, 1972; Coase, 1937, 1988; Williamson, 1975; Williamson and Winter, 1991).^[24]

Ijiri (1975) suggests that the foundations of double-entry bookkeeping lie in its integration with the economic causation embedded in the method. Economic exchange is central to Ijiri’s view of accounting where endogenous transactions are recorded with increments (e.g., sales revenue) matched simultaneously against decrements (e.g., cost of goods sold) with the residual representing earnings for the transaction and the business firm as a whole.

In Basu and Waymire (2010, 141–142), we suggested that the “fatal flaw” in Sprouse’s view of accounting (and by implication the FASB’s CF) was that it eroded the link between accounting and the economics of exchange by expanding:

the set of conditions that call for entries to the books of account. This cuts the link between the accounts and the causal forces that generate transactions…

(A) journal entry resulting from a consummated transaction encodes several simultaneously determined attributes of a transaction. Obvious attributes include the price and quantity for which a transaction is consummated. A less obvious but far more important attribute of any consummated transaction is the underlying decision to transact. This decision is of vital importance in a world where it takes skill and effort to discover favorable opportunities to transact with customers and factor suppliers. Stated differently, the decision to transact reflects an entrepreneur’s decision to “cause” the consummation of a specific transaction, when the firm’s raison d’être is to identify and transact value-increasing exchanges.”

FASB has (perhaps unknowingly) downplayed causal double-entry with its use of an approach that emphasizes the Balance Sheet and fair values for asset and liability valuation to a degree that has been harmful. We argue in Basu and Waymire (2021) that exchange causality is central to double-entry as it has been evolving over the course of several centuries; it is this feature of double-entry that enables more timely profit measurement than was possible with the single-entry system that was displaced. Profit calculation under single-entry requires only valuations of assets and liabilities at the end of a period with the period’s profit being the change in the difference between assets and liabilities for the period (Childs, 1895, 24). As a result, a single-entry bookkeeping system would suffice to implement FASB’s balance-sheet approach based on fair values of assets and liabilities.

KLRV (2018, 242) state that “… the three fair value standards (SFAS 105, 107, and 115) are associated with the greatest fall in shareholder value,” but FASB ignored the stock market feedback and continued to push fair values for derivatives (e.g., SFAS 133, FASB, 1998) generating further negative market returns. Because the FASB push for the Asset-Liability approach with fair values has persisted over several decades, it seems that the ideology driving the FASB approach is not political as with the SEC but rather quasi-religious (Basu, 2015; Young, 2014). Has FASB degraded accounting knowledge by advocating a CF tied to an Asset-Liability approach that could have been implemented with a single-entry system of the kind used during the Mercantilist era several centuries ago?

Mercantilism is an approach to economic policy that saw the retention of assets, specifically silver and gold, as central to the success of a nation’s economy. Hörnigk (1684) suggested nine principles for macroeconomic management that included bans on export of gold and silver and imports of foreign commodities that would compete with domestic products. Summarizing Mercantilist theory, Johnson, Van Metre, Huebner, and Hanchett (1915, 356) noted that “Trade must be so conducted that the money value of the commodities exported from the country exceeds the money cost of the goods imported, so that there is a “favorable balance of trade” with a steady flow of coin or bullion into the country.”^[25] In this sense, Mercantilist economic policy aligns well with FASB standard-setting focused on Balance Sheet primacy (Storey & Storey, 1998, 76–85).

A contrary view is provided by Adam Smith in The Wealth of Nations, which had the primary purpose of overthrowing Mercantilism (Sowell, 2006, 5–13). In the very first sentence, Smith (1776, 1) declares that the wealth of a nation comes about from productive activity rather than accumulated assets:

The annual labor of every nation is the fund which originally supplies it with all the necessaries and conveniences of life which it annually consumes, and which consist always either in the immediate produce of that labor, or in what is purchased with that produce from other nations.

Smith summarizes the tenets of Mercantilism in Chapter I of Book Four of The Wealth of Nations, and then destroys the arguments offered in support of Mercantilism in subsequent chapters. For present purposes, we would summarize the main conclusion from The Wealth of Nations as: the value of an entity, be it a nation or a specific firm, lies not in the assets held by the entity per se, or their money value if liquidated presently, but in the benefits that can be produced by putting those assets to productive use.

We view this as the main problem with the FASB’s Asset-Liability approach. The FASB Asset-Liability approach is misaligned fundamentally with the very reason why firms exist in the first place, which is to produce value through discovered exchange transactions rather than to be “ ‘asset greenhouses’, where the primary mission of the firm is to earn money by acquiring, storing, and growing assets” (Dichev, 2008, 458). Thus, it is perhaps not a big surprise that managers of real-world businesses have chafed under (or “misunderstood”) this approach (Storey & Storey, 1998, 76). This is similar to the experiences of British businesses (other than the very largest like the British East India Company who benefited from trade restrictions on their competitors) that were disadvantaged by Mercantilist policies (Smith 1776).

4 What is the Opportunity Cost of FASB?

Assume that FASB ceased operations tomorrow and announced the following:

FASB is suspending its operations. We’ve written accounting standards continuously since 1973. Because of work by our board members and staff, accounting has solved its “big problems” and we have written a conceptual framework that can be used to identify solutions to new problems that arise in the future. Because there is little left for us to do (i.e., the remaining problems in financial accounting and reporting are of lower-order importance) and continuing to operate would be costly to society, we will work with the SEC as they devise a successor organization to FASB that will meet future challenges in a cost-effective manner.

What would we do if this unlikely event actually occurred? What, if anything, would we do differently in the future than FASB did in the past?

Answering this question requires that we first consider opportunity cost – i.e., what would be the next best alternative to FASB as a mechanism to set accounting standards? Or perhaps we would not even need a standard-setter? Identifying the opportunity cost of FASB requires a clear alternative, which is not available for two reasons. First, the main comparable institution that exists today is the International Accounting Standards Board (IASB), and this may not be the best alternative since the structure and governance of IASB has been so influenced by the demand for convergence in accounting standards with FASB (Sunder, 2011). Second, no other serious alternative exists for the U.S. because FASB has completely monopolized the market for accounting standards (Dye & Sunder, 2001; Jamal & Sunder, 2014). Should we return to something that has been tried before (e.g., the Accounting Principles Board or the Committee on Accounting Procedure) or try to design a new institution?

In designing a new institution, we must better understand how accounting standards can benefit investors. Two such mechanisms immediately come to mind. One is that standards can lead to the production of better information about a firm’s performance. In this case, it is critical to understand how the informativeness of accounting data differs under one potential standard versus another so that better standards can be identified and implemented.

A second potential mechanism is that standards enhance comparability of data between firms. Prior research suggests that comparability is important to investors and has economic value (Chen, Collins, Kravet, & Mergenthaler, 2018; Choi, Choi, Myers, & Ziebart, 2019; De Franco, Kothari, & Verdi, 2011; Kim, Kraft, & Ryan, 2013; Kim, Li, Lu, & Yu, 2016). This suggests that standards that better enable comparisons of one firm’s performance with that of other firms will be critical. Further, if the value of a standard arises because it can better coordinate cross-firm evaluations, then the quality of a given standard in improving performance measurement may not depend on a specific firm’s use of a standard so much as use of any common standard by multiple firms. That is, the value of an accounting standard in coordinating investor evaluation can be secured by consistently applying it across firms at reasonable cost.^[26]

We have no specific alternative institution in mind but will suggest a few things that such an institutional alternative could consider. First, what should be the overarching goals for any successor organization to FASB? Second, how would such an organization promote new accounting knowledge development? That is, would the new organization try to develop new knowledge as FASB has done with its CF, or should it focus on knowledge curation? Third, if there is to be a formal body to opine on “generally accepted” accounting practices, what form should these opinions take? Finally, what would be the agenda for this institution and who would set it?

We think the overarching goals for any successor institution to FASB should be to produce recommendations about preferred accounting methods that will be (1) modest in ambition, (2) robust to possible changes in current conditions, and (3) provisional and subject to future refinement as new knowledge is obtained. When a revision to practice is suggested, any FASB successor should advocate modest improvements that can be implemented by preparers in a straightforward manner at reasonable cost. These improvements should be robust in that they will work effectively across a wide range of macroeconomic conditions.

No pronouncement should be viewed as the single final answer that will be universally applicable forever. Specific recommendations should be modest incremental changes to existing practice rather than revolutionary changes that re-orient the entire measurement process in the absence of knowledge of the effects of such a change.^[27] This approach would be consistent with the call for modesty in policymaking offered by Hayek (1989, 7):

To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm … (h)e cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

We believe that FASB’s successor should rely on knowledge curation rather than knowledge production reflected in a theory of accounting represented by a broad CF. We say this for two reasons. First, FASB has no comparative advantage in theory development, or even in theory evaluation (Madsen, 2013). Thus, FASB’s successor will be better off leaving theory development to academics trained to do such work (Glover, 2014). Second, actions by a body like FASB that is responsible for setting standards that “sanction” specific accounting rules are likely to have negative consequences for developing new knowledge (Baxter, 1953). In this sense, “less is more” if the goal is to improve extant practice rather than deter people from “clinging” to a “revenue and expense view” that has resulted from “a long tradition of ad hoc accounting principles” (Storey & Storey, 1998, 83).

This approach would allow multiple conceptual frameworks to co-exist and would provide a broader knowledge base for making accounting policy decisions. This knowledge base could include the FASB CF as well as Paton and Littleton (1940), and others suggested by affected/interested parties. Important contributions to accounting thought could be included in a global online archive that would be updated as new knowledge is discovered and debated. This would make the conceptual knowledge base for accounting practice dynamic instead of static.

We believe that any successor to FASB should provide recommendations rather than dictates. That is, it would be more like a court than an administrative agency. The idea for such an “accounting court” has long existed (Berle, 1938). Spacek (1958, 375) advocates the use of an accounting court because it would likely, if carefully designed, adapt better than top-down rules that compel uniform accounting:^[28]

From a professional point of view, we need the case method of arriving at decisions on accounting principles. We need it so that not only the accounting profession, but also industry, government, teachers, and students will know the views that prevail in arriving at accepted principles, and why they prevail. This is particularly important for research and teaching. Through research, we will be able to discover when such reasoning has become obsolete, where it is wrong, where the premises have changed, and therefore why principles of accounting must change.

The benefit of a court for designing accounting policies is that it could more readily accommodate timely feedback from those affected by the organization’s rules. This could be done through appeals of written rules, perhaps even using appellate courts as is done in typical legal processes.^[29] The U.S. tax court could serve as a model for this approach (Friedland, 2004). In any case, it is essential that the court’s opinions be revisited and re-deliberated if barriers arise that make effective implementation impractical. Having grounds for legitimate appeals will discourage the court from holding overconfident views of its abilities that can lead to false conclusions about the effects of such rules – i.e., a Nirvana fallacy (Demsetz, 1969). Because of this, the court would be a constructivist institution, but its doctrine would be an ecologically rational body of case law (Smith, 2003).

The agenda for this new body should be generated “bottom up” rather than “top down.” The agenda must be driven by a need to solve real problems that arise in practice rather than by a standard-setter’s need to “earn its keep” by trying to perfect policies that already work quite well. For example, was there really a compelling need for FASB to write a comprehensive standard on revenue to replace a set of revenue recognition policies, many of which were industry-specific, that had evolved out of practice over the course of centuries (Biondi et al., 2014)? Could evolved revenue recognition practices have worked well enough that it was not (on net) beneficial to put users and preparers through the pain and cost of designing a new single revenue recognition procedure?

Instead of trying to make all accounting standards consistent with its dubious CF, a standard-setter could add an issue to its agenda only when there was a clearly established accounting deficiency that needed to be addressed. In this event, it would be possible to identify parties to an action before the court and formal processes that would be invoked to evaluate the current practice. The result would be an agenda that was driven by real problems and, with the passage of time, a body of accounting case law that would evolve through legal reasoning built on precedents developed through court cases and an appellate process. In this way, accounting practice and accounting’s theoretical principles would co-evolve in a way that paralleled “the indispensable dynamic quality of law” emerging from legal reasoning that applies current precedent to new conditions that arise in practice (Levi, 1949/2013, 2). To promote efficiency, it would be useful to put time constraints on the court’s actions – e.g., any new ruling on a court item could be subject to a constraint that any written decision paper on the agenda item must be produced within say 18 months of the case being added to the court’s agenda.^[30]

5 Concluding Remarks

We have focused on three larger questions about the value of FASB. First, do FASB accounting standards generate economic value for their intended beneficiaries? Second, has the FASB CF improved thinking about accounting and financial reporting? Third, what is the opportunity cost of FASB? We do not answer these questions definitively but raise them in the hope of spurring further thinking about the larger issue of whether FASB is a socially useful institution.

FASB has now existed for nearly a half-century, and we question whether its institutional structure is best suited for producing accounting standards for the next half-century. Does it have a comparative advantage in producing accounting standards, and if so, why? Is there a better alternative to FASB for this function? Do we still need the FASB CF as the main guidepost in building better accounting policies to support financial markets, or should we use other conceptual frameworks that could encourage broader thinking about accounting policy? Are the gargantuan annual reports provided by U.S. corporations necessary to protect 21st century investors or are they the result of a concern to prevent stock market losses by small investors that borders on pathological altruism?

We encourage consideration of these questions through a fresh comprehensive evaluation of whether FASB, as a monopolistic U.S. supplier of accounting standards, represents the best vision for future accounting policymaking. Such an evaluation would be an exercise in accountability for FASB in evaluating its cumulative effects over its nearly 50-year history. The FASB “Strategic Plan” (FASB, 2015, 2) states that FASB is “accountable to stakeholders and to those organizations that oversee their activities. For the FASB, those organizations include the FAF Board of Trustees, the Securities and Exchange Commission (SEC), and through the SEC, the Congress of the United States.” Thus, the evaluation should consider whether FASB’s “stakeholders” (beyond its staff and regulatory sponsors) are satisfied with its performance in light of what is known about the size and informativeness of U.S. corporate reports today versus when FASB was founded in 1973. The results of such an evaluation could prove useful in charting a course for U.S. financial accounting.