Financial statements – have we lost sight of utility for the sake of concepts?
03 October 2013
The Oxford dictionaries give us the following definitions:
Utility: the state of being useful, profitable, or beneficial
Concept: an abstract idea.
The IASB is working hard on its conceptual framework. During the recent agenda consultation; the stakeholders and constituents (PwC among them) responded overwhelmingly that they should do it. So they are and good luck to them.
Are concepts enough for financial reporting? Or should we try and re-focus financial reporting on utility as well? The fundamental purpose of financial reporting is to capture the creation of wealth in the past and to help users to predict cash flows (or the creation of wealth in the future). It should also allow users to compare the performance and prospects of different companies.
Let’s think about the balance sheet as an illustration of utility. The IASB continues to focus on the balance sheet but may be backing away from an unspoken plan to do away with net income.
Consider what line items in the balance sheet have utility and let’s be ruthless.
Cash has utility (although as we were recently reminded cash in bank does carry credit risk). Debt, payables, pension obligations and broadly liabilities have a great deal of utility. They tell users what liquid resources the entity has and what demands there are on those liquid resources. Derivatives also have high utility because they will become or consume cash, usually soon.
But what are assets? Some assets are promises from others to pay cash (debtors), others are goods management is confident will become money in the near future (inventory). The rest of asset accounting is either deferrals so that we can match stuff in the income statement (property, plant and equipment) or balancing figures. Goodwill, for example, is a balancing figure; it is the difference between the negotiated price and the assets that are required to be valued under the accounting standards in a business combination.
Accounting, or rather double entry bookkeeping as invented by Luca Pacioli, needs balancing figures. Certainly, Pacioli was not seeking symmetry in the measurement of assets and liabilities or even to measure something as elusive as performance. He was simply trying to bring order to the records of a monastery in the 15th century. Can we acknowledge what those balancing figures are and then spend less time and effort obsessing about the conceptual measurement of them? I once heard a user comment that he hated all the phony assets recorded in acquisition accounting. He wasn’t advocating a return to pooling but rather wanted all the excess over book value to be goodwill and I quote ‘to hang around the necks of management like a millstone until the end of time’. Perhaps he was articulating his vision of stewardship.
The IASB continues to work on some controversial major standards as it also considers the Conceptual Framework. Leasing, revenue and insurance all started out as concepts and attracted firestorms of comment, resulting in pragmatic compromises. Is this an illustration of the tug of war between concepts and utility?
Good luck to the IASB as they work on the Conceptual Framework. Let’s not lose sight of utility in the process.
As ever I’d welcome your thoughts.