The principal role of financial accounting and reporting is to serve the public interest by providing information that is useful in making business and economic decisions. That information facilitates the efficient functioning of capital and other markets, thereby promoting the efficient and equitable allocation of scarce resources in the economy. To undertake and fulfill that role, financial accounting in the twentieth century has evolved from a profession relying almost exclusively on the experience of a handful of illustrious practitioners into one replete with a set of financial accounting standards and an underlying conceptual foundation.

An underlying structure of accounting concepts was deemed necessary to provide to the institutions entrusted with setting accounting principles or standards the requisite tools for resolving accounting problems. Financial accounting now has a foundation of fundamental concepts and objectives in the Financial Accounting Standards Board's (FASB) Conceptual Framework for Financial Accounting and Reporting, which is intended to provide a basis for developing the financial accounting standards that are promulgated to guide accounting practice.

The FASB's conceptual framework and its antecedents constitute the major subject matter of this chapter. Some significant terms, organizations, and authoritative pronouncements need to be identified or briefly introduced. They already may be familiar to most readers or will become so in due course.

(a) Financial Accounting Standards Board and General Purpose External Financial Accounting and Reporting

Financial accounting and reporting is the familiar name of the branch of accounting whose precise but somewhat imposing full proper name is general-purpose external financial accounting and reporting. It is the branch of accounting concerned with general-purpose financial statements of business enterprises and not-for-profit organizations. General-purpose financial statements are possible because several groups, such as investors, creditors, and other resource providers, have common interests and common information needs. General-purpose financial reporting provides information to users who are outside a business enterprise or not-for-profit organization and lack the power to require the entity to supply the accounting information they need for decision making; therefore, they must rely on information provided to them by the entity's management. Other groups, such as taxing authorities and rate regulators, have specialized information needs but also the authority to require entities to provide the information they specify.

General-purpose external financial reporting is the sphere of authority of the FASB, the private-sector organization that since 1973 has established generally accepted accounting principles in the United States. General-purpose external financial accounting and reporting provides information that is based on generally accepted accounting principles and is audited by independent certified public accountants (CPAs). Generally accepted accounting principles result and have resulted primarily from the authoritative pronouncements of the FASB and its predecessors.

The FASB's standards pronouncements—Statements of Financial Accounting Standards (often abbreviated FASB Statement, SFAS, or FAS) and FASB Interpretations (often abbreviated FIN)—are recognized as authoritative by both the Securities and Exchange Commission (SEC) and the American Institute of Certified Public Accountants (AICPA).

The FASB succeeded the Accounting Principles Board (APB), whose authoritative pronouncements were the APB Opinions. In 1959 the APB had succeeded the Committee on Accounting Procedure, whose authoritative pronouncements were the Accounting Research Bulletins (often abbreviated ARB), some of which were designated as Accounting Terminology Bulletins (often abbreviated ATB).

With respect to the long name general-purpose external financial reporting, this chapter does what the standards-setting bodies also have done: For convenience, it uses the shortcut term financial reporting.

(b) Management Accounting and Tax Accounting

Financial accounting and reporting is only part of the broad field of accounting. Other significant kinds of accounting include management accounting and tax accounting.

Management accounting is internal accounting designed to meet the information needs of managers. Although the same accounting system usually accumulates, processes, and disseminates both management and financial accounting information, managers' responsibilities for making decisions and planning and controlling operations at various administrative levels of a business enterprise or not-for-profit organization require more detailed information than is considered necessary or appropriate for external financial reporting. Management accounting includes information that is normally not provided outside an organization and is usually tailored to meet specific management information needs.

Tax accounting is concerned with providing appropriate information needed by individuals, corporations, and others for preparing the various returns and reports required to comply with tax laws and regulations, especially the Internal Revenue Code. It is significant in the administration of domestic tax laws, which are to a large extent self-assessing. Tax accounting is based generally on the same procedures that apply to financial reporting. There are some significant differences, however, and taxing authorities have the statutory power to prescribe the specific information they want taxpayers to submit as a basis for assessing the amount of income tax owed and do not need to rely on information provided to other groups.

2.2 Why We Have a Conceptual Framework

“Accounting principles” has proven to be an extraordinarily elusive term. To the nonaccountant (as well as to many accountants) it connotes things basic and fundamental, of a sort which can be expressed in few words, relatively timeless in nature, and in no way dependent upon changing fashions in business or the evolving needs of the investment community.

The Wheat Report

Principle. A general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice.

Accounting Research Bulletin No. 7

A recurring theme in financial accounting in the United States in the twentieth century has been the call for a comprehensive, authoritative statement of basic accounting principles. It has reflected a widespread perception that something more fundamental than rules or descriptions of methods or procedures was needed to form a basis for, explain, or govern financial accounting and reporting practice. A number of organizations, committees, and individuals in the profession have developed or attempted to develop their own variations of what they have diversely called principles, standards, conventions, rules, postulates, or concepts. Those efforts met with varying degrees of success, but by the 1970s none of the codifications or statements had come to be accepted or relied on in practice as the definitive statement of accounting's basic principles.

The pursuit of a statement of accounting principles has reflected two distinct schools of thought: that accounting principles are generalized or drawn from practice without reference to a systematic theoretical foundation or that accounting principles are based on a few fundamental premises that together with the principles provide a framework for solving specific problems encountered in practice. Early efforts to codify or develop accounting principles were dominated by the belief that principles are essentially a “distillation of experience,” a description generally attributed to George O. May, one of the most influential accountants of his time, who used it in the title of a book, Financial Accounting: A Distillation of Experience.¹ However, as accounting has matured and its role in society has increased, momentum in developing accounting principles has shifted to those accountants who have come to understand what has been learned in many other fields: that reliance on experience alone leads only so far because environments and problems change; that until knowledge gained through experience is given purpose, direction, and internal consistency by a conceptual foundation, fundamentals will be endlessly reargued and practice blown in various directions by the winds of changing perceptions and proliferating accounting methods; and that only by studying and understanding the foundations of practices can the path of progress be discovered and the hope of improving practice be realized.

The conceptual framework project of the FASB represents the most comprehensive effort thus far to establish a structure of objectives and fundamentals to underlie financial accounting and reporting practice. To understand what it is, how it came about, and why it took the form and included the concepts that it did requires some knowledge of its antecedents, which extend back more than 60 years.

(a) Special Committee on Cooperation with Stock Exchanges

The origin of the use of principle in financial accounting and reporting can be traced to a special committee of the American Institute of Accountants (American Institute of Certified Public Accountants since 1957). The Special Committee on Cooperation with Stock Exchanges, chaired by George O. May, gave the word special significance in the attest function of accountants. That significance is still evident in audit reports signed by members of the Institute and most other CPAs attesting that the financial statements of their clients present fairly, or do not present fairly, the client's financial position, results of operations, and cash flows “in conformity with generally accepted accounting principles.” The committee laid the foundation that has been the basis of both subsequent progress in identifying or developing and enunciating accounting principles and many of the problems that have accompanied the resulting principles.

In 1930 the Institute undertook a cooperative effort with the New York Stock Exchange aimed at improving financial disclosure by publicly held enterprises. It was widely believed that inferior accounting and reporting practices had contributed to the stock market decline and depression that began in 1929. The Exchange was concerned that its listed companies were using too many different accounting and reporting methods to reflect similar transactions and that some of those methods were questionable. The Institute wanted to make financial statements more informative and authoritative, to clarify the authority and responsibility of auditors, and to educate the public about the conventional nature of accounting and the limitations of accounting reports.

The Exchange's Committee on Stock List and the Institute's Special Committee on Cooperation with Stock Exchanges exchanged correspondence between 1932 and 1934. The special committee's report, comprising a series of letters that passed between the two committees, was issued to Institute members in 1934 under the title Audits of Corporate Accounts (reprinted in 1963). The key part was a letter dated September 22, 1932, from the Institute committee.

(i) “Accepted Principles of Accounting.”

The special committee recommended that an authoritative statement of the broad accounting principles on which “there is a fairly general agreement” be formulated in consultation with a small group of qualified persons, including accountants, lawyers, and corporate officials. Within that framework of “accepted principles of accounting,” each company would be free to choose the methods and procedures most appropriate for its financial statements, subject to requirements to disclose the methods it was using and to apply them consistently. Audit certificates (reports) for listed companies would state that their financial statements were prepared in accordance with “accepted principles of accounting.” The special committee anticipated that its program would improve financial reporting because disclosure would create pressure from public opinion to eliminate less-desirable practices.

The special committee did not define “principles of accounting,” but it illustrated what it had in mind. It gave two explicit examples of accepted broad principles of accounting:

It is a generally accepted principle that plant value should be charged against gross profits over the useful life of the plant….

Again, the most commonly accepted method of stating inventories is at cost or market, whichever is lower.²

It also listed five principles that it presumed would be included in the contemplated statement of “broad principles of accounting which have won fairly general acceptance”:

1. Unrealized profit should not be credited to income account of the corporation either directly or indirectly, through the medium of charging against such unrealized profits amounts, which would ordinarily fall to be charged against income account. Profit is deemed to be realized when a sale in the ordinary course of business is affected, unless the circumstances are such that the collection of the sale price is not reasonably assured. An exception to the general rule may be made [for industries in which trade custom is to take inventories at net selling prices, which may exceed cost].

2. Capital surplus [other paid-in capital], however created, should not be used to relieve the income account of the current or future years of charges, which would otherwise fall to be made there against. This rule might be subject to the exception that [permits use of quasi-reorganization].

3. Earned surplus [retained earnings] of a subsidiary company created prior to acquisition does not form a part of the consolidated earned surplus of the parent company and subsidiaries; nor can any dividend declared out of such surplus properly be credited to the income account of the parent company.

4. While it is perhaps in some circumstances permissible to show stock of a corporation held in its own treasury as an asset, if adequately disclosed, the dividends on stock so held should not be treated as a credit to the income account of the company.

5. Notes or accounts receivable due from officers, employees, or affiliated companies must be shown separately and not included under a general heading such as Notes Receivable or Accounts Receivable.³

The Institute submitted the committee's five principles for acceptance by its members in 1934, and they are now in ARB No. 43, Restatement and Revision of Accounting Research Bulletins (issued 1953), Chapter .1A, “Rules Adopted by Membership” [paragraphs 1–5].

The special committee's use of the word principle set the stage not only for the Institute's efforts to identify “accepted principles of accounting” but also for future confusion and controversy over what accountants mean when they use the word principle.

But Were They “Principles”?.

The special committee's examples of broad principles of accounting were much less fundamental, timeless, and comprehensive than what most people perceive to be principles. They had little or nothing in them that made them more basic or less concrete than conventions or rules. Moreover, the special committee itself referred to them as rules in describing exceptions to them, the Institute characterized them as rules in submitting them for approval by its members, and the chairman of the special committee later conceded that they were nothing more than rules:

When the committee…undertook to lay down some of the basic principles of modern accounting, it found itself unable to suggest more than half a dozen which could be regarded as generally acceptable, and even those were rules rather than principles, and were, moreover, admittedly subject to exception.⁴

Not surprisingly, the special committee's use of the word principles was soon challenged. In a contest sponsored by the Institute for its fiftieth anniversary celebration in 1937, Gilbert R. Byrne's essay entitled “To What Extent Can the Practice of Accounting Be Reduced to Rules and Standards?” won first prize for the best answer to the question posed in the title. He complained about accountants' propensity to downgrade principle by equating it with terms such as rule, convention, and procedure.

[R]ecent discussions have used the term “accounting principles” to cover a conglomeration of accounting practices, procedures, conventions, etc.; many, if not most, so-called principles may merely have to do with methods of presenting items on financial statements or technique of auditing, rather than matters of fundamental accounting principle.⁵

Stephen Gilman made the same point in his careful analysis of terms in five chapters of his book, Accounting Concepts of Profit.

With sublime disregard of lexicography, accountants speak of “principles,” “tenets,” “doctrines,” “rules,” and “conventions” as if they were synonymous.⁶

Gilman also quoted an excerpt from the Century Dictionary that he thought pertinent “because of the confusion noted in some accounting writings [about] the distinction between ‘principle’ and ‘rule’ ”:

There are no two words in the English language used so confusedly one for the other as the words rule and principle. You can make a rule; you cannot make a principle; you can lay down a rule; you cannot, properly speaking, lay down a principle. It is laid down for you. You can establish a rule; you cannot, properly speaking, establish a principle. You can only declare it. Rules are within your power, principles are not. A principle lies back of both rules and precepts; it is a general truth, needing interpretation and application to particular cases.⁷

Byrne, Gilman, and others pointed out that the form of accountant's report recommended by the special committee made accountants look foolish by requiring them to express opinions based on the existence of principles they actually could not specify. In that form of report, an accountant expressed the opinion that a client's financial statement is “fairly present, in accordance with accepted principles of accounting consistently maintained by the company during the year under review, its position…and the results of its operations.” According to Byrne, that opinion presumed that accepted principles of accounting actually existed and accountants in general knew and agreed on what they were. In fact, “While there have been several attempts to enumerate [those principles], to date there has been no statement upon which there has been general agreement.”⁸

That diagnosis was confirmed by Gilman as well as by Howard C. Greer:

…the entire body of precedent [the “accepted principles of accounting”] has been taken for granted.

It is as though each accountant felt that while he himself had never taken the time or the trouble to make an actual list of accounting principles, he was comfortably certain that someone else had done so….

[T]he accountants are in the unenviable position of having committed themselves in their certificates [reports] as to the existence of generally accepted accounting principles while between themselves they are quarreling as to whether there are any accounting principles and if there are how many of them should be recognized and accepted.⁹

There is something incongruous about the outpouring of thousands of accountants' certificates [reports] which refer to accepted accounting principles, and a situation in which no one can discover or state what those accepted accounting principles are. The layman cannot understand.¹⁰

Byrne argued that lack of agreement on what constituted accepted accounting principles resulted “in large part because there is no clear distinction, in the minds of many, between that body of fundamental truths underlying the philosophy of accounts which are properly thought of as principles, and the larger body of accounting rules, practices, and conventions which derive from principles, but which of themselves are not principles.”¹¹ His prescription for accountants was to use principle in its most commonly understood sense of being more fundamental and enduring than rules and conventions.

If accounting, as an organized body of knowledge, has validity, it must rest upon a body of principles, in the sense defined in Webster's New International Dictionary:

“A fundamental truth; a comprehensive law or doctrine, from which others are derived, or on which others are founded; a general truth; an elementary proposition or fundamental assumption; a maxim; an axiom; a postulate.” …

Accounting principles, then, are the fundamental concepts on which accounting, as an organized body of knowledge, rests…. [T]hey are the foundation upon which the superstructure of accounting rules, practices and conventions is built.¹²

Gilman, in contrast, could find no principles that fit Byrne's definition. He concluded that most, if not all, of the propositions that had been put forth as principles of accounting should be relabeled “as doctrines, conventions, rules, or mere statements of opinion.”¹³ He called on accountants to admit that there were no accounting principles in the fundamental sense and to waste no more time and effort on attempts to identify and state them.

May's Attempts to Rectify “Considerable Misunderstanding.”.

In several articles and a book, George O. May responded to those and other criticisms of “accounting principles” and explained what the special committee, as well as several other Institute committees of which he was chairman, had done and why. He detected, in the criticisms and elsewhere, what he described as “considerable misunderstanding” of both the nature of financial accounting and the committees' work on accounting principles and thought it necessary to get the matter back on the right track.

Although he acknowledged that “in the correspondence the [special] Committee had used the words ‘rules,’ ‘methods,’ ‘conventions,’ and ‘principles’ interchangeably,”¹⁴ May considered questions such as whether the propositions should be called rules or principles not to be matters “of any real importance.” As Byrne had pointed out, if there were any principles that fit his definition, “they must be few in number and extremely general in character (such as ‘consistency’ and ‘conservatism’).”¹⁵ Thus, they would afford less precise guidance than the more concrete principles illustrated by the special committee. Those who scolded the special committee for misusing “principles” had apparently forgotten that “accounting rules and principles are founded not on abstract theories or logic, but on utility.”¹⁶

May urged the profession and others to focus efforts to improve financial accounting, as had the special committee, on the questions “of real importance”—the consequences of the necessarily conventional nature of accounting and the limitations of accounting reports. He explained the philosophy underlying the recommendation of the special committee and summarized that philosophy in the introductory pages of his book:

In 1926,…I decided to relinquish my administrative duties and devote a large part of my time to consideration of the broader aspects of accounting. As a result of that study I became convinced that a sound accounting structure could not be built until misconceptions had been cleared away, and the nature of the accounting process and the limitations on the significance of the financial statements which it produced were more frankly recognized.

It became clear to me that general acceptance of the fact that accounting was utilitarian and based on conventions (some of which were necessarily of doubtful correspondence with fact) was an indispensable preliminary to real progress….

Many accountants were reluctant to admit that accounting was based on nothing of a higher order of sanctity than conventions. However, it is apparent that this is necessarily true of accounting as it is, for instance, of business law. In these fields there are no principles, in the fundamental sense of that word, on which we can build; and the distinctions between laws, rules, standards, and conventions lie not in their nature but in the kind of sanctions by which they are enforced. Accounting procedures have in the main been the result of common agreement between accountants.¹⁷

He also reiterated and amplified a number of points the special committee had emphasized in Audits of Corporate Accounts concerning what the investing public already knew or should understand about financial accounting and reporting, such as, that because the value of a business depended mainly on its earning capacity, the income statement was more important than the balance sheet and should indicate to the fullest extent possible the earning capacity of the business during the period on which it reported; that because the balance sheet of a large modern corporation was to a large extent historical and conventional, largely comprising the residual amounts of expenditures or receipts after first determining a proper charge or credit to the income account for the year, it did not, and should not be expected to, represent an attempt to show the present values of the assets and liabilities of the corporation; and that because financial accounting and reporting was necessarily conventional, some variety in accounting methods was inevitable.

Special Committee's Definition of Principle.

May not only identified the definition of principle the special committee had used but also explained why it had chosen that particular meaning. In his comment on Byrne's essay, he recalled the committee's discussion and searching of dictionaries before choosing the “perhaps rather magniloquent word ‘principle’…in preference to the humbler ‘rule.’ ” The definition of “principle” in the Oxford English Dictionary that came closest to defining the sense in which the special committee used the word was the seventh definition:

A general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice.

The time and effort spent in searching dictionaries was fruitful—the committee found exactly the definition for which it was looking:

[The]…sense of the word “principle” above quoted seemed…to fit the case perfectly. Examination of the report as a whole will make clear what the committee contemplated; namely, that each corporation should have a code of “laws or rules, adopted or professed, as a guide to action,” and that the accountants should report, first, whether this code conformed to accepted usages, and secondly, whether it had been consistently maintained and applied.¹⁸

Thus, the special committee opted for the lofty principle rather than the more precise rule or convention because the definition that best fit the committee's needs was a definition of principle, albeit an obscure one, not a definition of rule or convention. Moreover, rule and convention carried unfortunate baggage:

[The] word “rules” implied the existence of a ruling body which did not exist; the word “convention” was regarded as not appropriate for popular use and in the opinion of some would not convey an adequate impression of the authority of the precepts by which the accounts were judged.¹⁹

Principle, however, conveyed desirable implications:

It used to be not uncommon for the accountant who had been unable to persuade his client to adopt the accounting treatment that he favored, to urge as a last resort that it was called for by “accounting principles.” Often he would have had difficulty in defining the “principle” and saying how, why, and when it became one. But the method was effective, especially in dealing with those (of whom there were many) who regarded accounting as an esoteric but well established body of learning and chose to bow to its authority rather than display their ignorance of its rules. Obviously, the word “principle” was an essential part of the technique; “convention” would have been quite ineffective.²⁰

Rules were elevated into principles because the committee thought it necessary to use a word with the force or power of principle to prevent the auditor's authority from being lost on the client.

(ii) The Best-Laid Schemes

The special committee's program focused on what individual listed companies and their auditors would do. Each corporation would choose from “accepted principles of accounting” its own code of “laws or rules, adopted or professed, as a guide to action” and within that framework would be free to choose the methods and procedures most appropriate for its financial statements but would disclose the methods it was using and would apply them consistently. An auditor's report would include an opinion on whether or not each corporation's code consisted of accepted principles of accounting and was applied consistently. The Stock Exchange would enforce the program by requiring each listed corporation to comply in order to keep its listing.

The Institute was to sponsor or lead an effort in which accountants, lawyers, corporate officials, and other “qualified persons” would formulate a statement of “accepted principles of accounting” to guide listed companies and auditors, but it was not to get into the business of specifying those principles. The special committee had explicitly considered and rejected “the selection by competent authority out of the body of acceptable methods in vogue today [the] detailed sets of rules which would become binding on all corporations of a given class.” The special committee also had avoided using rule because the word implied a rule-setting body that did not exist, and it had no intention of imposing on anyone what it considered to be an unnecessary and impossible burden. “Within quite wide limits, it is relatively unimportant to the investor what precise rules or conventions are adopted by a corporation in reporting its earnings if he knows what method is being followed and is assured that it is followed consistently from year to year.”²¹ Moreover, the committee felt that no single body could adequately assess and allow for the varying characteristics of individual corporations, and the choice of which detailed methods best fit a corporation's circumstances thus was best left to each corporation and its auditors. Because financial accounting was essentially conventional and required estimates and allocations of costs and revenues to periods, the utility of the resulting financial statements inevitably depended significantly on the competence, judgment, and integrity of corporate management and independent auditors. Although there had been a few instances of breach of trust or abuse of investors, the committee had confidence in the trustworthiness of the great majority of those responsible for financial accounting and reporting.

In the end, the special committee's recommendations were never fully implemented. Nonaccountants were not invited to participate in developing a statement of accepted accounting principles. In fact, although the Institute submitted the special committee's five principles for acceptance by its members, it attempted no formulation of a statement of broad principles, even by accountants. Nor did the Exchange require its listed companies to disclose their accounting methods.

Special Committee's Heritage.

The only recommendation to survive was that each company should be permitted to choose its own accounting methods within a framework of “accepted principles of accounting.” The committee's definition of principle also survived, and “accepted principles of accounting” became “generally accepted.”

The special committee's definition of principle—“A general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice”—was incorporated verbatim in Accounting Research Bulletin No. 7, Report of the Committee on Terminology (George O. May, chairman), in 1940, but it was attributed to the New English Dictionary rather than to the Oxford English Dictionary. When ARB 1–42 were restated and revised in 1953, the same definition of “principle,” by then attributed only to “Dictionaries,” was carried over to Accounting Terminology Bulletin No. 1, Review and Résumé.

“Generally” was added to the special committee's “accepted principles of accounting” in Examination of Financial Statements by Independent Public Accountants, published by the Institute in 1936 as a revision of an auditing publication, Verification of Financial Statements (1929). According to its chairman, Samuel J. Broad, the revision committee inserted “generally” to answer questions such as “…accepted by whom? business? professional accountants? the SEC? I heard of one accountant who claimed that if a principle was accepted by him and a few others it was ‘accepted.’ ”²²

In retrospect, the legacy of institutionalizing that definition of principle has been that the terms principle, rule, convention, procedure, and method have been used interchangeably, and imprecise and inconsistent usage has hampered the development and acceptance of subsequent efforts to establish accounting principles. Moreover, within the context of so broad a definition of principle, the combination of the latitude given management in choosing accounting methods, the failure to incorporate into financial accounting and reporting the discipline that would have been imposed by the profession's adopting a few, broad, accepted accounting principles, and the failure to enforce the requirement that companies disclose their accounting methods gave refuge to the continuing use of many different methods and procedures, all justified as “generally accepted principles of accounting,” and encouraged the proliferation of even more “generally accepted” accounting methods.

Finally, despite the reluctance of the Institute to become involved in setting principles or rules, it eventually assumed that responsibility after the U.S. SEC was created.

(iii) Securities Acts and the Securities and Exchange Commission—“Substantial Authoritative Support.”

The Securities Exchange Act of 1934 established the SEC and gave it authority to prescribe accounting and auditing practices to be used by companies in the financial reports required of them under that Act and the Securities Act of 1933. The SEC, like the Stock Exchange before it, became increasingly concerned about the variety of accounting practices approved by auditors. Carman G. Blough, first Chief Accountant of the SEC, told a round-table session at the Institute's fiftieth anniversary celebration in 1937 that unless the profession took steps to develop a set of accounting principles and reduce the areas of difference in accounting practice, “the determination of accounting principles and methods used in reports to the Commission would devolve on the Commission itself. The message to the profession was clear and unambiguous.”²³

In April 1938, the Chief Accountant issued Accounting Series Release (ASR) No. 4, Administrative Policy on Financial Statements, requiring registrants to use only accounting principles having “substantial authoritative support.” That made official and reinforced Blough's earlier message: If the profession wanted to retain the ability to determine accounting principles and methods, the Institute would have to issue statements of principles that could be deemed to have “substantial authoritative support.” Through ASR 4, the Commission reserved the right to say what had “substantial authoritative support” but also opened the way to give that recognition to recommendations on principles issued by the Institute.

(b) Committee on Accounting Procedure, 1938–1959

The Institute expanded significantly its Committee on Accounting Procedure (not principles) and gave it responsibility for accounting principles and authority to speak on them for the Institute—to issue pronouncements on accounting principles without the need for approval of the Institute's membership or governing Council. The committee was intended to be the principal source of the “substantial authoritative support” for accounting principles sought by the SEC.

The president of the Institute was the nominal chairman of the Committee on Accounting Procedure. Its vice chairman and guiding spirit was George O. May.

(i) No Comprehensive Statement of Principles by the Institute

The course the committee would follow for the next 20 years was set at its initial meeting in January 1939. Carman G. Blough, who had left the Commission and become a partner of Arthur Andersen & Co. and who was a member of the committee, recounted in a paper at a symposium at the University of California at Berkeley in 1967 how the committee chose its course:

At first it was thought that a comprehensive statement of accounting principles should be developed which would serve as a guide to the solution of the practical problems of day to day practice….

After extended discussion it was agreed that the preparation of such a statement might take as long as five years. In view of the need to begin to reduce the areas of differences in accounting procedures before the SEC lost patience and began to make its own rules on such matters, it was concluded that the committee could not possibly wait for the development of such a broad statement of principles.²⁴

The committee thus decided that the need to deal with particular problems was too pressing to permit it to spend time and effort on a comprehensive statement of principles.

Statements of Accounting Principles by Others.

Although the Institute attempted no formulation of a statement of broad accounting principles, two other organizations did. Both statements were written by professors, and each was an early representative of one of the two schools of thought about the nature and derivation of accounting principles.

American Accounting Association's Theoretical Basis for Accounting Rules And Procedures

“A Tentative Statement of Accounting Principles Underlying Corporate Financial Statements,” by the Executive Committee of the American Accounting Association (AAA) in 1936, was based on the assumption “that a corporation's periodic financial statements should be continuously in accord with a single coordinated body of accounting theory.”²⁵ The phrase Accounting Principles Underlying Corporate Financial Statements emphasized that improvement in accounting practice could best be achieved by strengthening the theoretical framework that supported practice. The “Tentative Statement” was almost completely ignored by the Institute, and its effect on accounting practice at the time was minimal. However, two of its principles (one a corollary of the other) and a monograph by W. A. Paton and A. C. Littleton based on it proved to have long-lasting influence and are described shortly.

Sanders, Hatfield, and Moore's Codification of Accounting Practices

In contrast to the AAA's attempt to derive a coordinated body of accounting theory, A Statement of Accounting Principles, by Thomas Henry Sanders, Henry Rand Hatfield, and Underhill Moore, two professors of accounting and a professor of law, respectively, was a compilation through interviews, discussions, and surveys of “the current practices of accountants” and reflected no systematic theoretical foundation. It was prepared under sponsorship of the Haskins & Sells Foundation and was published in 1938 by the Institute, which distributed it to all Institute members as “a highly valuable contribution to the discussion of accounting principles.”

The report was excoriated for its virtually exclusive reliance on experience and current practice as the basis for principles, its reluctance to criticize even the most dubious practices, and its implication that accountants had no greater duty than to ratify whatever management wanted to do with its accounting as long as what it did was legal and properly disclosed. Many, perhaps most, of the characteristics criticized were inherent in what the authors were asked to do—formulate a code of accounting principles based on practice and the weight of opinion and authority. Even so, the report tended to strike a dubious balance between auditors' independence and duty to exercise professional judgment on the one hand and their deference to management on the other.

It was, nevertheless, “the first relatively complete statement of accounting principles and the only complete statement reflecting the school of thought that accounting principles are found in what accountants do.” It was a successful attempt to codify the methods and procedures that accountants used in everyday practice and “was in fact a ‘distillation of practice.’ ”²⁶ Moreover, since the Committee on Accounting Procedure adopted and pursued the same view of principles and incorporated existing practice and the weight of opinion and authority in its pronouncements, A Statement of Accounting Principles probably was a good approximation of what the committee would have produced had it attempted to codify existing “accepted principles of accounting.”

Sets of Principles by Individuals

Three less ambitious efforts in 1937 and 1938—eight principles in Gilbert R. Byrne's prize-winning essay,²⁷ nine accounting principles and conventions in D. L. Trouant's book Financial Audits,²⁸ and six accounting principles in A. C. Littleton's “Tests for Principles”²⁹—provided examples, rather than complete statements, of principles. Each described what principles meant and gave some propositions to illustrate the nature of principles or to show how propositions could be judged to be accepted principles. The resulting principles were substantially similar to those of the special committee. For example, all three authors included the conventions that revenue usually should be realized (recognized) at the time of sale and that cost of plant should be depreciated over its useful life. An interesting exception was Trouant's first principle—“Everything having a value has a claimant”—and the accompanying explanation: “In this axiom lies the basis of double-entry bookkeeping and from it arises the equivalence of the balance-sheet totals for assets and liabilities.”³⁰ That proposition not only was more fundamental than most principles of the time but also was distinctive in referring to the world in which accounting takes place rather than to the accounting process.

Principles from Resolving Specific Problems.

None of those five efforts to state principles of accounting seems to have had much effect on practice, although Sanders, Hatfield, and Moore's A Statement of Accounting Principles may indirectly have affected the decision of the Committee on Accounting Procedure to tackle specific accounting problems first: “[A]nyone who read it could not fail to be impressed with the wide variety of procedures that were being followed in accounting for similar transactions and in that way undoubtedly it helped to point up the need for doing something to standardize practices.”³¹

In any event, the Committee on Accounting Procedure decided that to formulate a statement of broad accounting principles would take too long and elected instead to use a problem-by-problem approach in which the committee would recommend one or more alternative procedures as preferable to other alternatives for resolving a particular financial accounting or reporting problem. The decision to resolve pressing and controversial matters that way was described by members of the committee as “a decision to put out the brush fires before they created a conflagration.”³²

(ii) Accounting Research Bulletins

The committee's means of extinguishing the threatening fires were the ARB. From September 1939 through August 1959 it issued 51 ARBs on a variety of subjects. Among the most important or most controversial (or both) were No. 2, Unamortized Discount and Redemption Premium on Bonds Refunded (1939); No. 23, Accounting for Income Taxes (1944); No. 24, Accounting for Intangible Assets (1944); No. 29, Inventory Pricing (1947); No. 32, Income and Earned Surplus [Retained Earnings] (1947); No. 33, Depreciation and High Costs (1947); No. 37, Accounting for Compensation in the Form of Stock Options (1948); No. 40 and No. 48, Business Combinations (1950 and 1957); No. 47, Accounting for Costs of Pension Plans (1956); and No. 51, Consolidated Financial Statements (1959).

Each ARB described one or more accounting or reporting problems that had been brought to the committee's attention and identified accepted principles (conventions, rules, methods, or procedures) to account for the item(s) or otherwise to solve the problem(s) involved, sometimes describing one or more principles as preferable. Because each Bulletin dealt with a specific practice problem or a set of related problems, the committee developed or approved accounting principles (to use the most common descriptions) case by case, ad hoc, or piecemeal.

Piecemeal Principles Based on Practice, Experience, and General Acceptance.

As a result of the way the committee operated and the bases on which it decided issues before it, the ARB became classic examples of George O. May's dictum that “the rules of accounting, even more than those of law, are the product of experience rather than of logic.”³³ Despite having “research” in the name, the ARBs, rather than being the product of research or theory, were much more the product of existing practice, the collective experience of the members of the Committee on Accounting Procedure, and the need to be generally accepted.

Since the committee had not attempted to codify a comprehensive statement of accounting principles, it had no body of theory against which to evaluate the conventions, rules, and procedures that it considered. Although individual ARBs sometimes reflected one or more theories apparently suggested or applied by individual members or agreed on by the committee, as a group they reflected no broad, internally consistent, underlying theory. On the contrary, they often were criticized for being inconsistent with each other. The committee used the word “consistency” to mean that a convention, rule, or procedure, once chosen, should continue to be used in subsequent financial statements, not to mean that a conclusion in one Bulletin did not contradict or conflict with conclusions in others.

The most influential unifying factor in the ARBs as a group was the philosophy that underlay Audits of Corporate Accounts, a group of propositions that May and the Special Committee on Cooperation with Stock Exchanges had described as pragmatic and realistic—not theoretical and logical. For example, the Bulletins clearly were based on the propositions that the income statement was far more important than the balance sheet; that financial accounting was primarily a process of allocating historical costs and revenues to periods rather than of valuing assets and liabilities; that the particular rules or conventions used were less significant than consistent use of whichever ones were chosen; and that some variety in accounting conventions and rules, especially in the methods and procedures for applying them to particular situations, was inevitable and desirable.

Most of the work of the Committee on Accounting Procedure, like that of most Institute committees, was done by its members and their partners or associates, and the ARBs reflected their experience. The experience of Carman G. Blough also left its mark on the Bulletins after he became the Institute's first full-time director of research in 1944. The Institute had established a small research department with a part-time director in 1939, which did some research for the committee but primarily performed the tasks of a technical staff, such as providing background and technical memoranda as bases for the Bulletins and drafting parts of proposed Bulletins. Committee members and their associates did even more of the committee's work as the research department also began to provide staff assistance to the Committee on Auditing Procedure in 1942 and then increasingly became occupied with providing staff assistance to a growing number (44 at one time) of other technical committees of the Institute.

The accounting conventions, rules, and procedures considered by the Committee on Accounting Procedure and given its stamp of approval as principles in an ARB were already used in practice, not only because the committee had decided to look for principles in what accountants did but also because only principles that were already used were likely to qualify as “generally accepted.” General acceptance was conferred by use, not by vote of the committee. Each Bulletin, beginning with ARB 4 in December 1939, carried this note about its authority: “Except in cases in which formal adoption by the Institute membership has been asked and secured, the authority of the bulletins rests upon the general acceptability of opinions…reached.”

The committee was authorized by the Institute to issue statements on accounting principles, which the Institute expected the SEC to recognize as providing “substantial authoritative support,” but the committee had no authority to require compliance with the Bulletins. It could only add a warning to each Bulletin “that the burden of justifying departure from accepted procedures must be assumed by those who adopt other treatment.”

The committee's reliance on general acceptability of principles developed or approved case by case, ad hoc, or piecemeal invited challenges to its authority whenever it tried either to introduce new accounting practices or to proscribe existing practices. Moreover, although the SEC also dealt with accounting principles case by case, ad hoc, or piecemeal, its power to say which accounting principles had substantial authoritative support—its own version of general acceptability—limited what the committee could do without the Commission's concurrence.

Challenges to the Committee's Authority

The Committee on Accounting Procedure introduced interperiod income tax allocation in ARB No. 23, Accounting for Income Taxes (December 1944). The reason it gave for changing practice was that “income taxes are an expense that should be allocated, when necessary and practicable, to income and other accounts, as other expenses are allocated. What the income statement should reflect…is the [income tax] expense properly allocable to the income included in the income statement for the year” (page 186 [fourth page of ARB 23], carried over with some changes to ARB No. 43, Restatement and Revision of Accounting Research Bulletins (June 1953), Chapter 10B, “Income Taxes,” paragraph 4).

A committee of the New Jersey Society of Certified Public Accountants reviewed ARB 23 soon after its issue and questioned whether the new procedures it recommended were “accepted procedures” at the date of its issue. General acceptability, the committee contended, depended on the extent to which procedures were applied in practice, which only time would tell. The committee proposed that the Institute submit a new Bulletin to a formal vote a year after issue because approval of a Bulletin by more than 90 percent of its members would demonstrate its general acceptability and authority.³⁴

The Institute ignored the proposal, but the New Jersey committee had in effect challenged the authority of the Committee on Accounting Procedure to change accounting practice, raising an issue that would not go away. The Institute's Executive Committee or its governing council found it necessary to reaffirm the committee's authority a number of times in the following years,³⁵ and in the committee's final year its authority to change practice was challenged in court, again on a matter involving income tax allocation. Three public utilities, subsidiaries of American Electric Power, Inc., sought to enjoin the Committee on Accounting Procedure from issuing a letter dated April 15, 1959, interpreting a term in ARB No. 44 (revised), Declining-Balance Depreciation (July 1958).

The object of the letter was to express the Committee's view that the “deferred credit” used in tax-allocation entries was a liability and not part of stockholders' equity. The three plaintiff corporations alleged that classification of the account as a liability would cause them “irreparable injury, loss and damage.” They also claimed that the letter was being issued without the Committee's customary exposure, thus not allowing interested parties to comment. The Federal District Court ruled against the plaintiffs. An appeal to the Second Circuit Court of Appeals was lost, the Court saying inter alia, “We think the courts may not dictate or control the procedures by which a private organization expresses its honestly held views.” Certiorari was denied by the U.S. Supreme Court, and the committee's letter was issued shortly thereafter [July 9, 1959].³⁶

Neither the Institute's repeated reconfirmations of the committee's status nor its success in court corrected the weaknesses inherent in accounting principles whose authority rested on their general acceptability. The Institute did not finally face up to the problem until almost two decades later when the authority of the APB was challenged on another income tax matter—accounting for the investment credit.

Influence of the Securities and Exchange Commission

Because accounting principles in the ARBs would be acceptable in SEC filings only if the Commission deemed them to have “substantial authoritative support,” two committees of the Institute carefully cultivated a working relationship with the Commission to try to ensure that the Bulletins met that condition. The Committee on Cooperation with the SEC met regularly with the SEC's accounting staff and occasionally with the Commissioners. The Committee on Accounting Procedure and the director of research met with representatives of the SEC as needed and took great pains to keep the Chief Accountant informed about the committee's work, not only sending him copies of drafts of proposed Bulletins but also seeking his comments and criticisms and, if possible, his concurrence. Efforts to secure his agreement usually were successful.³⁷

Some differences of opinion between the Committee on Accounting Procedure and the Commission were inevitable, of course, but they were the exception rather than the rule. Most disagreements were settled amicably, as was the long-running disagreement over the current operating performance and all-inclusive or clean surplus theories of income. The committee and the Commission sometimes were able to work out a compromise solution. The committee often adopted the Commission's view, at least once withdrawing a proposed Accounting Research Bulletin because of the Commission's opposition and at other times apparently being discouraged from issuing Bulletins by the Commission. The Commission occasionally adopted the committee's view or at least delayed issue of its own accounting releases pending issue of a Bulletin by the Institute.

The Commission affected accounting practice indirectly through its influence on the ARB. It also directly exercised its power to say whether or not a set of financial statements filed with it met the statutory requirements by means of rulings and orders, some published but most private.

The Commission published some formal rules, mostly on matters of disclosure rather than accounting principles. For example, the first regulations promulgated by the newly formed SEC required income statements to disclose sales and cost of goods sold, information that many managements had long considered to be confidential. Over 600 companies, about a quarter of those required to file registration statements in mid-1935, risked delisting of their securities by refusing to disclose publicly the required information. The Commission granted hearings to a significant number of them and also heard arguments of security analysts, investment bankers, and other users of financial statements that the information was necessary. The Commission then “notified all of the companies affected that the information was necessary for a fair presentation and that this need overcame any arguments that had been advanced against it.”³⁸

The companies had little choice but to comply, and the effect of the rule was to put reporting of sales and cost of sales in the United States decades ahead of most of the rest of the world. The controversy surrounding initial application of the rule subsided, and reporting sales and cost of goods sold has been common practice for so long that few people now know of its once controversial nature or of the Commission's part in promulgating it.

The Commission largely exercised its power behind the scenes through informal rulings and orders in “deficiency letters” on registrants' financial statements. The recipient of a deficiency letter could decide either to amend the financial statements to comply with the SEC's ruling or go to Washington to try to convince the staff, and anyone else at the Commission who would listen, of the merits of the accounting that the staff had challenged. If that informal conference process failed to produce agreement, a registrant could do little except comply or withdraw the registration and forgo issuing the securities. The only appeal to the Commission of a staff ruling on an accounting issue was in the form of a hearing to determine whether a stop order should be issued to prevent the registration from becoming effective because it contained misrepresentations—in effect “a hearing to determine whether or not [the registrant was] about to commit a fraud…. [Since b]usinessmen who have any reputation do not put themselves in the position of putative swindlers merely to determine matters of accounting,”³⁹ those private administrative rulings effectively settled most accounting questions.

The SEC's far-reaching rule that assets must never be accounted for at more than their cost was promulgated in that way. “[N]either the Securities and Exchange Commission nor the accounting profession issued rules or guidelines directly proscribing write-ups [of assets] or supplemental disclosures of current values. The change was brought about by the intervention of the SEC's staff, who ‘discouraged’ both practices through informal administrative procedures.”⁴⁰ “[T]he SEC took a stand from the very beginning…. establish[ing] its position so early [that] we often overlook the fact that in [the basis for accounting for assets] the Commission never gave the profession a chance to even consider the matter insofar as registrants are concerned.”⁴¹

In the sense that the commission's role has long been forgotten or unknown, experience with the cost rule was similar to that of the rule requiring disclosure of sales and cost of sales. But the similarity ended there. The cost rule involved accounting principle rather than disclosure. And, instead of subsiding as did resistance to the disclosure rule, controversy surrounding the cost rule intensified and in the years following the Second World War led to a major and long-lasting division within the Institute.

Because of widespread concern about the effects on financial statements of the high rate of inflation during the war and the greatly increased prices of replacing assets after the war, the Institute had created the Study Group on Business Income, financed jointly with the Rockefeller Foundation. Its report concluded that financial statements could be meaningful only if expressed in units of equal purchasing power. It advocated accounting that reflected the effects of changes in the general level of prices on the cost of assets already owned and the resulting costs and expenses from their use,⁴² a change in accounting considered necessary by many Institute leaders and members.

While the Study Group was still at work, the Committee on Accounting Procedure, supported by many other Institute leaders and members and by the SEC, issued ARB No. 33, Depreciation and High Costs (December 1947), which rejected “price-level depreciation” and suggested instead that management annually appropriate net income or retained earnings in contemplation of replacing productive facilities at higher price levels. The Bulletin effectively blocked use of depreciation in excess of that based on cost in measuring net income that had been contemplated or adopted by a few large companies but also provoked an active opposition to the committee's action.

Prominent among those who criticized the committee for in effect applying the SEC's cost rule instead of facing up to the accounting problems caused by the effects of changes in the general price level was George O. May,⁴³ who had been instrumental in creating the Study Group on Business Income. He served as consultant to and then as a member of the group and later would be a joint author of its report. He criticized the committee's action for prejudging and undermining the Study Group's efforts, thereby foreclosing any real discussion of “the relation between changes in the price level and the concept of business income.”⁴⁴ He considered ARB 33 to be, however, only one of a number of missteps over the following decade that showed that the committee had lost its way. He also criticized the committee, among other things, for failing to cast aside outmoded conventions in favor of others more consonant with the changed conditions in the economy and for adopting public utility accounting procedures such as the Federal Power Commission's “original (or predecessor) cost”—cost to the corporate or natural person first devoting the property to the public service rather than cost to the present owner—that the committee itself earlier had held to be contrary to generally accepted accounting principles.⁴⁵

Despite the criticisms, the committee held its course, though not without some wavering. It twice considered issuing a Bulletin approving upward revaluations of assets but each time dropped the attempt in the face of the unequivocal opposition of the SEC. Although the number of dissents to the cost rule increased each time the committee revisited the question of changing price levels, the committee “was unable to marshal a two-thirds majority in favor of a new policy”⁴⁶ and in 1958 dropped the subject from its agenda.

Whether it was influencing accounting practice directly through publishing rules or establishing them in informal rulings and private conferences with registrant companies or indirectly through the Committee on Accounting Procedure, the SEC generally seems to have had its way.

Decision to Issue Principles Piecemeal Reaffirmed.

The Committee on Accounting Procedure had to deal ad hoc with the SEC's comments on and objections to its Bulletins, issued or proposed, because it had no comprehensive statement of principles on which to base responses to the Commission's own ad hoc comments and rulings. Although the committee had decided early not to take the time required to develop a statement of broad principles on which to base solutions to practice problems (p. 2–12), the need for a comprehensive statement or codification of accounting principles continued to be raised occasionally, and the committee periodically revisited the question. Each time it decided against a project of that kind.

One of those occasions was in 1949, when the committee reconsidered its earlier decision and began work on a comprehensive statement of accounting principles. Ultimately, however, it again abandoned the project as not feasible and instead in 1953 issued ARB 43, Restatement and Revision of Accounting Research Bulletins. ARB 43 superseded the first 42 ARBs, except for three that were withdrawn as no longer applicable and eight that were reports of the Committee on Terminology and were reviewed and published separately in Accounting Terminology Bulletin No. 1, Review and Résumé. Although ARB 43 brought together the earlier Bulletins and grouped them by subject matter, “this collection retained the original flavor of the bulletins, i.e., a group of separate opinions on different subjects.”⁴⁷

Thus, the decision of the Committee on Accounting Procedure at its first meeting to put out brush fires as they flared up rather than to codify accepted accounting principles to provide a basis for solving financial accounting and reporting problems set the course that the committee pursued for its entire 21-year history. All 51 ARBs reflected that decision.

Influence of the American Accounting Association.

During the 21 years that the Committee on Accounting Procedure was issuing the ARBs, the AAA revised its 1936 “Tentative Statement of Accounting Principles Underlying Corporate Financial Statements” in 1941, 1948, and 1957, including eight Supplementary Statements to the 1948 Revision. In the “Tentative Statement,” as already noted, the executive committee of the AAA emphasized that improvement in accounting practice could best be achieved by strengthening the theoretical framework that supported practice and attempted to formulate a comprehensive set of concepts and standards from which to derive and by which to evaluate rules and procedures. Principles were not merely descriptions of procedures but standards against which procedures might be judged.

The executive committee of the Association, like the committees of the Institute concerned with accounting principles, regarded the principles as being derived from accounting practice, although the means of derivation differed—distillation or compilation according to the Institute and theoretical analysis according to the Association. Thus, the “Tentative Statement” set forth 20 principles, each a proposition embodying “a corollary of this fundamental axiom”:

Accounting is…not essentially a process of valuation, but the allocation of historical costs and revenues to the current and succeeding fiscal periods. [p. 188]

Although the AAA's intent was to emphasize accounting's conceptual underpinnings, the “Tentative Statement” was substantially less conceptual and more practice oriented than might appear, not only because its principles were derived from practice but also because its “fundamental axiom” was essentially a description of existing practice. The same description of accounting was inherent in the report of the Special Committee on Cooperation with Stock Exchanges, was voiced by George O. May at the annual meeting of the Institute in October 1935⁴⁸ and was evident in most of the ARBs.

That the principles in the Statements of the AAA were significantly like those in the ARBs should come as no surprise. “Inasmuch as both the Institute and the Association subscribed to the same basic philosophy regarding the nature of income determination, it was more or less inevitable that they should reach similar conclusions, even though they followed different paths.”⁴⁹

The AAA's 1941 and 1948 revisions generally continued in the direction set by the 1936 “Tentative Statement.” Some changes began to appear in some of the Supplementary Statements to the 1948 Revision and in the 1957 Revision. They probably were too late, however, to have had much effect on the ARBs, even if the Committee on Accounting Procedure had paid much attention.

Long-lasting influence on accounting practice of the “Tentative Statement,” as noted earlier, came some time after it was issued and mostly indirectly through two of its principles on “all-inclusive income” (one a corollary of the other) and a monograph by W. A. Paton and A. C. Littleton.

“All-Inclusive Income” versus “Avoiding Distortion of Periodic Income.”

“A Tentative Statement of Accounting Principles Underlying Corporate Financial Statements” strongly supported what was later called the all-inclusive income or clean surplus theory. The principle (No. 8, p. 189), which gave the theory one of its names, was that an income statement for a period should include all revenues, expenses, gains, and losses properly recognized during the period “regardless of whether or not they are the results of operations in that period.” The corollary (No. 18, p. 191), which gave the theory its other name, was that no revenues, expenses, gains, or losses should be recognized directly in earned surplus (retained earnings or undistributed profits).

The SEC later strongly supported that accounting, and it became a bone of contention between the SEC and the Committee on Accounting Procedure. The committee generally favored the “current operating performance” theory of income, which excluded from net income extraordinary and nonrecurring gains and losses “to avoid distorting the net income for the period.” The disagreement broke into the open with the issue of ARB No. 32, Income and Earned Surplus [Retained Earnings] (December 1947), whose publication in the January 1948 issue of The Journal of Accountancy was accompanied by a letter from SEC Chief Accountant Earle C. King saying that the “Commission has authorized the staff to take exception to financial statements which appear to be misleading, even though they reflect the application of Accounting Research Bulletin No. 32 (p. 25).” Two more Bulletins, ARB No. 35, Presentation of Income and Earned Surplus (October 1948), and ARB No. 41, Presentation of Income and Earned Surplus (Supplement to Bulletin No. 35) (July 1951), followed as the committee and the SEC tried to work out a number of compromises. Each effort proved unsatisfactory to one or both parties.

Years later the APB would adopt an all-inclusive income statement in APB Opinion No. 9, Reporting the Results of Operations (December 1966). That accounting and reporting has since been modified by admitting some significant exceptions, primarily by FASB Statement No. 12, Accounting for Certain Marketable Securities (December 1975),⁵⁰ and FASB Statement No. 52, Foreign Currency Translation (December 1981). Thus, net income reported under current generally accepted accounting principles cannot accurately be described as all-inclusive income, but the idea of all-inclusive income is still generally highly regarded, and many still see it as a desirable goal to which to return.

“Matching of Costs and Revenues” and “Assets Are Costs.”

Two members of the AAA executive committee that issued “A Tentative Statement of Accounting Principles Underlying Corporate Financial Statements” in 1936 undertook to write a monograph to explain its concepts. The result, An Introduction to Corporate Accounting Standards, by W. A. Paton and A. C. Littleton (1940), easily qualifies as the academic writing that has been most influential in accounting practice. Although the monograph rejected certain existing practices—such as last in, first out (LIFO) and cost or market, whichever is lower—it generally rationalized existing practice, providing it with what many saw as a theoretical basis that previously had been lacking.

The monograph accepted two of the premises that underlay the ARBs: (1) that periodic income determination was the central function of financial accounting—“the business enterprise is viewed as an organization designed to produce income”⁵¹—and (2) that (in the words of the “fundamental axiom” of the AAA's 1936 “Tentative Statement”) accounting was “not essentially a process of valuation, but the allocation of historical costs and revenues to the current and succeeding fiscal periods.”

The fundamental problem of accounting, therefore, is the division of the stream of costs incurred between the present and the future in the process of measuring periodic income. The technical instruments used in reporting this division are the income statement and the balance sheet…. The income statement reports the assignment [of costs] to the current period; the balance sheet exhibits the costs incurred which are reasonably applicable to the years to come.⁵²

The monograph described the periodic income determination process as the “matching of costs and revenues,” giving it not only a catchy name but also strong intuitive appeal—a process of relating the enterprise's efforts and accomplishments. The corollary was that most assets were “deferred charges to revenue,” costs waiting to be “matched” against future revenues:

The factors acquired for production which have not yet reached the point in the business process where they may be appropriately treated as “cost of sales” or “expense” are called “assets,” and are presented as such in the balance sheet. It should not be overlooked, however, that these “assets” are in fact “revenue charges in suspense” awaiting some future matching with revenue as costs or expenses.

The common tendency to draw a distinction between cost and expense is not a happy one, since expenses are also costs in a very important sense, just as assets are costs. “Costs” are the fundamental data of accounting….

The balance sheet thus serves as a means of carrying forward unamortized acquisition prices, the not-yet-deducted costs; it stands as a connecting link joining successive income statements into a composite picture of the income stream.⁵³

Not surprisingly, those who had supported the accounting principles developed in the ARBs but were uncomfortable with those principles' apparent lack of theoretical support found highly attractive the theory that “matching costs and revenues” not only determined periodic net income but also justified the practice of accounting for most assets at their historical costs or an unamortized portion thereof.

However, just as the institutionalizing of a broad definition of accounting principles had caused problems for the Committee on Accounting Procedure itself and later for the APB, the institutionalizing of “matching costs with revenues,” “costs are assets,” and “avoiding distortion of periodic income” also caused problems for the FASB in developing a conceptual framework for financial accounting and reporting. The FASB found those expressions not only to be ingrained in accountants' vocabularies and widely used as reasons for or against particular accounting or reporting procedures but also to be generally vague, highly subjective, and emotion laden. They have proven to be of minimal help in actually resolving difficult accounting issues.

(iii) Failure to Reduce the Number of Alternative Accounting Methods

The Institute's effort aimed at improving accounting by reducing the number of acceptable alternatives probably did improve accounting by culling out some “bad” practices.

There are those who seem to believe that very little progress has been made towards the development of accounting principles and the narrowing of areas of differences in the principles followed in practice.

It is difficult for me to see how anyone who has knowledge of accounting as it was practiced during the first quarter of this century and how it is practiced today can fail to recognize the tremendous advances that have taken place in the art.⁵⁴

A number of the practices for whose acceptance Sanders, Hatfield, and Moore's Statement of Accounting Principles had been lambasted⁵⁵ had disappeared by about 1950. It is uncertain, however, how much of that improvement was due to the ARBs and how much to other factors, such as the good professional judgment of corporate officials or auditors or the SEC's rejection of some egregious procedures.

Ironically, the end result was an overabundance of “good” practices that had survived the process. That plethora of sanctioned alternatives for accounting for similar transactions continued to thrive despite the committee's charge to reduce the number of alternative procedures because, just as Will Rogers never met a man he didn't like, the committee rarely met an accounting principle it didn't find acceptable.

Two factors contributed to the increase in the number of accepted alternatives: (1) the committee on accounting procedure failed to make firm choices among alternative procedures, and (2) the committee was clearly reluctant to condemn widely used methods even though they were in conflict with its recommendations. For example, in its very first pronouncement on a specific problem—unamortized discount and redemption premium on refunded bonds [ARB 2]—the committee considered three possible procedures, of which it rejected one and accepted two.

The committee had a clear preference—it praised the method of amortization of cost over the remaining life of the old bonds as consistent with good accounting thinking regarding the relative importance of the income statement and the balance sheet. It condemned immediate writeoff as a holdover of balance-sheet conservatism which was of “dubious value if attained at the expense of a lack of conservatism in the income account, which is far more significant” [ARB 2, p. 13]. Nevertheless, the latter method had “too much support in accounting theory and practice and in the decisions of courts and commissions for the committee to recommend that it should be regarded as unacceptable or inferior.” [ARB 2, p. 20]

…The solution turned out to be a “live-and-let-live” policy. The major thing accomplished by the bulletin was the elimination of a method [amortization over the life of the new issue] which was not widely used anyway. And this type of solution was characteristic of the bulletins, rather than exceptional.

The extreme to which this attitude was sometimes carried is exemplified in the Institute's inventory bulletin [ARB 29], a classic example of trying to please everyone. The committee accepted almost every conceivable inventory [pricing] procedure, except the discredited base-stock method. The committee therefore passed up the opportunity to narrow the range of acceptable alternative procedures in the area of inventory [pricing]…. Instead, the individual practitioner was left with the high-sounding but useless admonition that the method chosen should be the one which most clearly reflected periodic income.⁵⁶

The proliferation of accepted alternative principles was probably inherent in an approach that championed disclosure and consistency in use of procedures over specific principles and consistency between principles.

Most of the controversial subjects covered by the ARB came back to haunt the Committee on Accounting Procedure's successor, the APB. The case-by-case, ad hoc, or piecemeal approach produced few lasting solutions to financial accounting and reporting problems.

(c) Accounting Principles Board—1959–1973

The American Institute of Accountants changed its name to the American Institute of Certified Public Accountants in June 1957, and in October of that year the new president of the AICPA, Alvin R. Jennings, proposed that the Institute reorganize its efforts in the area of accounting principles.⁵⁷ His recommendation came at a time when the Committee on Accounting Procedure was under fire for, among other things, failing to reduce the number of alternative accounting procedures. A growing number of Institute members sensed that the committee's firefighting approach to accounting principles had gone about as far as it could and expressed an urgent need for the committee to abandon that effort and to do what it had theretofore been reluctant to do—formulate or codify a comprehensive statement of accounting principles.

Jennings called for an increased research effort to reexamine the basic assumptions of accounting and to develop authoritative statements to guide accountants. He appointed a Special Committee on Research Program, and its report, Organization and Operations of the Accounting Research Program and Related Activities, in December 1958, provided the basis for the organization of an APB and an Accounting Research Division. The committee set a lofty goal:

The general purpose of the Institute in the field of financial accounting should be to advance the written expression of what constitutes generally accepted accounting principles, for the guidance of its members and others. This means something more than a survey of existing practice. It means continuing effort to determine appropriate practice and to narrow the areas of difference and inconsistency in practice. In accomplishing this, reliance should be placed on persuasion rather than on compulsion. The Institute, however, can, and it should, take definite steps to lead in the thinking on unsettled and controversial issues.⁵⁸

The APB in September 1959 replaced the Committee on Accounting Procedure as the senior technical committee of the Institute with responsibility for accounting principles and authority to issue pronouncements on accounting principles without the need for approval of the Institute's membership or governing Council. The Board's 18 members were members of the Institute, and thus CPAs, who, like members of the Committee on Accounting Procedure, continued their affiliations with their firms, companies, and universities while serving without compensation on the Board.

The APB was originally envisioned as the instrument through which a definitive statement of accounting principles would finally be achieved—what the Wheat Report later would call a “‘grand design’ of accounting theory upon which all else would rest.”⁵⁹ The report of the Special Committee on Research Program in 1958 outlined a hierarchy of postulates, principles, and rules to guide the APB's work:

The broad problem of financial accounting should be visualized as requiring attention at four levels: first, postulates; second, principles; third, rules or other guides for the application of principles in specific situations; and fourth, research.

Postulates are few in number and are the basic assumptions on which principles rest. They necessarily are derived from the economic and political environment and from the modes of thought and customs of all segments of the business community. The profession…should make clear its understanding and interpretation of what they are, to provide a meaningful foundation for the formulation of principles and the development of rules or other guides for the application of principles in specific situations….

A fairly broad set of co-ordinated accounting principles should be formulated on the basis of the postulates. The statement of this probably should be similar in scope to the statements on accounting and reporting standards issued by the American Accounting Association. The principles, together with the postulates, should serve as a framework of reference for the solution of detailed problems.

Rules or other guides for the application of accounting principles in specific situations, then, should be developed in relation to the postulates and principles previously expressed. Statements of these probably should be comparable as to subject matter with the present accounting research bulletins. They should have reasonable flexibility.

Adequate accounting research is necessary in all of the foregoing.⁶⁰

The report of the Special Committee on Research Program contemplated that the APB would quickly concern itself with providing the conceptual context from which would flow the rules or procedures to be applied in specific situations. The APB would then use the postulates and principles in choosing between alternate rules and procedures to narrow the areas of difference and inconsistency in practice.

(i) Postulates and Principles

Following that prescription, the new Accounting Research Division published Accounting Research Study No. 1, The Basic Postulates of Accounting, by Maurice Moonitz in 1961, and Accounting Research Study No. 3, A Tentative Set of Broad Accounting Principles for Business Enterprises, by Robert T. Sprouse and Maurice Moonitz in 1962. Accounting Research Studies (ARSs) were not publications of the APB and thus did not constitute official Institute pronouncements on accounting principles. On the authority of the Director of Accounting Research, Maurice Moonitz, they were issued for wide exposure and comment.

In an article entitled “Why Do We Need ‘Postulates’ and ‘Principles’?” Moonitz explained that postulates and principles were necessary to give accounting “the integrating structure it needs to give more than passing meaning to its specific procedures. It will provide ‘experience’ with the aid it needs from ‘logic’ to explain why it is that some procedures are appropriate and others are not.”⁶¹ An integrating structure would provide accounting with a mechanism by which to rid itself of procedures that clearly were not in harmony with the authoritatively stated principles.

Among the most significant contributions of those ARSs was their development of the terms postulates and principles, especially postulates, which Moonitz explained in his article:

“[P]ostulates” is used…to denote those basic propositions of accounting which describe the accountant's understanding of the world in which he lives and acts. The propositions are therefore generalizations about the environment of accounting, generalizations based upon a more or less comprehensive view and understanding of that environment. The term “principles” is used to denote those basic propositions which stem from the postulates and refer expressly to accounting issues.⁶²

To qualify as a postulate, a proposition had to meet two conditions: It must be “self-evident,” an assertion about the environment in which accounting functions that is universally accepted as valid; and it must be “fruitful for accounting,” that is, it must “relate to (be inferred from) a world that does exist and not to one that is a fiction.” Moonitz also noted that self-evident is not, as some who commented on ARS 1 seemed to have believed, the same as trivial.⁶³ An example from ARS 1 to which he referred made his point: “Most of the goods and services that are produced are distributed through exchange, and are not directly consumed by the producers” (Postulate A-2. Exchange). In that straightforward observation lie the reasons that accounting is concerned with production and distribution of goods and services and with exchange prices; if it is further observed that most exchanges are for cash, the reasons that accounting is concerned with cash prices and cash flows become apparent. As Moonitz observed, the “proposition is an extraordinarily fruitful one for accounting.”⁶⁴

Emphasis on a basis for accounting principles comprising self-evident propositions about the real-world environment in which accounting functions, and on which it reports, constituted a significant shift in thinking. Accountants' earlier emphasis, largely in a conceptual vacuum, had been on the conventional nature of accounting and the resulting necessity for conventional procedures, allocations, opinion, and judgment to produce the numbers in income statements and balance sheets. That emphasis provided an unstable and uncertain basis for accounting principles.

Accounting is often described as “conventional” in nature, and its principles as “conventions.” The two terms, conventions and conventional, are ambiguous; the statement that accounting is conventional may be true or false depending on which meaning is intended. It is true if it refers to such things as the use of Arabic numerals, the use of the dollar sign, or the sequence in which assets, liabilities, revenues, and expenses are listed in financial statements because other symbols and forms could be used to convey precisely the same message. It is not true if the statement means that any proposition which accountants accept is a valid one. As a farfetched example, assume that all uninsured losses, without exception, were to be converted into “assets” by the expedient of calling them “deferred charges against future operations.” This convention would not make assets out of losses; it would merely give the approval of accountants to a false assertion concerning the enterprise that suffered the losses, and would place accountants and accounting in an unfavorable light in the eyes of those who knew what had happened.

Suppose, however, that the assertion about accounting principles as “conventions” is intended to convey the idea that they are generalizations, inferences drawn from a large body of data, and that they are not intended to be literal descriptions of reality. “Conventions” and “conventional” are clearly valid descriptions, then, but not because accounting is unique. Instead, accounting is like every other field of human endeavor in this one respect: Its basic propositions are generalizations or abstractions and not minute descriptions of every aspect of “reality.”⁶⁵

Postulates that were self-evident propositions about the real world and also fruitful for accounting were needed to provide a solid basis for accounting principles and rules—“a platform from which to start,” “a place to stand”—and “a place to stand” was prerequisite to real improvement in accounting practice. “Failure by accountants to agree on a ‘place to stand’ will mean continued operation in mid-air, as unstable and uncertain in the future as in the past.”⁶⁶

In the more than 30 years since the two studies were published, their valuable contributions to accounting thought increasingly have been recognized. Some of the conclusions and recommendations of ARS 3, A Tentative Set of Broad Accounting Principles for Business Enterprises, such as use of replacement costs of inventories and plant and equipment and accounting for the effects of changes in the general price level, have remained controversial and still are largely unacceptable to many accountants. In contrast, most of the conclusions of ARS 1, The Basic Postulates of Accounting, long ago became commonplace in accounting literature. For example, the basic idea that the foundation for accounting principles lies in self-evident propositions about the environment in which accounting functions was incorporated into APB Statement No. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises, in 1970. By 1975 that basic idea had become an essential part of the FASB's conceptual framework.

When ARS 3 was published in April 1962, however, each copy contained a Statement of the Accounting Principles Board (later designated APB Statement No. 1) passing judgment on both studies: “The Board believes…that while these studies are a valuable contribution to accounting thinking, they are too radically different from present generally accepted accounting principles for acceptance at this time.”

It was not the APB's finest hour. Even though general dissatisfaction with the state of existing practice had been the reason for the APB's creation and the new emphasis on research, the Board and many others reacted as if they had been caught by surprise that the studies recommended some significant changes in existing practice. Moreover, instead of letting consideration of the studies follow the anticipated course of wide circulation and exposure and receipt of comments from interested readers before the Board considered the studies, the Board reacted first, spoiling any opportunity of receiving unbiased comments on the studies. The experience seems to have adversely affected for years the Board's approach to postulates and principles.

The experience may have made the APB “disillusioned with, or at least skeptical toward, the potential that fundamental or ‘theoretical’ research might have for solving accounting problems…. [T]he Board seemed to abandon the hope of the Special Committee on Research Program that such research could serve as a foundation for pronouncements on accounting principles.”⁶⁷ In any event, the Board did little or nothing more on accounting postulates and principles until 1965, except to authorize the project that in March 1965 became ARS No. 7, Inventory of Generally Accepted Accounting Principles, by Paul Grady, the second Director of Accounting Research. In 1965, the Board renewed efforts on fundamental matters—which it then called basic concepts and principles rather than postulates and principles—to comply with recommendations to the Institute's governing Council by the Special Committee on Opinions of the Accounting Principles Board (the Seidman Committee), but most Board members seemed to lack enthusiasm for the effort.

By the summer of 1962, when the Board hoped that it had put behind it the fuss over the postulates and principles studies, three years had passed since an Institute committee had issued a pronouncement on accounting principles. The Board turned its attention from postulates and principles and toward solving specific problems, just as had the Committee on Accounting Procedure.

(ii) The Accounting Principles Board, the Investment Credit, and the Seidman Committee

When the Board decided to tackle the thorny issue of accounting for the investment credit, which was enacted in federal income tax law for the first time in October 1962, it inadvertently created an ideal scenario for fueling doubts about its effectiveness and authority. The law provided that a company acquiring a depreciable asset other than a building could deduct up to 7 percent of the cost of the asset from its income tax otherwise payable in the year the asset was placed in service. Two accounting methods sprang up—the “flow-through” method, by which the entire reduction in tax was included in income of the year the asset was placed in service, and the “deferral” method, by which the tax reduction was included in net income over the productive life of the acquired property.

APB Opinion No. 2, Accounting for the “Investment Credit,” was issued in December 1962, setting forth the Board's choice of the deferral over the flow-through method. Some of the large accounting firms then popularly called the Big Eight almost immediately made it known that they would not expect their clients to abide by the Opinion. The SEC ruled that both methods had substantial authoritative support, making either acceptable and thereby effectively undercutting the Board's position. Fifteen months later, the Board issued APB Opinion No. 4 (Amending No. 2), Accounting for the “Investment Credit,” reaffirming its opinion that the investment credit should be accounted for by the deferral method. It recognized, however, the inevitable effect of the SEC's action on the authority of APB Opinion No. 2:

[T]he authority of Opinions of this Board rests upon their general acceptability. The Board, in the light of events and developments occurring since the issuance of Opinion No. 2, has determined that its conclusions as there expressed have not attained the degree of acceptability which it believes is necessary to make the Opinion effective.

In the circumstances the Board believes that…the alternative method of treating the credit as a reduction of Federal income taxes of the year in which the credit arises is also acceptable. [paragraphs 9 and 10]

The APB's authority had been severely undermined. Did APB Opinions still have to pass the test of general acceptance, as did the ARB before them, or did they constitute generally accepted accounting principles solely because the APB had issued them? The Board voted to bring the matter to the Executive Committee and the governing Council of the AICPA.

In May 1964, after an extended and heated debate, Council adopted a resolution “that it is the sense of this Council that [audit] reports of members should disclose material departures from Opinions of the Accounting Principles Board.” Pursuant to a directive in the resolution, the Institute formed a Special Committee on Opinions of the Accounting Principles Board to suggest ways of implementing the resolution and to review the entire matter of the status of APB Opinions and the development of accounting principles and practices for financial reporting.

The special committee reported to Council on its first charge in October 1964, and Council adopted a resolution and transmitted it to Institute members in a Special Bulletin, Disclosure of Departures from Opinions of the Accounting Principles Board. It declared that members of the Institute should see to it that a material departure from APB Opinions (or from ARBs still in effect)—even if the auditor concluded that the departure rested on substantial authoritative support—was disclosed in notes to the financial statements or in the auditor's report. Since Council adopted recommendations that “1. ‘Generally accepted accounting principles’ are those principles which have substantial authoritative support [and] 2. Opinions of the APB constitute ‘substantial authoritative support,’ ” the authority of APB Opinions no longer depended on their passing a separate test of general acceptability.

The special committee, commonly referred to as the Seidman Committee after its second chairman, J. S. Seidman,⁶⁸ reported to Council on its second charge in May 1965, reiterating that an authoritative identification of generally accepted accounting principles was essential if an independent CPA was to fulfill his or her primary function of attesting to the conformity of financial statements with generally accepted accounting principles. Its Recommendation No. 1 was that:

At the earliest possible time, the [Accounting Principles] Board should:

a. Set forth its views as to the purposes and limitations of published financial statements….

b. Enumerate and describe the basic concepts to which accounting principles should be oriented.

c. State the accounting principles to which practices and procedures should conform.

d. Define such phrases in the auditor's report as “present fairly” and “generally accepted accounting principles.” …

e. Define the words of art employed by the profession, such as “substantial authoritative support,” “concepts,” “principles,” “practices,” “procedures,” “assets,” “liabilities,” “income,” and “materiality.”⁶⁹

The committee made that recommendation acknowledging that the Special Committee on Research Program had contemplated that the APB would have accomplished the task described by that time in its life, but it exculpated the Board: “This planned course ran into difficulty because current problems commanded attention and could not be neglected.”⁷⁰

However, the need for a solid conceptual foundation for accounting no longer could be neglected either:

[I]t remains true that until the basic concepts and principles are formulated and promulgated, there is no official bench mark for the premises on which the audit attestation stands. Nor is an enduring base provided by which to judge the reasonableness and consistency of treatment of a particular subject. Instead, footing is given to controversy and confusion.⁷¹

…Accounting, like other professions, makes use of words of art. Since accounting talks to the public, the profession's meaning, as distinguished from the literal dictionary meaning, must be explained to the public.

For example, …

What is meant by the expression “generally accepted accounting principles”? How is “generally” measured? What are “accounting principles”? Where are they inscribed, and by whom? …

By “accepted,” is the profession aiming at what is popular or what is right? There may be a difference. The…Special Committee on Research Program said that “what constitutes generally accepted accounting principles…means more than a survey of existing practice.”

Then again, “accepted” by whom—the preparer of the financial statement, the profession, or the user?⁷²

The profession has said that generally accepted accounting principles are those with “substantial authoritative support.” What does that expression mean? What yardstick is to be applied to the words “substantial” and “authoritative”? What are the guidelines to prevent mere declaration, or use by someone, somewhere, from becoming the standard?

Many other expressions in accounting need explanation and clarification for the public. They include such words as “concepts,” “principles,” “practices,” “procedures,” “assets,” “liabilities,” “income,” and “materiality.”

Until the profession deals with all these matters satisfactorily, first for itself and then for understanding by the consumer of its product, there will continue to be an awkward failure of communication in a field where clear communication is vital.⁷³

Accounting Principles Board Statement No. 4.

Issued in October 1970, APB Statement No. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises, was the Board's response to the Seidman Committee's recommendations. For those who had hoped for definitive answers to the Seidman Committee's questions or a statement of accounting's fundamental concepts and principles, APB Statement No. 4 was a disappointment. The Board gave every indication of having issued it primarily to comply, somewhat grudgingly, with the Seidman Committee's recommendations.

The definition of generally accepted accounting principles in APB Statement No. 4 and its description of their nature and how they become accepted, although couched in the careful language that characterized the Statement, merely reiterated what the Institute had been saying about them for over 30 years.

Generally accepted accounting principles incorporate the consensus^* at a particular time as to…[the items that should be recognized in financial statements, when they should be recognized, how they should be measured, how they should be displayed, and what financial statements should be provided].

…Generally accepted accounting principles encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time…. includ[ing] not only broad guidelines of general application, but also detailed practices and procedures.

Generally accepted accounting principles are conventional—that is, they become generally accepted by agreement (often tacit agreement) rather than by formal derivation from a set of postulates or basic concepts. The principles have developed on the basis of experience, reason, custom, usage, and, to a significant extent, practical necessity.⁷⁴

Generally accepted accounting principles were a mixture of conventions, rules, procedures, and detailed practices that were distilled from experience and identified as principles primarily by observing existing accounting practice.

The basic concepts in Chapters 3 to 5 of APB Statement No. 4 were a mixed bag. On one hand, the definitions of assets, liabilities, and other “basic elements of financial accounting” were what George J. Staubus, who gave the Statement a generally positive review, called the Definitions Mess. All of the definitions were defective because the only essential distinguishing characteristic of assets (or liabilities) was that they were “recognized and measured as assets [or liabilities] in conformity with generally accepted accounting principles,” and the other definitions depended on the definitions of assets and liabilities.⁷⁵

On the other hand, the basic concepts also included new ideas (at least for Institute pronouncements) and normative propositions, and at least some of the concepts looked to what financial accounting ought to be in the future, not just to what it already was. These are examples:

The basic purpose of financial accounting is to provide information that is useful to owners, creditors, and others in making economic decisions (paragraphs 40 and 73).
Financial accounting is shaped to a significant extent by the nature of economic activity in individual business enterprises (paragraph 42).
The transactions and other events that change an enterprise's resources, obligations, and residual interest include exchange transactions, nonreciprocal transfers, and other external events as well as production and other internal events (paragraph 62).
Certain qualities or characteristics such as relevance, understandability, verifiability, neutrality, timeliness, comparability, and completeness make financial information useful (paragraphs 23 and 87–105).
To make comparisons between enterprises as meaningful as possible, “differences between enterprises' financial statements should arise from basic differences in the enterprises themselves or from the nature of their transactions and not merely from differences in financial accounting practices and procedures” (paragraph 101).

Anyone familiar with the report of the Trueblood Study Group on objectives of financial statements and the FASB's conceptual framework will recognize that those and similar ideas later appeared in one or both of those sources.

Nevertheless, in describing itself, APB Statement No. 4 virtually ignored that it contained anything that was new, normative, or forward-looking, emphasizing instead that it looked only at the present and the past, even in describing its basic concepts. The Board was adamant that it had not passed judgment on the existing structure and apparently was almost equally reluctant to admit that it had broken new ground:

The Statement is primarily descriptive, not prescriptive. It identifies and organizes ideas that for the most part are already accepted…. [T]he Statement contains two main sections that are essentially distinct—(a) Chapters 3–5 on the environment, objectives, and basic features of financial accounting and (b) Chapters 6–8 on present generally accepted accounting principles. The description of present generally accepted accounting principles is based primarily on observation of accounting practice. Present generally accepted accounting principles have not been formally derived from the environment, objectives, and basic features of financial accounting [that is, from the basic concepts.]^*

The aspects of the environment selected for discussion are those that appear to influence the financial accounting process directly. The objectives of financial accounting and financial statements discussed are goals toward which efforts are presently directed. [Emphasis added.] The accounting principles described are those that the Board believes are generally accepted today. The Board has not evaluated or approved present generally accepted accounting principles except to the extent that principles have been adopted in Board Opinions. Publication of this Statement does not constitute approval by the Board of accounting principles that are not covered in its Opinions. [Emphasis in the original.] [paragraphs 3 and 4]

The expected contribution of the basic concepts in the Statement was generally vague, and still in the future.

The Statement is a step toward development of a more consistent and comprehensive structure of financial accounting and of more useful financial information. It is intended to provide a framework within which the problems of financial accounting may be solved, although it does not propose solutions to those problems and does not attempt to indicate what generally accepted accounting principles should be. Evaluation of present accounting principles and determination of changes that may be desirable are left to future pronouncements of the Board. [paragraph 6]

Those paragraphs seemed to deflate unduly the most laudable parts of the Statement, almost as if the Board had gone out of its way to disparage the effort or otherwise to lower expectations about it. Instead of emphasizing that APB Statement No. 4 had begun to lay a basis for delineating what accounting ought to be and suggesting positive steps needed to build on it, the Board chose to characterize the Statement as primarily descriptive, thereby casting it into the category of uncritical description of what accounting already was. Once again, accounting principles had been defined as being essentially the product of experience.

However, there were by then too many people within and outside the profession who could no longer be satisfied with that view of accounting principles. Principles distilled from experience could lead only so far, and that point had long since been reached. For 15 to 20 years, principles distilled from experience had created more problems than they had solved, and a growing number of people interested in accounting principles had become convinced that principles had to be defined to mean a higher order of things than conventions or procedures. Dissatisfaction with the APB's performance in this area was mounting, and there was increasing pressure for the Board to state “the objectives of financial statements” as a basis for moving forward.

(iii) End of the Accounting Principles Board

At the same time, the APB was constantly under pressure from the SEC and others to confront current, specific problems encountered in practice and to issue Opinions on subjects seemingly far removed from the domain of principles, such as the presumed overstating of sales prices in some real estate sales with long-term financing, accounting for nonmonetary transactions, and reporting the effects of disposing of a segment of a business.

The SEC's urgency to deal with specific practice problems and widespread criticism of the use of the pooling of interests method influenced the APB and its staff to expend extra effort to produce an opinion on a highly controversial subject—accounting for business combinations—on which the Accounting Research Division had completed two related ARS: No. 5, A Critical Study of Accounting for Business Combinations, by Arthur R. Wyatt, and No. 10, Accounting for Goodwill, by George R. Catlett and Norman O. Olson.

Although the Board worked diligently and analyzed the problems about as well as could be expected in the absence of postulates and principles or other conceptual foundation, it became hopelessly deadlocked. It could find no solutions acceptable to a two-thirds majority to the problems of choosing between the purchase and pooling of interests methods for accounting for a business combination and of whether and how to capitalize goodwill and, if capitalized, whether to amortize it. Yet, it felt compelled to issue an Opinion because the SEC was almost certain to issue its own rule if the APB failed to do so.

The experience produced two Opinions in 1970, APB Opinion No. 16, Business Combinations, and No. 17, Intangible Assets, as well as more intense criticism of, and threats of legal action against, the Board. In a section entitled “Opinions 16 and 17—Vesuvius Erupts,” Stephen A. Zeff reported that neither the Board's “hard-won compromise” nor the “'pressure-cooker' manner in which it was achieved” pleased anyone. “These two Opinions, perhaps more than any other factor, seem to have been responsible for a movement to undertake a comprehensive review of the procedure for establishing accounting principles.”⁷⁶

In January 1971, AICPA president Marshall S. Armstrong convened a conference to consider how the Institute might improve the process of establishing accounting principles, and two study groups were appointed to explore ways of improving financial reporting. The group chaired by Francis M. Wheat was formed to “examine the organization and operation of the APB and [to] determine what changes are necessary to attain better results faster.”⁷⁷ The Wheat Group was primarily concerned with the processes and means by which accounting principles should be established. The Accounting Objectives Study Group, under the chairmanship of Robert M. Trueblood, was organized to review the objectives of financial statements and the technical problems in achieving those objectives.

The APB's days were numbered, although that was not yet clear, and perhaps not even suspected, in 1971, and the Board went on with its work. It issued almost half of its total of 31 Opinions after wheels were put in motion to develop an alternative structure that would eventually replace it.

Despite the criticisms the APB received for Opinions Nos. 16 and 17 and others and although some of its Opinions provided only partial solutions that would need to be revisited in the future, on balance its Opinions were successful. In several problem areas, the APB succeeded in remedying, sometimes almost completely and often to a significant degree, the greatest ill of the time by carrying out the charge it received at its creation: “to determine appropriate practice and to narrow the areas of difference and inconsistency in practice.”⁷⁸ APB Opinions such as No. 9, Reporting the Results of Operations; No. 18, The Equity Method of Accounting for Investments in Common Stock; and No. 20, Accounting Changes, laid to rest long-standing controversies. APB Opinion No. 22, Disclosure of Accounting Policies, required implementation in 1972 of one of the key recommendations made in Audits of Corporate Accounts in 1932: Each company would disclose which methods it was using. Some of the most controversial APB Opinions—such as No. 5, Reporting of Leases in Financial Statements of Lessee; No. 8, Accounting for the Cost of Pension Plans; No. 11, Accounting for Income Taxes; No. 16, Business Combinations; No. 17, Intangible Assets; No. 21, Interest on Receivables and Payables; and No. 26, Early Extinguishment of Debt—caused some consternation and often fierce opposition, but both industry and public accountants learned to live with them, and later the FASB encountered opposition when it proposed changing some of them.

The report of the Wheat Group in March 1972, Establishing Financial Accounting Standards, concluded that many of the APB's problems were fatal flaws. The APB was weakened by nagging doubts about its independence, the inability of its part-time members to devote themselves entirely to the important problems confronting it, and the lack of coherence and logic of many of its pronouncements, which resulted from having to compromise too many opposing points of view. The group's solution was directed toward remedying those flaws, which, in its opinion, required a new arrangement.

The Wheat Report proposed establishment of a Financial Accounting Foundation, with trustees whose principal duties would be to appoint the members of a FASB and to raise funds for its operation. The Board would comprise seven members, all of whom would be salaried, full time, and unencumbered by other business affiliations during their tenure on the Board, and some of whom would not have to be CPAs. The group recommended “Standards” Board rather than “Principles” Board because

the APB (despite the prominence in its name of the term “principles”) has deemed it necessary throughout its history to issue opinions on subjects which have almost nothing to do with “principles” in the usual sense [which “connotes things basic and fundamental, of a sort which can be expressed in few words, relatively timeless in nature, and in no way dependent upon changing fashions in business or the evolving needs of the investment community”].⁷⁹

“Standard”—which connotes something established by authority or common consent as a pattern or model for guidance or a basis of comparison for judging quality, quantity, grade, level, and so on, and may need to be spelled out in some detail—was more descriptive than “principles” for most of what the APB did and what the FASB was expected to do.

The Wheat Group's diagnosis of the APB's terminal condition became the popular explanation, but it was not the only one. Oscar S. Gellein, a member of the APB during its final years and a member of the FASB during its early years, offered a perceptive analysis:

The conditions most often identified with the problems of the APB were perceived conflicts of interests causing a waffling of positions and part-time effort where full-time effort was needed. In retrospect, those probably were not as significant as the absence of a structure of fundamental notions that would elevate the level at which debate begins and provide assurance of considerable consistency to the standards pronounced. The APB repetitively argued fundamentals. The same fundamentals were argued in taking up projects near the end of its tenure as were argued in connection with early projects. Even the most fundamental of fundamentals—assets, liabilities, revenue, expense—were never defined nor could the definitions be inferred from APB pronouncements.⁸⁰

Thus, it may have been the Board's continual rejection of the ineluctable need to develop an underlying philosophy as a basis for accounting principles in favor of the Committee on Accounting Procedure's “brush fire” approach that most directly contributed to the way it was perceived and ultimately to its demise. The APB had never been able to achieve a consensus on the conceptual aspects of its work, which had effectively been pushed aside by the Board's efforts to narrow the areas of difference in accounting practice by a problem-by-problem treatment of pressing issues. Although the ARS on basic postulates and broad principles of accounting and APB Statement No. 4 had made conceptual contributions that would prove fruitful in the hands of the Study Group on the Objectives of Financial Statements and the FASB, the APB steadfastly refused to take credit for, or even acknowledge, those contributions. Thus, accounting was still without a statement of fundamental principles at the end of the APB's tenure, and its absence would continue to plague the profession until the FASB, mostly on its own initiative, did something about it.

(d) Financial Accounting Standards Board Faces Defining Assets and Liabilities

The FASB, which was not part of the AICPA, began operations in Stamford, Connecticut, on January 2, 1973, with Marshall S. Armstrong, the first chairman, and a small staff. The other six Board members and additional staff joined the group during the first half of the year, and the FASB was fully operational by the time it succeeded the APB at midyear.

Meanwhile, the Institute had approved a restated code of professional ethics that in a new Rule 203 covered for the first time infractions of the recommendations adopted by Council in 1964 regarding disclosure of departures from APB Opinions:

A member shall not express an opinion that financial statements are presented in conformity with generally accepted accounting principles if such statements contain any departure from an accounting principle promulgated by the body designated by Council to establish such principles.

Council at its May 1973 meeting designated the FASB as the body to establish principles covered by Rule 203. The APB issued its final two Opinions—No. 30 and No. 31—and went out of business on June 30, 1973.

Later that year, the SEC's ASR No. 150, Statement of Policy on Establishment and Improvement of Accounting Principles and Standards, reaffirmed the policy set forth 35 years earlier in ASR 4 and declared that the Commission would recognize FASB Statements and Interpretations as having, and contrary statements as lacking, substantial authoritative support.

The FASB set its first technical agenda of seven projects in early April 1973, including a project called Broad Qualitative Standards for Financial Reporting. The Board undertook the project in expectation of receiving the report of the Trueblood Study Group, noting:

[A]s [the Board] develops specific standards, and others apply them, there will be a need in certain cases for guidelines in the selection of the most appropriate reporting…. [and] the report of the special AICPA committee on objectives of financial statements chaired by Robert Trueblood will be of substantial help in this project.⁸¹

The FASB received the report of the Trueblood Study Group, Objectives of Financial Statements, in October 1973.⁸² The Study Group had concluded:

Accounting is not an end in itself…. [T]he justification for accounting can be found only in how well accounting information serves those who use it. Thus, the Study Group agrees with the conclusion drawn by many others that “The basic objective of financial statements is to provide information useful for making economic decisions.” [p. 61]

The report's other 11 objectives were more specific; for example, the next two identified the purposes of financial statements with meeting the information needs of those with “limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise's economic activities” and with providing information useful to actual and potential owners and creditors in making decisions about placing resources available for investment or loan (p. 62). The report also included a group of seven “qualitative characteristics of reporting” that information “should possess…to satisfy users' needs” (p. 57).

Soon afterward, the FASB announced that the scope of “Broad Qualitative Standards for Financial Reporting” had been broadened because

[m]embers of the Standards Board believe that the…project should encompass the entire conceptual framework of financial accounting and reporting, including objectives, qualitative characteristics and the information needs of users of accounting information.⁸³

The Board also for the first time used the title “Conceptual Framework for Accounting and Reporting.”

(i) Were They Assets? Liabilities?

In the meantime, two other original projects confronted the new Board with the key questions of what constituted and what did not constitute an asset or a liability. The FASB's first technical agenda included some unfinished projects inherited from the APB. One was on accounting for research and development and similar costs, which eventually resulted in FASB Statement No. 2, Accounting for Research and Development Costs (October 1974), and FASB Statement No. 7, Accounting and Reporting by Development Stage Enterprises (June 1975); the other was on accruing for future losses, which eventually resulted in FASB Statement No. 5, Accounting for Contingencies (March 1975). Principal questions raised by those projects were: Do expenditures for research and development, start-up, relocation, and the like result in assets? Do “reserves for self-insurance,” “provisions for expropriation of overseas operations,” and the like constitute liabilities? decreases in assets?

The Board quite naturally turned to the definitions of assets and liabilities in APB Statement No. 4, which were the pertinent definitions in the authoritative accounting pronouncements. The definitions proved to be of no use to the FASB in deciding the major questions raised by the projects or to anyone else in trying to anticipate how the Board would decide the issues in the two projects.

The Board had to turn elsewhere for useful definitions of assets and liabilities to resolve the issues in those projects, and Board members learned that an early priority of the Board's conceptual framework project would have to be providing definitions of assets and liabilities and other elements of financial statements to fill a yawning gap in the authoritative pronouncements.

The reasons that the FASB found the definitions of assets and liabilities in APB Statement No. 4 to be useless underlay the Board's subsequent actions on the conceptual framework project. The related topics, the proliferation of questionable deferred charges and credits, the pervasive influence of the belief in “proper matching to avoid distorting periodic net income,” and the common use of the expressions “assets are costs” and “costs are assets” help explain not only why Board members took the initiative in establishing a conceptual framework for financial accounting and reporting but also why the Board adopted the basic concepts that it did. Robert T. Sprouse used the term what-you-may-call-its to describe certain deferred charges and deferred credits routinely included in balance sheets as assets and liabilities without much consideration of whether they actually were assets or liabilities,⁸⁴ and the name has become widely used; expressions such as “proper matching,” “nondistortion of periodic net income,” and “assets are costs” originated in the 1930s and 1940s, as noted in describing the influence of the AAA on U.S. accounting practice, and became widely used in the 1950s, 1960s, and 1970s.

Assets, Liabilities, and What-You-May-Call-Its.

The introduction to the definitions of assets and liabilities in APB Statement No. 4 said: “The basic elements of financial accounting—assets, liabilities …—are related to…economic resources, economic obligations …” (paragraph 130), suggesting that the Statement's discussion of economic resources and obligations provided a basis for the definitions of assets and liabilities. The Statement did define economic resources and economic obligations in a way that both accountants and nonaccountants would understand them to be, or to be synonymous with, what they also generally understood to be assets and liabilities:

Economic resources are the scarce means (limited in supply relative to desired uses) available for carrying on economic activities. The economic resources of a business enterprise include: 1. Productive resources…the means used by the enterprise to produce its product…2. Products… . 3. Money 4. Claims to receive money 5. Ownership interests in other enterprises.

The economic obligations of an enterprise at any time are its present responsibilities to transfer economic resources or provide services to other entities in the future…. Economic obligations include: 1. Obligations to pay money 2. Obligations to provide goods or services. (paragraphs 57 and 58)

Moreover, the first sentence of the parallel definitions of assets and liabilities in paragraph 132 did identify assets with economic resources and liabilities with economic obligations:

in conformity with generally accepted accounting principles.

The second sentence of the definitions broke the relationships between assets and economic resources and between liabilities and economic obligations, however, by including what-you-may-call-its in both assets and liabilities:

but that are recognized and measured in conformity with generally accepted accounting principles.

The definitions actually defined nothing: Assets were whatever (economic resources and what-you-may-call-its) generally accepted accounting principles recognized and measured as assets, and liabilities were whatever (economic obligations and what-you-may-call-its) generally accepted accounting principles recognized and measured as liabilities. The definitions also were circular: Since the FASB was the body responsible for determining generally accepted accounting principles, research and development costs would be assets, and self-insurance reserves would be liabilities, if the Board said they were.

Nevertheless, APB Statement No. 4's definitions of assets and liabilities actually were descriptions of items recognized as assets and liabilities in practice. But why should balance sheets include as assets and liabilities items that lacked essential characteristics of what most people would understand to be assets and liabilities—items that involved no scarce means of carrying out economic activities, such as consumption, production, or saving, or items that involved no obligations to pay cash or provide goods or services to other entities?

Proper Matching to Avoid Distorting Periodic Net Income.

The Board issued a Discussion Memorandum—a neutral document that describes issues and sets forth arguments for and against particular solutions or procedures but gives no Board conclusions—for each of the two projects and scheduled public hearings. At the hearings, respondents to the Discussion Memorandums were able to explain or clarify their analyses of the issues, and Board members could ask questions to pursue certain points made in comment letters and otherwise make sure they understood respondents' proposed solutions to the issues raised by the Discussion Memorandums and their underlying reasoning.

The Board discovered in the comment letters and the hearings that many respondents were less interested in what constituted assets and liabilities than in whether capitalizing and amortizing research and development costs and accruing self-insurance reserves “properly matched” costs with revenues and thus did not “distort periodic net income.” Many of the respondents argued that “proper matching” required research and development and similar costs to be capitalized and amortized over their useful lives. Similarly, many argued that “proper matching” required self-insurance and similar costs to be accrued or otherwise “provided for” each period, whether or not the enterprise suffered damage from fire, earthquake, heavy wind, or other cause during the period. Unless the Board required proper matching of costs and revenues, many respondents counseled, periodic income of the affected enterprises would be distorted.

Board members were largely frustrated in their attempts to pin down what respondents meant by “proper matching” and “periodic income distortion,” but the reasons for the proliferation of what-you-may-call-its emerged clearly. The following four snippets paraphrase what Board members heard at the hearings on research and development and similar costs and accounting for contingencies. Two of them are clear standing alone; two are understandable only if the questions being answered also are included.

1. Q. In other words, you would focus on the measurement of income? You would not be concerned about the balance sheet?

A. Yes. I think that is the major focus.

2. Much of the controversy over accrual of future loss has focused on whether a company had a liability for future losses or not. However, the impact on income should be overriding. The credit that arises from a provision for self-insurance is not a liability in the true sense, but that in and of itself should not keep it out of the balance sheet. APB Opinion No. 11 recognized deferred tax credits in balance sheets even though all agreed that the credit balances were not liabilities. Income statement considerations were considered paramount in that case, and similar thinking should prevail in accounting for self-insurance.

3. Defining assets does not really solve the problem of accounting for research and development expenditures and similar expenses. If some items that do not meet the definition of an asset are included in expenses of the current period, they may well distort the net income of that period because they do not relate to the revenues of that period. That accounting also may distort the net income of other periods in which the items more properly belong. The Board should focus on deferrability that gets away from the notion of whether or not those costs are assets and concentrates on the impact of deferral on the determination of net income.

4. Q. One of your criteria for capitalization is that net income not be materially distorted. Do you have any operational guidelines to suggest regarding material distortion?

A. The profession has been trying to solve that one for a great many years and has been unsuccessful. I really do not have an answer.

Q. Then, is material distortion a useful criterion that we can work with?

A. Yes, I believe it is. Despite the difficulty, I think it is necessary to work with that criterion. It is a matter of applying professional judgment.⁸⁵

Board members were not satisfied with the kinds of answers just illustrated.

Members of the FASB concluded early that references to vague notions such as “avoiding distortion” and “better matching” were neither an adequate basis for analyzing and resolving controversial financial accounting issues nor an effective way to communicate with one another and with the FASB's constituency.⁸⁶

Many of the responses indeed were vague, and it soon became clear that proper matching and distortion of periodic net income were largely in the eye of the beholder. Respondents said essentially that although they had difficulty in describing proper matching and distorted income, they knew them when they saw them and could use professional judgment to assure themselves that periodic net income was determined without distortion in individual cases. The thinking and practice described in the comment letters and at the hearings seemed to make income measurement primarily a matter of individual judgment and provided no basis for comparability between financial statements. To Board members, the arguments for including in balance sheets items that could not possibly qualify as assets or liabilities—what-you-may-call-its—sounded a lot like excuses to justify smoothing reported income, thereby decreasing its volatility.

The experience generally strengthened Board members' commitment to a broad conceptual framework—one beginning with objectives of financial statements and qualitative characteristics (the Trueblood Report) and also defining the elements of financial statements and including concepts of recognition, measurement, and display—and affected the kind of concepts it would comprise.

(ii) Nondistortion, Matching, and What-You-May-Call-Its

The proliferation of what-you-may-call-its and durability of apparently widely held and accepted notions of accounting such as the overriding importance of “avoidance of distortion of periodic income” and “proper matching of costs with revenues” were the legacy of 40 years of accountants' emphasis on the accounting process and accounting procedures instead of on the economic things and events on which financial accounting is supposed to report. As a result, an accounting convention or procedure with narrow application but a catchy name was elevated to the focal point of accounting: Matching of costs and revenues to determine periodic net income for a period became the major function of financial accounting, and whatever was left over from the matching procedure (mostly “unexpired” costs and “unearned” receipts) was carried over to future periods as assets or liabilities, depending on whether the leftover items were debits or credits.

Although Paton and Littleton's AAA monograph, An Introduction to Corporate Accounting Standards (1940), popularized the term matching of costs and revenues and provided existing practice with what many saw as a theoretical basis that previously had been lacking, the roots of the emphasis on proper matching and nondistortion of periodic net income were older. For example, the basic rationale—that the single most important function of financial accounting was determination of periodic net income and that the function of a balance sheet was not to reflect the values of assets and liabilities but to carry forward to future periods the costs and credits already incurred and received but needed to determine net income of future periods—appeared in the report of the Institute's Special Committee on Cooperation with Stock Exchanges:

It is probably fairly well recognized by intelligent investors today that the earning capacity is the fact of crucial importance in the valuation of an industrial enterprise, and that therefore the income account is usually far more important than the balance-sheet. In point of fact, the changes in the balance-sheets from year to year are usually more significant than the balance-sheets themselves.

The development of accounting conventions has, consciously or unconsciously, been in the main based on an acceptance of this proposition. As a rule, the first objective has been to secure a proper charge or credit to the income account for the year, and in general the presumption has been that once this is achieved the residual amount of the expenditure or the receipt could properly find its place in the balance-sheet at the close of the period, the principal exception being the rule calling for reduction of inventories to market value if that is below cost.⁸⁷

That thinking led in two related directions that came together only later as the argument that proper matching was needed to avoid distorting periodic net income, which was so popular in the comment letters and hearings on whether to defer research and development expenditures or accrue future losses. The nondistortion and matching arguments seem to have developed separately in the 1940s and 1950s and made common cause only later.

Nondistortion and the Balance Sheet as Footnote.

Since the purpose of income measurement was to indicate the earning power of an enterprise as well as to help appraise the performance of the enterprise and the effectiveness of management, periodic income was expected to be an indicator of the long-run or normal trend of income. The usefulness of the net income of a period as a long-run or normal measure was distorted therefore by including in it the effects of unusual or random events—gains or losses with no bearing on normal performance because they were extraordinary, caused by chance, or tended to average out over time—that could cause significant extraneous fluctuations in reported net income.

Emphasis on nondistortion of periodic net income surfaced in discussions of the effects of extraordinary and nonrecurring gains and losses in comparing the current operating performance and all-inclusive or clean-surplus theories of income, briefly described earlier, but also was later applied to accounting for recurring transactions and other events. The emphasis on stability and nondistortion of reported net income seems to have increased in the late 1940s and 1950s. Herman W. Bevis, who described the need to avoid distorting periodic net income in more detail and with more careful terminology than many accountants, set forth the underlying philosophy.

If the corporation watches the general economy, the latter also watches the corporation. For example, one of the important national economic indicators is the amount of corporate profits (and the dividends therefrom). Fluctuations in this particular index have important implications both for the private sector and with respect to the government's revenues from taxation; they also have a psychological effect on the economic mood of the nation. There is no doubt that, given a free choice between steadiness and fluctuation in the trend of aggregate corporate profits, the economic well-being of the nation would be better served by the former. Thus…society will welcome any contribution that the accounting discipline can make to the avoidance of artificial fluctuations in reported yearly net incomes of corporations. Conversely, the creation by accounting of artificial fluctuations will be open to criticism.⁸⁸

The primary accounting tool for avoiding artificial fluctuations was accrual accounting, which “reflects the fact that the corporation's activities progress much more evenly over the years than its cash outflow and inflow” and “attempts to transfer the income and expense effect of cash receipts and disbursements, other transactions, and other events from the year in which they arise to the year or years to which they more rationally relate.”⁸⁹ However, accrual accounting was sometimes too general, and further guidance was needed. Bevis described four guidelines for repetitive transactions and events, which had been developed out of long experience, beginning with the transaction guideline and the matching guideline:

1. Record the effect on net income of transactions and events in the period in which they arise unless there is justification for recording them in some other period or periods.

2. Where a direct relationship between the two exists, match costs with revenues.⁹⁰

To Bevis, in contrast to most accountants of the time, who tended to describe matching of costs and revenues very broadly, the matching guideline was of restricted application because “matching attempts to make a direct association of costs with revenues.” Its application to a merchandising operation was obvious: “Carrying forward of the inventory of unsold merchandise so as to offset its cost against the revenue from its sale is clearly useful in determining the net income of each of the two years,” although its use with some costing methods, such as LIFO, was at least questionable. Another clear application was to “the effecting of a sale [which] can be matched with a liability to pay a sales commission.” Otherwise, however, “the ordinary business operation is so complex that revenues are the end product of a variety of corporate activities, often over long periods of time; objective evidence is lacking to connect the cost of most of the activities with any particular revenues.” To emphasize that the matching guideline applied “to relatively few types of items,” Bevis illustrated the kind of situations to which it clearly did not apply: “The matching guideline can become potentially dangerous when it attempts to match today's real costs with hopes of tomorrow's revenues, as in deferring research and development costs to be matched against hoped-for, but speculative, future revenues.”⁹¹

In viewing matching narrowly, Bevis essentially agreed with George O. May, to whose memory the book was dedicated. May (in a report written with Oswald W. Knauth for the Study Group on Business Income) noted that it had become common, especially in academic circles, “to speak of income determination as being essentially a process of ‘matching costs and revenues’ ” but warned: “Only in part are costs ‘matched’ against revenues, and ‘matching’ gives an inadequate indication of what is actually done…. [I]t would be more accurate to describe income determination as a process of (1) matching product costs against revenues, and (2) allocating other costs to periods.”⁹²

Bevis also noted that the matching guideline was “sometimes confused with the allocation of costs to periods. Taxes, insurance, or rent, for example, may be paid in advance and properly allocated to the years covered. However, this allocation is to a period, and one would be hard pressed to establish any direct connection between—i.e., to match—these costs and specific sales of the period to which they are allocated.” Those kinds of allocations came not under the matching guideline but rather under the much broader systematic and rational guideline:

3. Where there is justification for allocating amounts affecting net income to two or more years, but there is no direct basis for measuring how much should be associated with each year, use an allocation method that is systematic and rational.⁹³

An essential companion of the systematic and rational guideline was the nondistortion guideline:

4. From among systematic and rational methods, use that which tends to minimize distortions of periodic net income.⁹⁴

Illustrations of “specific allocation practices that are designed to avoid or minimize distortions of net income among years” included self-insurance provisions, provisions for costs of dry-docking ships for major overhauls, and provisions for costs of relining of blast furnaces. For all of them, “a rational practice is to spread the costs over a reasonable period of time.”

All three of the nondistortion practices described were potential what-you-may-call-its—deferred credits that did not qualify as liabilities. They were recognized not because they were liabilities incurred by the enterprise but because they would lessen the volatility of reported net income.

As already noted in describing the hearing on accruing future losses, not even those who advocated accruing self-insurance provisions and reserves argued that the reserves were liabilities. They argued for accruing the reserves to ensure proper matching and to avoid distorting periodic net income despite the fact that the resulting reserves were not liabilities. Similarly, the effect on net income, “to spread the costs over a reasonable period of time,” was the principal consideration in accruing provisions for dry-docking ships and relining blast furnaces.

An enterprise does not incur a liability for costs that later will be expended in dry-docking a ship or relining a blast furnace by operating the ship or using the furnace. Rather, it begins to incur the pertinent liabilities only when it dry-docks the ship and begins to scrape off the barnacles or otherwise overhaul her or when it shuts down the furnace and starts the relining, but certainly not before making a contract with one or more other entities to do the work.

Costs of dry-docking a ship or relining a furnace might legitimately be recognized between dry-dockings or relinings by recognizing them as decreases in the carrying amount of the asset because accumulations of barnacles reduce the ship's efficiency or use of the furnace wears out the lining, but proponents of accruing costs to avoid distortion of periodic net income usually have not argued that way. Since their attention has focused almost entirely on the effect on reported net income, they have not been much concerned with “niceties” of whether periodically recognizing the cost increased liabilities or decreased assets. They have been likely to dismiss questions of that kind on the grounds that they are “merely geography” in the financial statements—an insignificant detail. Lack of concern about assets and liabilities was a distinguishing characteristic of true believers in the matching or nondistortion “gospel.”

Bevis reflected that kind of focus on nondistortion of periodic net income and lack of concern about the resulting balance sheet:

[T]he amounts at which many assets and liabilities are stated in the balance sheet are a by-product of methods designed to produce a fair periodic net income figure. The objective is not to produce a liquidating value or a current fair market value of assets. This approach is consistent with the primary interest of the stockholder in periodic income, as opposed to liquidating or “pounce” values in a not-to-be-liquidated enterprise.⁹⁵

Indeed, he came up with the most imaginative—and pertinent—description in the entire nondistortion and proper-matching literature of the way proponents see a balance sheet—as a footnote to an income statement:

[T]wo-thirds of the items on the asset side of the balance sheet [a “Composite Statement of Financial Position” of “100 Large Industrial Corporations” in the Appendix]…are not assets in the sense of either being or expected to be directly converted to cash. They represent a huge amount of “deferred costs,” mostly past cash expenditures, which are to be included as costs in future income statements…. Among all the footnotes explaining and elaborating on the income statement, this makes the balance sheet the biggest footnote of all.⁹⁶

The same idea had been expressed less flatteringly by Professor William Baxter of the University of London (London School of Economics):

[A group] of accountants bent on belittling the balance-sheet and elevating the revenue account…tend to dismiss the balance-sheet as a mere appendage of the revenue account—a mausoleum for the unwanted costs that the double-entry system throws up as regrettable by-products.⁹⁷

Although Bevis defined matching narrowly and gave it only a limited place in periodic income determination, relying more on the rational and systematic guideline and the nondistortion guideline, his was probably a minority view. Most accountants who have emphasized the need for nondistorting income determination procedures have considered careful timing of recognition of revenues and expenses by proper matching to be critical in avoiding distortion of periodic income.

Proper Matching and “Assets Are Costs.”.

In contrast to Bevis's and May's narrow definitions of matching, most accountants have described matching of costs and revenues broadly, making matching either (1) one of two central functions of financial accounting or (2) the central function of financial accounting. Either way, matching encompasses allocations of costs using systematic and rational procedures, such as depreciation and amortization, which Bevis explicitly excluded from matching.

Accountants of the first group, whose use of matching has been the narrower of the two, have described periodic income determination as a two-step process: revenue recognition or “realization” and matching of costs with revenues (expense recognition). To them, matching not only recognized perceived direct relationships between costs and revenues, such as between cost of goods sold (product costs) and sales, but also recognized perceived indirect relationships between costs and revenues through mutual association with the same period. The latter would include relationships such as those between, on one hand, costs recognized as expenses in the period incurred and depreciation and other costs allocated to the same period by a rational and systematic procedure and, on other hand, revenues allocated to the same period by “realization.” That is, matching encompassed both matching product costs with specific revenues (Bevis's and May's definitions) and what usually has been called allocation—matching other costs with periods. For example, this definition clearly encompassed both kinds of matching:

Matching is one of the basic processes of income determination; essentially it is a process of determining relationships between costs…and (1) specific revenues or (2) specific accounting periods.⁹⁸

Accountants of the second group have used matching of costs and revenues in the broadest possible sense—as a synonym for periodic income determination—making matching the central function of financial accounting. To them, matching encompassed both revenue recognition or “realization” and expense recognition. Matching dictated what has been included in income statements, as it did in both of these definitions:

matching 1. The principle of identifying related revenues and expense with the same accounting period.⁹⁹

By means of accounting we seek to provide these test readings [of progress made] by a periodic matching of the costs and revenues that have flowed past “the meter” in an interval of time.¹⁰⁰

The degree to which matching of costs and revenues had become the central function of financial accounting in the minds of many accountants by the time of the FASB's projects on research and development expenditures and similar costs and accruing future losses was indicated by Delmer Hylton's description in 1965, which was by no means an overstatement:

Concurrent with the ascendency of the income statement in recent years, we have also witnessed increasing emphasis on the accounting convention known as “matching revenue with expense.” In fact, it seems that most innovations in accounting in recent years have been justified essentially as better performing this matching process. In the minds of many accountants, this single convention outweighs all others; in other words, if a given procedure can be asserted to conform to the matching concept, nothing else need be said: the matter is settled and the procedure is justified.¹⁰¹

That is basically what Board members read and heard in the comment letters and public hearings on accounting for research and development expenditures and similar costs and accruing future losses. The need for proper matching of costs and revenues to avoid distorting periodic net income was the overriding consideration in many letters and in the prepared statements and answers of a significant number of those who appeared at the hearings and responded to Board members' questions. They showed little or no interest in whether research and development expenditures resulted in assets and whether reserves for self-insurance were liabilities.

Rather, those deferred charges and deferred credits belonged in the balance sheet because they were needed for proper matching to avoid distorting periodic net income. And what were most assets, anyway, except deferred or “unexpired” costs, as Paton and Littleton's monograph had said:

[A]ssets are costs. “Costs” are the fundamental data of accounting, and…. it is possible to apply the term “cost” equally well to an asset acquired, a service received, and a liability incurred. Under this usage assets, or costs incurred, would clearly mean charges awaiting future revenue, whereas expenses, or costs applied, would mean charges against present revenue.¹⁰²

That usage followed from the monograph's view that periodic income measurement was not only a process of matching costs and revenues but also the focal point of accounting.

The factors acquired for production which have not yet reached the point in the business process where they may be appropriately treated as “cost of sales” or “expense” are called “assets,” and are presented as such in the balance sheet…. [T]hese “assets” are in fact “revenue charges in suspense” awaiting some future matching with revenue as costs or expenses….

The fundamental problem of accounting…is the division of the stream of costs incurred between the present and the future in the process of measuring periodic income…. The balance sheet…serves as a means of carrying forward unamortized acquisition prices, the not-yet-deducted costs; it stands as a connecting link joining successive income statements into a composite picture of the income stream.¹⁰³

Long before the time of the FASB projects on research and development costs and self-insurance reserves, however, Paton had recognized that matching had become an obsession of many accountants. It had been carried much too far and had been the cause of downgrading the meaning and significance of assets.

For a long time I've wished that the Paton and Littleton monograph had never been written, or had gone out of print twenty-five years or so ago. Listening to Bob Sprouse take issue with the “matching” gospel, which the P & L monograph helped to foster, confirmed my dissatisfaction with this publication…. The basic difficulty with the idea that cost dollars, as incurred, attach like barnacles to the physical flow of materials and stream of operating activity is that it is at odds with the actual process of valuation in a free competitive market. The customer does not buy a handful of classified and traced cost dollars; he buys a product, at prevailing market price. And the market price may be either above or below any calculated cost….

For a long time I've been touting the idea that the central element in business operation is the resources (in hand or in prospect) and that the main objective of operation is the efficient utilization of the available assets.¹⁰⁴

His intermediate accounting textbook, published a mere dozen years after the monograph, was entitled Asset Accounting.¹⁰⁵

(iii) An Overdose of Matching, Nondistortion, and What-You-May-Call-Its

Board members had, as former chairman Donald J. Kirk once put it, cut their accounting teeth on matching, nondistortion, assets are costs, and similar notions. Some of them may have entertained some doubts about some of the ideas before serving on the Board, but it was the paramount importance that was attributed to those ideas in early comment letters and at the early hearings that made the Board increasingly uncomfortable with them. Those notions seemed to be open-ended; no one could explain the limits, if any, on matching or nondistortion procedures or how to verify that proper matching or nondistortion had been achieved. The experience made most, if not all, Board members highly skeptical about arguments that the need for proper matching to avoid distortion of periodic net income was the “be-all and end-all of financial accounting”¹⁰⁶ with little or no concern expressed about whether the residuals left over after matching actually were assets or liabilities.

Among other things, those early experiences had graphically demonstrated to Board members that once accountants had come to perceive assets primarily as costs, they often failed to distinguish assets in the real world from the entries in the accounts and financial statements. What-you-may-call-its were a consequence of the habit of using “costs” and “assets” interchangeably—“assets were costs; costs were assets”—without worrying about whether the costs actually represented anything in the real world.

The “Pygmalion Syndrome” (after the legendary sculptor who fell in love with his statue of a woman) was at work. That name was given by the noted physicist J. L. Synge to “the tendency of many people to confuse conceptual models of real-world things and events with the things and events themselves.”¹⁰⁷ Perhaps the most common example has been the habit of lawyers, accountants, corporate directors and officers, stockholders, and others to describe a dividend as paid “out of surplus (retained earnings).” That habit led a prominent lawyer to chide:

Distributions are never paid “out of surplus,” they are paid out of assets; surplus cannot be distributed—assets are distributed. No one ever received a package of surplus for Christmas.¹⁰⁸

The fact that the matching literature was so full of references to “unexpired” costs that “expired” when matched against revenues also caused a prominent professor of finance to admonish that accountants had confused matters by defining

depreciation as “expired capital outlay”—in other words, as “expired cost”—thereby transferring the word from a value to a cost category. But this definition was a dodge rather than a solution, and the fact that it still enjoys some currency among accounting writers who must be aware of its spurious character illustrates the tenacity of convenient though specious phrases. For cost does not “expire.” What may be said gradually to expire is the economic significance of the asset as it grows older, in short, its utility or its value. “Expired cost” is therefore mumbo jumbo, and a reversion to the old association of depreciation with loss in value would be a far more sensible alternative.¹⁰⁹

As Board members began to look at problems likely to come onto the Board's agenda, they began to see more what-you-may-call-its in their future. In addition to self-insurance reserves and provisions for removing barnacles from ships or relining blast furnaces, which have already been described, a significant number of what-you-may-call-its were part of existing practice in the early 1970s, had been or were being proposed to become part of practice, or had recently been proscribed:

Unamortized debt discount
Deferred tax credits and deferred tax charges
Deferred gains and losses on securities in pension funds
Deferred gains on translating foreign exchange balances (the APB issued in late 1971 an exposure draft of a proposal to permit deferral of losses on foreign exchange balances but dropped the subject without issuing an Opinion.)
Deferred gains or losses on sales of long-term investments
Deferred gains or losses on sale-and-leaseback transactions
Negative goodwill remaining after reducing to zero the noncurrent assets acquired in a business combination

Since several of those what-you-may-call-its were part of topics that might well come before the Board within a few years, Board members thought it essential to ensure that the Board would not have to face those kinds of matters without the necessary tools. They were not anxious to repeat their experiences with research and development expenditures and similar costs and accruing future losses. They not only wanted to get in place a broad conceptual framework to provide a basis for sound financial accounting standards but also had some firm ideas of the kinds of concepts that were needed.

Kirk later described his own thinking at the time, and other Board members probably would concur with most of what he said:

Among the projects on the Board's initial agenda were accounting for research and development costs and accounting for contingencies. The need for workable definitions of assets and liabilities became apparent in those projects and served as a catalyst for the part of the framework projects that became FASB Concepts Statement No. 3, Elements of Financial Statements of Business Enterprises (1980)….

To me, the definitions were the missing boundaries that were needed to bring the accrual accounting system back under control. The definitions have, I hope, driven a stake part way through the “nondistortion” guideline. But I am realistic enough to know, having dealt with the subjects of foreign currency translation and pension cost measurement, that the aversion to volatility in earnings is so strong that the notion of “nondistortion” will not die easily.¹¹⁰

Kirk's reference to volatility of reported net income was not accidental—that has been and will continue to be a major bone of contention between the FASB and its constituents. Managements have been and continue to be concerned that volatility of periodic net income will affect adversely the market prices of their enterprises' securities and hence their cost of capital. The Board's general response to that concern has been that accounting must be neutral, and if financial statements are to represent faithfully an entity's net income, the presence of volatility must be reported to investors and creditors. For example, former Board member Robert T. Sprouse probably expressed the thinking of many Board members:

I submit…that minimizing the volatile results of actual economic events should be primarily a matter for management policy and strategy, not a matter for accounting standards. To the extent volatile economic events actually occur, the results should be reflected in the financial statements. If it is true that volatility affects market prices of securities and the related costs of capital, it is especially important that, where it actually exists, volatility be revealed rather than concealed by accounting practices. Otherwise, financial statements do not faithfully represent the results of risks to which the enterprise is actually exposed.

To me, the least effective argument one can make in opposing a proposed standard is that its implementation might cause managers or investors to make different decisions…. The very reason for the existence of reliable financial information for lenders and investors…is to help them in their comparisons of alternative investments. If stability or volatility of financial results is an important consideration to some lenders and investors, all the more reason that the degree of stability or volatility should be faithfully reflected in the financial statements.¹¹¹

That kind of problem is nothing new. For example, almost 50 years earlier, Paton made essentially the same point as Sprouse in writing about the effects on income of the choice of inventory methods:

[Sanders, Hatfield, and Moore] quote, with apparent approval, the following statement from Arthur Andersen: “The practice of equalizing earnings is directly contrary to recognized accounting principles.” But…they go out of their way to support a European practice, the base-stock inventory method, which…has been vigorously revived and sponsored in recent years [in the United States] under the “last in, first out” label, which represents nothing more nor less than a major device for equalizing earnings, to avoid showing in the periodic reports the severe fluctuations which are inherent in certain business fields…. Actually, we do have good years and bad years in business, fat years and lean years. There is nothing imaginary about this condition—particularly in the extractive and converting fields, where this agitation centers…. It may be that in some situations the year is too short a period through which to attempt to determine net income (as surely the month and quarter often are), but if this is the case, the solution lies not in doctoring the annual report, but in lengthening the period. Certainly it is not good accounting to issue reports for a copper company, for example, which make it appear that the concern has the comparative stability of earning power of the American Telephone and Telegraph Co.¹¹²

The earlier description of the experiences of Board members that led them to support a broad conceptual framework project and to develop firm ideas about the kinds of concepts needed has focused on the projects on accounting for research and development expenditures and similar costs and accounting for contingencies, including accruing future losses. Those projects were highly significant experiences for Board members, as the preceding indicates, but later projects have provided additional or similar experiences. As the comments on volatility of income suggest, the education of Board members and members of the constituency is a continuing process in which the conceptual framework has been both a source of disagreement and controversy and a significant help in setting sound financial accounting standards.

(iv) Initiation of the Conceptual Framework

Confronted with the fruits of decades of the profession's lethargy and inability to fashion a statement defining accounting's most basic concepts, the FASB, on its own initiative and motivated by the experiences of its members, decided to undertake the development of a statement of basic concepts that went beyond the objectives of financial statements to definition, recognition, measurement, and display of the elements of financial statements. In 1973 it initiated a conceptual framework project that was intended to be at once both the reasoning underlying procedures and a standard by which procedures would be judged.

A deliberative, authoritative body with responsibility for accounting standards finally had decided to do what the Committee on Accounting Procedure and the APB had been implored to do but had never felt strongly was a part of their mission. The FASB concluded that accounting did possess a core of fundamental concepts that were neither subject to nor dependent on the moment's particular, transitory consensus. Accounting had achieved the stage in its development that made it imperative and proper to place before its constituents a definitive statement of its fundamental principles.

2.3 Financial Accounting Standards Board's Conceptual Framework

In an open letter to the business and financial community, which prefaced the booklet, Scope and Implications of the Conceptual Framework Project (December 2, 1976), Marshall S. Armstrong, the first chairman of the FASB, expressed some of the Board's aspirations for the conceptual framework project:

The conceptual framework project will lead to definitive pronouncements on which the Board intends to rely in establishing financial accounting and reporting standards. Though the framework cannot and should not be made so detailed as to provide automatically an accounting answer to a set of financial facts, it will determine bounds for judgment in preparing financial statements. The framework should lead to increased public confidence in financial statements and aid in preventing proliferation of accounting methods.

The excerpt highlighted a significant characteristic of the conceptual framework project. Although Board members were aware of the widespread criticism directed at the Committee on Accounting Procedure and the Accounting Principles Board for their collective inability to provide the profession with an enduring framework for analyzing accounting issues, the FASB's stimulus was entirely different from that of its predecessors. It was not reacting to instructions or recommendations to establish basic concepts by groups such as the AICPA's Special Committees on Research Program or Opinions of the APB, the Wheat Group, or the SEC. Rather, the Board undertook the self-imposed task of providing accounting with an underlying philosophy because Board members had concluded that to discharge their standards-setting responsibilities properly, they needed a set of fundamental accounting concepts for their own guidance in resolving issues brought before the Board.

The idea that the conceptual framework was intended to benefit the FASB by guiding its ongoing work in establishing accounting standards was embodied in the Preface, entitled “Statements of Financial Accounting Concepts,” to each Concepts Statement:

The Board itself is likely to be the most direct beneficiary of the guidance provided by the Statements in this series. They will guide the Board in developing accounting and reporting standards by providing the Board with a common foundation and basic reasoning on which to consider merits of alternatives.

Armed with the conviction that a coordinated set of pervasive concepts was prerequisite to establishing sound and consistent accounting standards, the FASB in late 1973 formally expanded the scope of its original concepts project, “Broad Qualitative Standards for Financial Reporting,” and changed its name. The new title—“Conceptual Framework for Accounting and Reporting: Objectives, Qualitative Characteristics and Information”—for the first time used the words “conceptual framework” by which the project would become identified.

The Board concluded at the outset that it was unrealistic to attempt to devise a complete conceptual framework and adopt it by a single Board action. It already had experienced an urgent need for a definitive statement about some of the most fundamental components of the envisioned conceptual framework—the objectives of financial reporting and definitions of the elements of financial statements. The absence of meaningful definitions of assets and liabilities in the accounting literature had already hindered the FASB's work on the other projects on its agenda.

The project was conceived as comprising six major parts, as illustrated by Exhibit 2.1. (A seventh part was added in 2000. See Subsection 2.3(b)(v).) The parts were expected to be undertaken in the order shown by moving down the pyramid and from left to right at each level.

Exhibit 2.1 FASB's Conceptual Framework for Financial Accounting and Reporting

The numbers in parentheses in Exhibit 2.1 reflect that although six Concepts Statements were issued, their numbers did not correspond to the order just described for the six boxes in the exhibit because (a) the Statement on qualities of useful information was finished before the Statement on elements of financial statements; (b) not-for-profit organizations were included within the scope of the framework, resulting in Concepts Statement No. 4, which pertained only to not-for-profit organizations, and in Concepts Statement No. 6, which amended Concepts Statement No. 2 and replaced Concepts Statement No. 3, making them applicable to not-for-profit organizations; and (c) little conceptual work was actually completed on the topics in the two lower levels of Exhibit 2.1, and what was done on all three topics was included in a single Concepts Statement, No. 5.

Exhibit 2.2 shows the six Concepts Statements by topic and date of issue and explains how they fit together in relation to Exhibit 2.1.

Exhibit 2.2 Six Concepts Statements

No. 1 “Objectives of Financial Reporting by Business Enterprises” (November 1978)
No. 2 “Qualitative Characteristics of Accounting Information” (May 1980)	No. 2 amended by No. 6 to apply to not-for-profit organizations as well as to business enterprises]
No. 3 “Elements of Financial Statements of Business Enterprises” (December 1980)	No. 3 superseded by No. 6, which applies to both business enterprises and not-for-profit organizations
No. 4 “Objectives of Financial Reporting by Nonbusiness Organizations” (December 1980)
No. 5 “Recognition and Measurement in Financial Statements of Business Enterprises” (December 1984)	No. 5 also briefly covers display in financial statements and disclosure in notes and other means of financial reporting
No. 6 “Elements of Financial Statements” (December 1985)

The conceptual framework constitutes the subject matter of the remainder of this chapter, which considers, among other things, the underlying philosophy of and emphasis in the framework, the effects on it of matters discussed earlier in the chapter, the ways that it has been and might be used by the FASB and others in improving financial accounting and reporting practice, and a more detailed look at some of the concepts. The discussion is divided into two sections: It looks at the conceptual framework first as a body of concepts that underlies financial accounting and reporting in the United States and then as five interrelated Concepts Statements, each focused on one of four parts of the framework: objectives of financial reporting, qualitative characteristics of accounting information, elements of financial statements, and recognition and measurement and display in financial statements.

(a) Framework as a Body of Concepts

The Concepts Statements as a group reflect a number of sources and other influences, most of which have already been introduced or otherwise noted, including:

The Trueblood Study Group's report, Objectives of Financial Statements (October 1973), whose 12 objectives and seven “qualitative characteristics of reporting” and supporting discussion and analysis directly affected the two Concepts Statements on objectives and the one on qualitative characteristics and indirectly affected the others
Board members' experiences in trying to set standards in the absence of an accepted conceptual basis, which was a significant factor both in the FASB's having a conceptual framework and in the kinds of concepts it comprises
Conceptual work of the APB and Accounting Research Division, primarily ARS 1 and 3 on basic postulates and broad principles of accounting and the basic concepts part of APB Statement No. 4
Conceptual work of others reported in the literature, including the work of individuals, the AAA's concepts and standards statements, and developments in Canada, the United Kingdom, Australia, New Zealand, and other countries
Conceptual work of the FASB itself, including preparatory work on its original concepts project and development of Discussion Memorandums and Exposure Drafts that led to the Concepts Statements and related projects, such as that on materiality; and the fruits of “due process,” such as some excellent comment letters and exchanges of views at a number of hearings

Some of the most fundamental concepts in the framework had their roots in those sources and influences. The three examples of fundamental concepts under the next three headings combine ideas from one or more Concepts Statements and illustrate those connections.

(i) Information Useful in Making Investment, Credit, and Similar Decisions

Financial accounting and reporting is not an end in itself but is intended to provide information that is useful to present and potential investors, creditors, other resource providers, and other users outside an entity in making rational investment, credit, and similar decisions about it.

The FASB generally followed the report of the Trueblood Study Group on objectives of financial statements in focusing the objectives of financial reporting on information useful in investment, credit, and similar decisions, instead of on information about management's stewardship to owners or information based on the operating needs of managers. The description of Concepts Statement No. 1 later in this chapter shows the influence of the Trueblood Study Group's objectives on the FASB's objectives.

That focus on information for decision making represented a fundamental change in attitude toward the purposes of financial statements. Before the Trueblood Study Group's report, APB Statement No. 4 was the only AICPA pronouncement identifying financial reporting with the needs of investors and creditors for decision making rather than with the traditional accounting purpose of reporting on management's stewardship. A vocal minority, which still is heard from occasionally, has insisted that the primary function of accounting by an enterprise is to serve management's needs and that the objectives should reflect that purpose. It has never been obvious why proponents of that view think that a body such as the APB or FASB should be establishing objectives and setting standards for information that is primarily for internal and private use and that management can require in whatever form it finds most useful. The message intended apparently is that management, not the APB, FASB, or similar body, should decide what information financial statements are to provide to investors, creditors, and others.

The Study Group, which may have been influenced to some extent by APB Statement No. 4, emphasized the role of financial statements in investors' and creditors' decisions and identified the purposes of financial statements with the decisions of investors and creditors, existing or prospective, about placing resources available for investment or loan. The Study Group's recommendations became the starting point for the FASB to build a conceptual framework.

(ii) Representations of Things and Events in the Real-World Environment

The items in financial statements represent things and events in the real world, placing a premium on representational faithfulness and verifiability of accounting information and neutrality of both standards setting and accounting information.

The FASB's decision to ground its concepts in the environment in which financial accounting takes place and the economic things, events, and activities that exist or happen there, instead of on accounting processes and procedures, was influenced significantly by Accounting Research Study 1 on basic postulates of accounting and the section of APB Statement No. 4 on basic concepts. The postulates in ARS 1 were, as already described, self-evident propositions about the environment in which accounting functions—a world that does exist and not one that is a fiction—that were fruitful for accounting.

For example, the observation that most of the goods and services produced in the United States are not directly consumed by their producers but are sold for cash or claims to cash suggests both why financial accounting is concerned with production and distribution of goods and services and with exchange prices and why investors, creditors, and other users of financial statements are concerned with cash prices and cash flows.

That focus of financial accounting on the environment and the things and events in it that are represented in financial statements constituted a fundamental change from the earlier emphasis on the conventional nature of accounting and the conventional procedures and allocations used to produce the numbers in financial statements. Thus, the Concepts Statements devote considerable space to describing activities such as producing, distributing, exchanging, saving, and investing in what they variously call the “real world,” “economic, legal, social, political, and physical environment in the United States,” or “U.S. economy,” and what is involved in representing those economic things and events in financial statements. Concepts Statement No. 1 notes a significant consequence of that focus on things and events in the environment that is pertinent to the definitions of the elements of financial statements.

The information provided by financial reporting pertains to individual business enterprises…. Since business enterprises are producers and distributors of scarce resources, financial reporting bears on the allocation of economic resources to producing and distributing activities and focuses on the creation of, use of, and rights to wealth and the sharing of risks associated with wealth. [paragraph 19]

Thus, the elements of financial statements are assets and liabilities and the effects of transactions and other events that change assets and liabilities—that change and transfer wealth.

(iii) Assets (and Liabilities)—Fundamental Element(s) of Financial Statements

The fundamental elements of financial statements are assets and liabilities because all other elements depend on them:

Equity is assets minus liabilities;

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Because liabilities depend on assets—liabilities are obligations to pay or deliver assets—assets is the most fundamental element of financial statements.

Soon after its inception, the FASB needed definitions of assets and liabilities and found many examples of two types of definition in the accounting literature.

Definitions of one type identified assets with economic resources and wealth, emphasizing the service potential, or benefits, and economic values that an asset confers on the holding or owning entity. Similarly, they identified liabilities with amounts or duties owed to other entities, emphasizing the payment or expenditure of assets required of the debtor or owing entity to satisfy the claim. They were definitions that described things that most people could recognize as assets and liabilities because they had experience in their everyday lives as well as in their business activities with rights to use economic resources and with obligations to pay debts.

Three sets of definitions of assets and liabilities by the AAA, Robert K. Mautz, and Eric L. Kohler, respectively,¹¹³ are examples of the numerous definitions the FASB considered that had those characteristics:

Assets are economic resources devoted to business purposes within a specific accounting entity; they are aggregates of service-potentials available for or beneficial to expected operations.	The interests or equities of creditors (liabilities) are claims against the entity arising from past activities or events which, in the usual case, require for their satisfaction the expenditure of corporate resources.
An asset may be defined as anything of use to future operations of the enterprise, the beneficial interest in which runs to the enterprise. Assets may be monetary or nonmonetary, tangible or intangible, owned or not owned.	Liabilities are claims against a company, payable in cash, in other assets, or in service, on a fixed or determinable future date.
asset Any owned physical object (tangible) or right (intangible) having economic value to its owner; an item or source of wealth . . .	liability 1. An amount owing by one person (a debtor) to another (a creditor), payable in money, or in goods or services: the consequence of an asset or service received or a loss incurred or accrued . . .

The FASB also found a second type of definition of assets and liabilities that included economic resources and obligations but also let in some ultimately undefinable what-you-may-call-its—such as deferred tax charges and credits, deferred losses and gains, and self-insurance reserves—items that are not economic resources or obligations of an entity but were included in its balance sheet as assets or liabilities “to achieve ‘proper’ matching of costs and revenues” or “to avoid distorting periodic net income” (pp. 2–33–2–47 of this chapter).

Prime examples of the second type of definition were those in APB Statement No. 4, paragraph 132, which explicitly included what-you-may-call-its in its definitions of assets and liabilities:

Assets—economic resources of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Assets also include certain deferred charges that are not resources but that are recognized and measured in conformity with generally accepted accounting principles.

Liabilities—economic obligations of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Liabilities also include certain deferred credits that are not obligations but that are recognized and measured in conformity with generally accepted accounting principles.

Those definitions were circular and open-ended, however, being both determinants of and determined by generally accepted accounting principles and saying in effect that assets and liabilities were whatever the Board said they were.

In trying to use the definitions in APB Statement No. 4 to set financial accounting standards for research and development expenditures and accruing future losses, Board members found that assets and liabilities defined as fallout from periodic recognition of revenues and expenses were too vague and subjective to be workable. That experience strongly reinforced the conceptual and practical superiority of definitions of assets and liabilities based on resources and obligations that exist in the real world rather than on deferred charges and credits that result only from bookkeeping entries.

APB Statement No. 4's definitions proved to be of little help to the Board in deciding whether results of research and development expenditures qualified as assets or whether reserves for self-insurance qualified as liabilities because they permit almost any debit balance to be an asset and almost any credit balance to be a liability. They were hardly better than the definitions that they had replaced, which also included what-you-may-call-its and were circular and open-ended in the same ways:

[T]he word “asset” is not synonymous with or limited to property but includes also that part of any cost or expense incurred which [according to generally accepted accounting principles] is properly carried forward upon a closing of books at a given date.

…Thus, plant, accounts receivable, inventory, and a deferred charge are all assets in a balance-sheet classification.

The last named is not an asset in the popular sense, but if it may be carried forward as a proper charge against future income, then in an accounting sense, and particularly in a balance-sheet classification, it is an asset….

…Thus, the word [“liability”] is used broadly to comprise not only items which constitute liabilities in the popular sense of debts or obligations…but also credit balances to be accounted for which do not involve the debtor and creditor relation. For example, capital stock, deferred credits to income, and surplus are balance-sheet liabilities in that they represent balances to be accounted for by the company; though these are not liabilities in the ordinary sense of debts owed to legal creditors.¹¹⁴

Definitions of that kind provide no effective limits or restraints on the matching of costs and revenues and the resulting reported net income. If balance sheets at the beginning and end of a period include debits and credits that are labeled assets and liabilities but that result from bookkeeping entries and are assets only “in an accounting sense” or “in a balance-sheet classification” or are only “balance-sheet liabilities,” the income statement for the period will include components of income that are equally suspect—namely, debits and credits that are labeled revenues, expenses, gains, or losses but that result from the same bookkeeping entries as the what-you-may-call-its in the balance sheet. They have resulted not from transactions or other events that occurred during the period but from shifting revenues, expenses, gains, or losses from earlier or later periods to match costs and revenues properly or to avoid distorting reported periodic income.

Thus, when the Board defined the elements of financial statements in Concepts Statement No. 3 (and used the same definitions in Concepts Statement No. 6), it defined assets and liabilities in essentially the same way as the three sets of definitions by the AAA, Mautz, and Kohler, emphasizing the benefits that assets confer on their holders and the obligations to others that bind those with liabilities to pay or expend assets to settle them.

Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. [Concepts Statement No. 6, paragraph 25]

Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. [Concepts Statement No. 6, paragraph 35]

The definitions that were adopted exclude all what-you-may-call-its. Deferred charges and credits that “need to be carried forward for matching in future periods” can no longer be included in assets and liabilities merely by meeting definitions no more restrictive than “assets are costs” and “liabilities are proceeds.”

Although definitions identifying assets with economic resources and wealth and liabilities with amounts or duties owed to other entities had been common in the accounting literature from the turn of the century to the 1970s, the definitions in APB Statement No. 4 actually reflected accounting practice at the time the FASB was developing its definitions. Thus, its definitions represented a fundamental change from the emphasis on financial accounting as primarily a process of matching costs and revenues.

Misunderstanding and Controversy about the Financial Accounting Standards Board's Defining Assets and Liabilities as the Fundamental Elements.

Both of the other fundamental concepts described earlier—that the objective of financial reporting is to provide information useful in making investment, credit, and similar decisions and that items in financial statements represent things and events in the real-world environment—also constituted significant changes in perceptions of the purpose and nature of financial accounting and reporting. Both caused concern among many members of the FASB's constituency at the beginning and drew some criticism and opposition. With time, however, both concepts seem to have been understood reasonably well, their level of acceptance has increased, and active opposition has subsided.

In contrast, this third concept—that assets and liabilities are the fundamental elements of financial statements—still is undoubtedly the most controversial, and the most misunderstood and misrepresented, concept in the entire conceptual framework.

Two Views of Income

The FASB's emphasis on assets and liabilities in the definitions of the elements of financial statements became a focus of controversy in the development of the conceptual framework because it highlighted the tension in accounting thought and practice between two widely held and essentially incompatible views about income:

Income is an enhancement of wealth or command over economic resources.
Income is an indicator of performance of an enterprise and its management.

That difference of opinion about income usually has involved the question of whether certain items should be reported in the net income for a period or should be excluded from net income and reported directly in equity. It most often has been described as the issue of how to display the effects of unusual, extraordinary, or nonrecurring happenings and prior period adjustments, which underlay the disagreement between the SEC and the Institute's Committee on Accounting Procedure over the all-inclusive and current-operating-performance types of income statement, and has troubled accounting standards-setting bodies for more than half a century.

Standard setters, including the Committee on Accounting Procedure, the Accounting Principles Board, and the Financial Accounting Standards Board, have issued more pronouncements dealing with display of the effects of unusual and nonrecurring events than any other subject.¹¹⁵

It also underlies differences between comprehensive income and earnings, recently manifesting itself most prominently in the issue of whether to extend the traditional display of unusual, nonrecurring, or extraordinary events—to exclude them from net income and report them directly in equity—to recurring but often volatile holding gains and losses that largely are beyond the control of an entity and its management.

Difference of opinion about whether income is wealth enhancement or performance indicator likewise underlay the controversy that followed issue of the FASB Discussion Memorandum on definitions of elements of financial statements and their measurement (December 2, 1976), but the matter went deeper than financial statement display. In the FASB's conceptual framework, definitions of elements of financial statements are more fundamental than recognition, measurement, or display in financial statements (see Exhibit 2.1), and the Discussion Memorandum emphasized definition rather than display.

The Board referred to the two views of income or earnings as the asset and liability view and the revenue and expense view and described the difference between them for purposes of defining elements of financial statements as whether definitions of assets and liabilities should be the controlling definitions or should depend on definitions of revenues and expenses.

The conceptual issue in choosing between the asset and liability view and the revenue and expense view concerns selecting the most fundamental elements whose precise definitions control the definitions of the other elements. [p. 35]

Former Board member Oscar Gellein (writing in 1984) described the issue as one of identifying the elements that have what he called conceptual primacy and said that the question of which concepts had primacy was “[a] central issue [that] pervades the FASB's effort to construct a conceptual framework.”¹¹⁶ That question was the first issue in the Discussion Memorandum.

Should the asset and liability view…[or] the revenue and expense view…be adopted as the basis underlying a conceptual framework for financial accounting and reporting? [p. 36]¹¹⁷

According to the Discussion Memorandum, proponents of the asset and liability view hold that assets should be defined as the economic resources of an enterprise (its scarce means of carrying out economic activities such as exchange, production, saving, and investment), that liabilities should be defined as its obligations to transfer assets to other entities in the future, and that definitions of income and its components should depend on the definitions of assets and liabilities. Thus, no revenues or gains can occur unless an asset increases or a liability decreases, and no expenses or losses can occur unless an asset decreases or a liability increases. As a result, income reflects an increase in wealth of the enterprise, and a loss reflects a decrease in its wealth.

Accounting Research Bulletins

No. 8, Combined Statement of Income and Earned Surplus (Retained Earnings) (February 1941)

No. 32, Income and Earned Surplus (December 1947)

No. 35, Presentation of Income and Earned Surplus (October 1948)

No. 41, Presentation of Income and Earned Surplus (Supplement to Bulletin No. 35) (July 1951)

No. 43, Restatement and Revision of Accounting Research Bulletins (June 1953) Chapter 2(b), “Combined Statement of Income and Earned Surplus” Chapter 8, “Income and Earned Surplus”

APB Opinions

No. 9, Reporting the Results of Operations [Income] (December 1966)

No. 20, Accounting Changes (July 1971)

No. 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (June 1973)

FASB Statements

No. 4, Reporting Gains and Losses from Extinguishment of Debt (an amendment of APB Opinion No. 30) (March 1975)

No. 16, Prior Period Adjustments (June 1977)

Proponents of the revenue and expense view, in contrast, hold that income is a measure of performance of an enterprise and its management, that income results from proper matching of costs and revenues, and that most nonmonetary assets and liabilities are by-products of the matching process. Proper matching of costs and revenues involves timing their recognition to relate effort (expenses) and accomplishment (revenues) for a period. Thus, the effects of past expenditures or receipts that are deemed to be expenses or revenues of future periods are recognized as assets or liabilities (deferred charges or deferred credits) whether or not they relate to economic resources or obligations to transfer resources to other entities in the future.

Asset and Liability View and Conceptual Primacy of Assets and Liabilities

Although Concepts Statements Nos. 3 and 6 neither mentioned the asset and liability view and the revenue and expense view nor explained how or why the Board had settled on one of them, the definitions themselves left no doubt about which view the Board had endorsed. Following the steps it had set down in the Discussion Memorandum, it first identified assets and liabilities as “the most fundamental elements whose precise definitions control the definitions of the other elements” (p. 35 of the Discussion Memorandum). The Board then used the most fundamental definitions—assets and liabilities—in defining all of the other elements. For example, equity is assets minus liabilities. Investments by and distributions to owners and comprehensive income and its components—revenues, expenses, gains, and losses—are inflows, outflows, or other increases and decreases in assets and liabilities. (Assets actually is the most fundamental element of financial statements because the definition of liabilities depends on the definition of assets—liabilities are obligations to pay or deliver assets.) The emphasis on assets and liabilities in the definitions of the elements of financial statements in Concepts Statement No. 3 showed that the Board had adopted the asset and liability view and rejected the revenue and expense view.

Assets and (to a lesser extent) liabilities have conceptual primacy, while income and its components—revenues, expenses, gains, and losses—do not.

Every conceptual structure builds on a concept that has primacy. That is simply another way of saying some element must be given meaning before meaning can be attached to others. I contend that assets have that primacy. I 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 I mean by conceptual primacy of assets. No one has ever been successful in giving meaning to income without first giving meaning to assets.¹¹⁸

The Board's early experiences had convinced it that definitions of assets and liabilities that depended on definitions of income and its components did not work. As already noted, those kinds of definitions proved to be of little help to the Board in deciding whether results of research and development expenditures qualified as assets or whether reserves for self-insurance qualified as liabilities because they permit almost any debit balance to be an asset and almost any credit balance to be a liability.

In addition, the Board had attempted to test whether revenues and expenses could be defined without first defining assets and liabilities. It asked respondents to the Discussion Memorandum to submit for its consideration precise definitions of revenues and expenses that were wholly or partially independent of economic resources and obligations (assets and liabilities) and capable of general application in a conceptual framework. That no one was able to do that without having to resort to subjective guides, such as proper matching and nondistortion of income, was a significant factor in the Board's ultimate rejection of the revenue and expense view.

Attempts to identify a good match based on the primacy of revenue and expense have been unsuccessful so far. There is a serious question as to whether revenue and expense can be defined independent of assets and liabilities.¹¹⁹

Thus, revenues and expenses could not fulfill the function of concepts having primacy, which

are the concepts used to define other concepts. They prevent the systems from being open-ended and potentially circular. They are the concepts that are used to test for unity and maintenance of a consistent direction—they are the anchor.¹²⁰

Instead, the Board found that definitions that made assets and liabilities essentially fallout of the process of matching revenues and expenses provided no anchor. They excluded almost nothing from income because they excluded almost nothing from assets and liabilities. The definitions were primarily conventional, not conceptual, and had made periodic income measurement largely a matter of individual judgment and personal opinion. The resulting accounting lacked the conceptual underpinning that provides, among other things, “the means for judging whether one solution is better than another…[and] the restraints necessary to prevent proliferation of perceptions and resulting diversity of accounting methods for substantially similar circumstances.”¹²¹ That is, the Board found the revenue and expense view to be part of the problem rather than part of the solution.

In contrast, the Board's definitions of assets and liabilities limited what can be included in all of the other elements. The Board's choice of the asset and liability view limited the population of assets and liabilities to the underlying economic resources and obligations of an enterprise. The resulting definitions impose limits or restraints not only on what can be included in assets and liabilities but also on what can be included in income. The only items that can meet the definitions of income and its components—revenues, expenses, gains, and losses—are those that increase or decrease the wealth of an enterprise.

The Board based its definitions of elements of financial statements on the conceptual primacy of assets and liabilities for both conceptual and practical reasons. However, that decision was to put the Board at odds with many of its constituents because, among other reasons, “both [conceptual primacy], and the implications of the FASB position on it are still rather widely misunderstood.”¹²²

Revenue and Expense View and Its Hold on Practice

The revenue and expense view had been the basis for accounting practice and for most authoritative accounting pronouncements for over 40 years when the Board looked closely at it in the 1970s. The FASB saw clear evidence of its pervasiveness in practice and in accountants' minds in its early projects on research and development expenditures and accruing future losses. An emphasis on the “proper matching of costs and revenues,” a concern for avoiding “distortion of periodic net income,” and a willingness to allow what-you-may-call-its to appear in balance sheets are all characteristics of the revenue and expense view of income, which has been described extensively earlier in this chapter without referring to it by that name.¹²³ When the Board issued the Discussion Memorandum, the revenue and expense view was the only view of accounting that most of its constituents knew.

Many of them apparently could not, or would not, believe that the Board's primary concern was the need for a set of definitions that worked. That reaction probably was to have been expected. Definitions of assets and liabilities have not been significant in the thinking underlying the revenue and expense view, which has focused on the need to measure performance by relating efforts expended with the resulting accomplishments and has emphasized proper matching and nondistortion of periodic net income as the means of achieving that association of effort and accomplishment. Its proponents might find it difficult to believe that definitions of assets and liabilities could be considered to be fundamental concepts.

Unfortunately, the issue became highly emotional, and many of those who did not accept the Board's explanations looked for other explanations for its decision. Although the Board had defined assets and liabilities in a way that could accurately be described as venerable, many members of the Board's constituency found something unusual, perhaps even sinister, in the Board's definitions of elements of financial statements.

For example, a popular criticism of the asset and liability view charged the FASB with having the intent

To downgrade the importance of net income and the income statement by making the balance sheet more important than the income statement
To supplant accounting based on completed transactions and matching of costs and revenues with a “new” accounting based on the valuation of assets and liabilities at current values or costs

That many of the comment letters the Board received on the Discussion Memorandum echoed those charges mostly reflected the success of an illustrated-lecture tour by Robert K. Mautz, partner of Ernst & Ernst (now Ernst & Young LLP), in which he urged members of 65 to 70 chapters of the Financial Executives Institute to reject the asset and liability view.¹²⁴

Board and staff members became concerned that discussion of the FASB's decision to base its definitions of elements of financial statements on the conceptual primacy of assets and liabilities had gone astray. The focus had been shifted from the definitions to some oversimplified and essentially irrelevant distinctions between the asset and liability and revenue and expense views concerning which financial statement is more useful and which measurement basis goes with which view.

Conceptual primacy has nothing to do with the question of what information is most useful or of how it is measured. It refers only to the matter of definitional dependency.¹²⁵

The Discussion Memorandum had tried to keep the emphasis on the definitions, explaining why the relative usefulness of income statements and balance sheets was never a real issue between the two views:

[A]dvocates of the asset and liability view agree with advocates of the revenue and expense view that the information in a statement of earnings is likely to be more useful to investors and creditors than the information in a statement of financial position. That is, both groups agree that earnings measurement is the focus of financial accounting and financial statements. [paragraph 45]

Concepts Statement No. 1 was unequivocal in identifying information about income as most useful to investors, creditors, and other users:

The primary focus of financial reporting is information about an enterprise's performance provided by measures of earnings and its components. Investors, creditors, and others who are concerned with assessing the prospects for enterprise net cash inflows are especially interested in that information. [paragraph 43]¹²⁶

Thus, to say that the asset and liability view downgrades the significance of net income and the income statement by making the balance sheet more significant than the income statement at best reflects misunderstanding of the conceptual primacy of assets and liabilities and of the asset and liability view used by the Board. At worst, it misrepresents the Board's reasons for accepting the asset and liability view and rejecting the revenue and expense view of income.

The idea that the Board chose the asset and liability view to impose some kind of current value accounting on an unwilling world reflects the same misunderstanding and misrepresentation. None of the Concepts Statements except No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, says anything about how assets or liabilities should be measured, and Concepts Statement No. 5 does not embrace a “new” accounting based on the valuation of assets and liabilities at current values or costs. If anything, it favors “historical-cost accounting” and erects barriers to current values or costs, for example, placing a higher hurdle for recognizing current values or costs than for recognizing historical costs: “Information based on current prices should be recognized if it is sufficiently relevant and reliable to justify the costs involved and more relevant than alternative information” (paragraph 90). Moreover, Concepts Statement No. 5 and numerous speeches made and articles written by Board members while the Concepts Statements were in progress furnish abundant evidence that Board members never were sufficiently of the same mind on the relative merits and weaknesses of current cost or value and so-called historical cost for measuring assets and liabilities for the Board accurately to be characterized as “having the intent” to adopt any particular measurement model for assets and liabilities.

Since Board members' continual public denials of that kind of intent and their explanations of what the Board actually was trying to accomplish were publicly brushed aside by many members of the Board's constituency, the unfortunate result was a generally unenlightening digression that served no purpose except to cast aspersions on Board members' veracity and integrity and to polarize opinion. It made little or no contribution to the conceptual framework, but it did reveal a deep-seated distrust of a conceptual framework, or perhaps of concepts generally, on the part of many accountants and a fear, easily triggered by, for example, labeling the asset and liability view a “valuation approach,” that the FASB might be in the process of turning the world of accounting upside down.

The revenue and expense view is still deeply ingrained in many accountants' minds, and their first reaction to an accounting problem is to think about “proper matching of costs and revenues.” Time will be needed for them to become accustomed to thinking first about effects of transactions or other events on assets and liabilities (or both) and then about how the effect on assets and liabilities has affected revenues, expenses, gains, or losses. Many will be able to make that adjustment only with difficulty, and a significant number simply will make no attempt to do so, clinging instead to the revenue and expense view. The FASB's experience suggests that a long tradition of ad hoc accounting principles has fostered a propensity to resist restraints on flexibility, especially those that limit an enterprise's ability to decide what can be included in income for a period.

Yet the hold of the revenue and expense view on practice is destined to decline. Definitions reflecting the revenue and expense view have been weighed in the balance and found wanting, not only by the FASB but also by other standards-setting bodies.

The conceptual frameworks of the standard-setting bodies [in Australia, Canada, the United Kingdom and the United States and the International Accounting Standards Committee] do rest on the bedrock of the balance sheet. This may be inevitable, given that advocates of a p[rofit] & l[oss] account-driven approach have so far failed to produce rigorous, coherent and consistent definitions of its elements that refer to underlying events rather than the recognition process itself.¹²⁷

Countries besides the United States that have adopted or are in the process of adopting conceptual frameworks or statements also generally have developed definitions of elements of financial statements that reflect the conceptual primacy of assets and liabilities. Thus, standards setters in Australia, Canada, and the United Kingdom, as well as the International Accounting Standards Committee, all have definitions that are generally similar to those of the FASB.

To those familiar with the FASB's experience with the Discussion Memorandum on elements of financial statements, the related Exposure Drafts, and Concepts Statement No. 3, what has happened recently in some of those countries is (in the words of Yogi Berra) “déjà vu all over again.” At the annual Financial Times financial reporting conference in the United Kingdom in September 1993, for example,

David Lindsell, senior technical partner at Ernst & Young, reiterated his firm's criticism of the A[ccounting] S[tandards] B[oard]'s conceptual approach (Accountancy, October 1993, page 11). Whereas the ASB's Statement of Principles makes the balance sheet the “focal point of the accounts” and “treats financial reporting primarily as a process of valuation,” E&Y believes that the primary focus should be on “the measurement of earnings, and that the balance sheet should be seen as a residual statement, derived after measuring the company's profits and not the other way round.”¹²⁸

Essentially E&Y accuses the ASB of focusing on the balance sheet at the expense of the p[rofit] & l[oss] account and argues for a return to pure historical cost accounting…. [S]ince E&Y went public with its criticism, it has heard from a lot of people, particularly finance directors, who have expressed sympathy with its arguments.¹²⁹

International harmonization of accounting practice is likely to continue to be in the direction of phasing out the revenue and expense view.

However, change is likely to be rather deliberate, and at least in the United States, features of the revenue and expense view are likely to be part, though a shrinking part, of financial statements for some time to come. The Board has said that it “intends future change to occur in the gradual, evolutionary way that has characterized past change” (Concepts Statement No. 5, paragraph 2). And, although it precluded self-insurance reserves and similar what-you-may-call-its in balance sheets, the Board has permitted other what-you-may-call-its to avoid unduly disrupting practice. For example, it explicitly responded to concerns about volatility of reported net income expressed by respondents to the Exposure Draft that preceded FASB Statement No. 87, Employers' Accounting for Pensions (December 1985), concluding that to require accounting that was conceptually appropriate under the definitions in Concepts Statement No. 3 would be too great a change from past practice to be adopted in a single step. Thus, Statement No. 87 “retains three fundamental aspects of past pension accounting” despite their conflict with the Concepts Statements and accounting principles applied elsewhere (paragraph 84). One of the three—delaying recognition of actuarial gains and losses to spread over future periods the recognition of gains or losses that have already occurred to a liability for pensions or pension plan assets—requires recognizing in the accounts a number of what-you-may-call-its even though they do not qualify as assets or liabilities under the Board's definitions. The Board's perception of a need for expedients of that kind means that at least some “what-you-may-call-its” in balance sheets and the related arguments about “proper matching of costs and revenues” and “avoiding distortion of periodic net income” are likely to disappear only gradually.

(iv) Functions of the Conceptual Framework

The Preface of each FASB Concepts Statement has carried the following, or a similar, description (this excerpt is from Concepts Statement No. 6):

The conceptual framework is a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and reporting. It is expected to serve the public interest by providing structure and direction to financial accounting and reporting to facilitate the provision of evenhanded financial and related information that helps promote the efficient allocation of scarce resources in the economy and society, including assisting capital and other markets to function efficiently.

Establishment of objectives and identification of fundamental concepts will not directly solve financial accounting and reporting problems. Rather, objectives give direction, and concepts are tools for solving problems.

The FASB's conceptual framework is intended to be primarily a set of tools to help the Board in setting sound financial accounting standards and to help members of the Board's constituency not only understand and apply those standards but also contribute significantly to their development. It is not expected automatically to provide ready-made, unique, and obviously logical answers to complex financial accounting or reporting problems, but it should help to solve them by:

Providing a set of common premises as a basis for discussion
Providing precise terminology
Helping to ask the right questions
Limiting areas of judgment and discretion and excluding from consideration potential solutions that are in conflict with it
Imposing intellectual discipline on what traditionally has been a subjective and ad hoc reasoning process

Those contributions of the conceptual framework have all been introduced at least indirectly earlier in this chapter, and the last two were cited as factors in the FASB's conclusions in the preceding discussion of assets as the fundamental element of financial statements. The following paragraphs add a few points on the first three.

A critical function of the conceptual framework is to provide a set of common premises from which to begin discussing specific accounting problems and developing solutions for them. The accounting profession's earlier efforts to establish accounting principles have shown that if experience is the frame of reference, no one can be sure of the starting point, if one exists at all, because everyone's experience is different. The FASB's predecessors tried to use experience as a common point of departure, but when confronted with the same problems, people with different experiences too often offered widely different solutions, and financial accounting was inundated with multiple solutions to the same problems. The problems of communication and understanding between those supporting the revenue and expense view and those supporting the asset and liability view offer a striking illustration.

A framework of coordinated concepts as the frame of reference, in contrast, can change that picture. The FASB and its constituency start from common ground, vastly increasing the likelihood that they can communicate with and understand each other on the complex and difficult problems that often arise in financial accounting and reporting. A set of common premises does not guarantee agreement, but it does avoid the problems and wasted time that result if those discussing a matter talk past each other because they actually are not talking about the same thing. It also promotes consensus once a problem is solved. For example, Donald J. Kirk, former chairman of the FASB, noted that the conceptual framework was undertaken “with the expectation that it would articulate definitions and concepts that would diminish the need for and details in standards; it was to be the ‘relief’ from the so-called ‘firefighting’ [approach] for which the FASB's predecessors had been criticized.”¹³⁰

A related purpose of the conceptual framework is to provide a precise terminology. Good terminology serves much the same function as a set of common premises: “Loose terminology encourages loose thinking. Precision in the use of words does not solve human controversies, but at least it paves the way for clear thinking.” ¹³¹The FASB's conceptual framework has contributed significantly to precise terminology through its careful definitions of the elements of financial statements in Concepts Statement No. 6 and the qualitative characteristics of accounting information in Concepts Statement No. 2.

The conceptual framework helps to ask the right questions. Indeed, the FASB has emphasized that contribution as much as any. For example, the definitions of elements of financial statements not only make clear which are the right questions but also the order in which to ask them:

What is the asset? What is the liability?

Did an asset or liability or its value change? Increase or decrease?

By how much? Did the change result from:

An investment by owners? A distribution to owners?

Comprehensive income? Was the source of comprehensive income what we call:

Revenue? Expense?

Gain? Loss?

To start at the bottom and work up the list will not work. That is what ad hoc accounting has tried to do over many years, resulting in assets and liabilities in balance sheets that cannot meet the definitions.

The conceptual framework does not guarantee logical solutions to accounting problems. The results depend significantly on those who use the concepts to establish financial accounting standards. But it does provide valuable tools to standards setters.

Standard setters' instincts alone are not adequate to maintain direction—to discriminate between a solution that better lends usefulness to a standard than another solution, and at the same time maintain consistency. Their instincts need conceptual guidance.

…The objectives build on the role of financial reporting and underlie the definitions of financial statement elements. Acceptance of the definitions provides the necessary discipline for order. Instead of arguing about the definitions, the FASB, as well as its constituents, now focuses attention on whether a matter in a given situation meets the conditions of a definition. That contributes to efficiency and furthers the chances of consistency.¹³²

(b) Financial Accounting Standards Board Concepts Statements

The Concepts Statements set forth the objectives and conceptual foundation of financial accounting that are the basis for the development of financial accounting and reporting standards. This section of the chapter discusses the individual Concepts Statements in a logical order according to their subject matter. The objectives of financial reporting constitute the subject matter of Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises, and Concepts Statement No. 4, Objectives of Financial Reporting by Nonbusiness Organizations. The qualities that make accounting information useful for investment, credit, and other resource allocation decisions are described in Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. Concepts Statements No. 3 and No. 6 define the Elements of Financial Statements. Finally, Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, describes a complete set of financial statements and what is meant by recognition and measurement.

(i) Objectives of Financial Reporting

After the FASB received the report of the Trueblood Study Group, Objectives of Financial Statements, in October 1973, it issued a Discussion Memorandum, Conceptual Framework for Accounting and Reporting: Consideration of the Report of the Study Group on the Objectives of Financial Statements, in June 1974. The Discussion Memorandum was based primarily on the Trueblood Report's 12 objectives of financial statements and seven qualitative characteristics of reporting. The Board held a public hearing in September and began to develop its own conclusions on the objectives.

Concepts Statement No. 1.

In December 1976, the Board published for comment a draft entitled Tentative Conclusions on Objectives of Financial Statements of Business Enterprises and a Discussion Memorandum, Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement. Although the Trueblood Report included an objective of financial statements for governmental and not-for-profit organizations, the FASB had decided to concentrate its initial efforts on formulating objectives of financial statements of business enterprises. Following a public hearing on those publications the following August, the Board issued an Exposure Draft, Objectives of Financial Reporting and Elements of Financial Statements of Business Enterprises, in December 1977. Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises, was issued in November 1978.

The change in title between the Tentative Conclusions and the Exposure Draft indicated a change in the Board's perspective from a focus on financial statements to financial reporting. To a significant extent, it reflected comments received on the Tentative Conclusions document. The change also emphasized that financial statements were the primary, but not the only, means of conveying financial information to users. During the Board's consideration of objectives, it had decided that for general purpose external financial reporting, the objectives of financial statements and the objectives of financial reporting are essentially the same, although, as the Statement said, some information is better provided by financial statements and other information is better provided by other means of financial reporting (paragraph 5).

That brief sketch of the background of the Statement has touched only certain points. Concepts Statement No. 1, like all of the Concepts Statements, contains an appendix on its background (paragraphs 57–63).

Concepts Statement No. 1 and the Trueblood Group's Objectives

The FASB accepted the starting point and basic objective in the report of the Trueblood Study Group and, although some differences in direction had begun to appear in the supporting discussion, accepted in a general way the group's second and third objectives. These excerpts are from the Study Group's report:

Accounting is not an end in itself….

The basic objective of financial statements is to provide information useful for making economic decisions.

An objective of financial statements is to serve primarily those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise's economic activities.

An objective of financial statements is to provide information useful to investors and creditors for predicting, comparing, and evaluating potential cash flows to them in terms of amount, timing, and related uncertainty. [pp. 61–62]

These excerpts are from Concepts Statement No. 1:

Financial reporting is not an end in itself but is intended to provide information that is useful in making business and economic decisions—for making reasoned choices among alternative uses of scarce resources in the conduct of business and economic activities. [paragraph 9]

The objectives in this Statement…stem primarily from the informational needs of external users who lack the authority to prescribe the financial information they want from an enterprise and therefore must use the information that management communicates to them. [paragraph 28]

Potential users of financial information most directly concerned with a particular business enterprise are generally interested in its ability to generate favorable cash flows because their decisions relate to amounts, timing, and uncertainties of expected cash flows. To investors, lenders, suppliers, and employees, a business enterprise is a source of cash in the form of dividends or interest and perhaps appreciated market prices, repayment of borrowing, payment for goods or services, or salaries or wages. They invest cash, goods, or services in an enterprise and expect to obtain sufficient cash in return to make the investment worthwhile. They are directly concerned with the ability of the enterprise to generate favorable cash flows and may also be concerned with how the market's perception of that ability affects the relative prices of its securities. (paragraph 25)

Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. [paragraph 34]

None of the other nine objectives of the Study Group was adopted in recognizable form in Concepts Statement No. 1. Many of them were about matters that the Board had decided to include in the recognition, measurement, and display parts of the conceptual framework.

Concepts Statement No. 4.

By 1977 the fiscal problems of a number of large cities, including New York and Cleveland, had prompted public officials and private citizens increasingly to question the relevance and reliability of financial reporting by governmental and not-for-profit organizations. That concern was reflected in many legislative initiatives and widely publicized allegations of serious deficiencies in the financial reporting of various kinds of not-for-profit organizations.

The Board began to consider concepts underlying general purpose external financial reporting by not-for-profit organizations by commissioning a research report to identify the objectives of financial reporting by organizations other than business enterprises. That report, Financial Accounting in Nonbusiness Organizations, by Robert N. Anthony, was published in May 1978. Rather than delay progress on the objectives of financial reporting by business enterprises by attempting to include not-for-profit organizations within its scope, the Board decided to proceed with two separate objectives projects. It issued a Discussion Memorandum based on the research report, followed by an Exposure Draft. Then, Objectives of Financial Reporting by Nonbusiness Organizations was issued as Concepts Statement No. 4 in December 1980. After Concepts Statement No. 4 was issued, the FASB changed the key term from nonbusiness to not-for-profit organizations.

Effects of Environment and Information Needs of Resource Providers.

Concepts Statement No. 1 and Concepts Statement No. 4 have the same structure. Both sets of objectives are based on the fundamental notion that financial reporting concepts and standards should be based on the information needs of users of financial statements who make decisions about committing resources to either business enterprises or not-for-profit organizations with the expectation of pecuniary reward or to not-for-profit organizations for reasons other than expectations of monetary return of or return on resources committed. From that broad focus, the Statements narrow the focus, on one hand, to the primary interest of investors, creditors, and other users in the prospects of receiving cash from their investments in or loans to business enterprises and the relationship of their prospects to those of the enterprise, and, on the other hand, to the needs of resource providers for information about a not-for-profit organization's services, its ability to continue to provide them, and the relationship of management's stewardship to the organization's performance. Finally, both Statements focus on the kinds of information that financial reporting can provide to meet the respective needs of both groups.

The objectives of financial reporting cannot be properly understood apart from the environmental context in which they have been developed—the real world in which financial accounting and reporting takes place. They are affected by the economic, legal, political, and social environment of the United States. The objectives “stem largely from the needs of those for whom the information is intended, which in turn depend significantly on the nature of the economic activities and decisions with which the users are involved” (Concepts Statement No. 1, paragraph 9). Thus, Concepts Statement No. 1 describes the highly developed exchange economy of the United States, in which:

Most goods and services are exchanged for money or claims to money instead of being consumed by their producers.
Most productive activity is carried on through investor-owned business enterprises whose operations are controlled by directors and professional managers acting in the interests of investor-owners.
Well-developed securities markets tend to allocate scarce resources to enterprises that use them efficiently.
Productive resources are generally privately rather than government owned, although government intervenes in the resource allocation process through taxation, borrowing and spending for government operations and programs, regulation, subsidies, or monetary and fiscal policy.

Cash is important in the economy “because of what it can buy. Members of the society carry out their consumption, saving, and investment decisions by allocating their present and expected cash resources” (Concepts Statement No. 1, paragraph 10). Entities' efficient allocation of cash and other economic resources is a means to the desired end of a well-functioning, healthy economy. The following excerpt from Concepts Statement No. 1 describes how financial reporting can contribute to achieving that social good. It refers to reporting about business enterprises, but its premise relates as well to the objectives of financial reporting of not-for-profit organizations.

The effectiveness of individuals, enterprises, markets, and government in allocating scarce resources among competing uses is enhanced if those who make economic decisions have information that reflects the relative standing and performance of business enterprises to assist them in evaluating alternative courses of action and the expected returns, costs, and risks of each. The function of financial reporting is to provide information that is useful to those who make economic decisions about business enterprises and about investments in or loans to business enterprises. [paragraph 16]

Business enterprises and not-for-profit organizations have both similarities and differences in their operating environments that affect the information needs of those who make decisions about them and thus affect the objectives of financial reporting. Both kinds of entities have transactions with suppliers of goods and services who expect to be paid for what they provide, with employees who expect to be paid for their work, and with lenders who expect to be repaid with interest. Both entities may sell the goods or services they produce, although to survive, business enterprises charge prices sufficient to cover their costs, usually plus a profit, whereas not-for-profit organizations often may sell below cost or at nominal prices or may even give their outputs to beneficiaries without charge.

Not-for-profit organizations commonly need certain kinds of control arrangements more than do business enterprises. Although not-for-profit organizations must often compete not only with each other but also with business enterprises for goods and services, employees, and lendable funds, the operating performance of business enterprises generally is subject to the discipline of market controls to a greater extent than is the performance of not-for-profit organizations because business enterprises must compete in equity markets for funds to finance their operations while not-for-profit organizations do not. Spending mandates and budgets to control uses of resources are significant factors in obtaining and allocating resources for not-for-profit organizations to compensate for the lesser influence of direct market competition.

Business enterprises and not-for-profit organizations also differ in their relationships to some significant resource providers. Business enterprises have stockholders or other owners who invest with the expectation of receiving profits commensurate with the risks incurred. In contrast, not-for-profit organizations have no owners in the same sense as business enterprises and often receive significant amounts of resources by gift or donation from those who do not expect pecuniary returns. Those contributors are interested in the services the organizations provide and receive compensation for their contributions by nonfinancial means, such as by seeing the purposes and goals of the organizations advanced.

Objectives of Financial Reporting by Business Enterprises.

The objectives of financial reporting by business enterprises are derived from the information needs of investors, creditors, and others outside an enterprise who generally lack the authority to prescribe the information they want and thus must rely on information that management communicates to them. They are the primary users of the information provided by general purpose external financial reporting, whose primary objective is to

provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. [Concepts Statement No. 1, paragraph 34]

The objectives of general purpose external financial reporting are not derived from and do not comprehend satisfying the information needs of all potential users. Regulatory and taxing authorities, for example, have needs for special kinds of financial information that is not normally provided by financial reporting but also have the statutory authority to obtain the specific information they need. Thus they do not have to rely on information provided to other groups. Management is interested in the information provided by external financial reporting but also has ready access not only to that information but also to a great deal of internal information that is normally unavailable to those outside the enterprise. Management's primary role in external financial reporting is that of a provider or communicator of information for use by investors, creditors, and others outside the enterprise who must rely on management for information.

In emphasizing the information needs of investors, creditors, and similar users, the FASB recognized that external financial reporting cannot satisfy the particular and perhaps diverse needs of various individual users who look to the information provided by financial reporting for assistance in making resource allocation decisions. However, those who make investment, credit, and similar decisions do have common, overlapping interests in the ability of a business enterprise to generate favorable cash flows. It is the common interest in an enterprise's cash flow potential that the objectives of external financial reporting seek to satisfy.

The objectives in Concepts Statement No. 1 focus financial reporting on a particular kind of economic decision—the decision to commit or to continue to commit cash or other resources to a business enterprise with the expectation of payment or of future return of and return on the investment, usually in cash but sometimes in other goods and services. That kind of decision is made by investors, creditors, suppliers, employees, and other potential users of financial information, and they are interested in net cash inflows to the enterprise because their own prospects for receiving cash flows from investments in, loans to, or other participation in an enterprise depend significantly on its ability to generate favorable cash flows.

Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. The prospects for those cash receipts are affected by an enterprise's ability to generate enough cash to meet its obligations when due and its other cash operating needs, to reinvest in operations, and to pay cash dividends and may also be affected by perceptions of investors and creditors generally about that ability, which affect market prices of the enterprise's securities. Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise. [Concepts Statement No. 1, paragraph 37]

Concepts Statement No. 1 explicitly recognizes that financial reporting does not and cannot provide all of the information needed by those who make economic decisions about business enterprises. It is but one source. Information provided by financial reporting needs to be combined with information about, among other things, the general economy, political climate, and prospects for an enterprise's particular industry or industries.

The objectives ultimately focus on the kind of information that fulfills the users' needs described and that the accounting system can provide better than other sources: information about assets, liabilities, and changes in them. Thus financial reporting should

provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners' equity), and the effects of transactions, events, and circumstances that change resources and claims to those resources. [Concepts Statement No. 1, paragraph 40]

That includes information about an enterprise's assets, liabilities, and owners' equity; information about enterprise performance provided by measures of comprehensive income (called earnings in Concepts Statement No. 1) and its components; information about liquidity, solvency, and funds flows; information about management stewardship and performance; and management's explanations and interpretations [paragraphs 41–54].

Objectives of Financial Reporting by Not-for-Profit Organizations.

The objectives of financial reporting by not-for-profit organizations are derived from the information needs of external resource providers who, like investors and creditors of business enterprises, generally cannot prescribe the information they want and thus must rely on information that management communicates to them. They are the primary users of the information provided by general purpose external financial reporting, whose primary objective is to

provide information that is useful to present and potential resource providers and other users in making rational decisions about the allocation of resources to those organizations. [Concepts Statement No. 4, paragraph 35]

Resource providers encompass those who receive direct compensation for providing resources, including lenders, suppliers, and employees, as well as members, contributors, taxpayers, and others who are concerned with a not-for-profit organization's activities but who are not directly and proportionately compensated financially for their involvement.

The objectives flow from the common interests of those who provide resources to not-for-profit organizations in the services those organizations provide and in their continuing ability to provide services. Because the goals of not-for-profit organizations are to provide services rather than to generate profits,

[f]inancial reporting should provide information to help present and potential resource providers and other users in assessing the services^* that a [not-for-profit] organization provides and its ability to continue to provide those services. They are interested in that information because the services are the end for which the resources are provided. The relation of the services provided to the resources used to provide them helps resource providers and others assess the extent to which the organization is successful in carrying out its service objectives. [Concepts Statement No. 4, paragraph 38]

The kinds of controls imposed on the operations of not-for-profit organizations to compensate for the reduced influence of markets significantly affect the objectives of their financial reporting. Alternative controls, such as specific budgetary appropriations that may limit the amount an organization is allowed to spend for a particular program or donor-imposed restrictions on the use of resources, usually place a special stewardship responsibility on managers to ensure that resources are used for their intended purposes. Those kinds of spending mandates tend to have a pervasive effect on the conduct and control of the activities of not-for-profit organizations. Because of the nature of the resources entrusted to managers of not-for-profit organizations, Concepts Statement No. 4 identifies the evaluation of management stewardship and performance information as an objective of the financial reporting of not-for-profit organizations:

Financial reporting should provide information that is useful to present and potential resource providers and other users in assessing how managers of a [not-for-profit] organization have discharged their stewardship responsibilities and about other aspects of their performance. [Concepts Statement No. 4, paragraph 40]

Management stewardship is of concern to investors and creditors of business enterprises and resource providers of not-for-profit organizations. Both kinds of resource providers hold management accountable not only for the custody and safekeeping of an organization's resources but also for their efficient and effective use. Concepts Statement No. 1 identifies comprehensive income as the common focus for assessing management's stewardship or accountability (paragraph 51). Since profit figures are not available for not-for-profit organizations, Concepts Statement No. 4 instead delineates information about an organization's performance as the focus for assessing management stewardship. It says that financial reporting can provide information about the extent to which managers have acted in accordance with provisions specifically designated by donors. Information about departures from budget mandates or donor-imposed stipulations that may adversely affect an organization's financial performance or its ability to provide a satisfactory level of services is important in assessing how well managers have discharged their stewardship responsibilities.

The objectives of not-for-profit organizations, like those of business enterprises, ultimately focus on the kind of information that the accounting system can provide better than other sources:

Financial reporting should provide information about the economic resources, obligations, and net resources of an organization and the effects of transactions, events, and circumstances that change resources and interests in those resources. [Concepts Statement No. 4, paragraph 43]

Resources are the lifeblood of an organization in the sense that it must have resources to render services. Since resource providers tend to direct their interest to information about how an organization acquires and uses its resources, financial reporting should provide information about an organization's assets, liabilities, and net assets; information about its performance, such as about the nature of and relation between resource inflows and outflows and about service efforts and accomplishments; information about liquidity; and managers' explanations and interpretations (paragraphs 44–55).

Keeping the Objectives in Perspective.

Financial accounting information is not intended to measure directly the value of a business enterprise. Nor is it intended to determine or influence the decisions that are made with information it provides about business enterprises and not-for-profit organizations. Its function is to provide the neutral or unbiased information that investors, creditors, various resource providers, and others who are interested in the activities of business enterprises and not-for-profit organizations can use in making those decisions. If financial information were directed toward a particular goal, such as encouraging the reallocation of resources toward particular business enterprises or industries or in favor of certain programs or activities of not-for-profit organizations, it would not be serving its broader objective of providing information useful for resource allocation decisions.

Moreover, as Concepts Statement No. 1 says, financial reporting is not financial analysis:

Investors, creditors, and others often use reported [income] and information about the components of [income] in various ways and for various purposes in assessing their prospects for cash flows from investments in or loans to an enterprise. For example, they may use [income] information to help them (a) evaluate management's performance, (b) estimate “earning power” or other amounts they perceive as “representative” of long-term earning ability of an enterprise, (c) predict future [income], or (d) assess the risk of investing in or lending to an enterprise. They may use the information to confirm, reassure themselves about, or reject or change their own or others' earlier predictions or assessments. Measures of [income] and information about [income] disclosed by financial reporting should, to the extent possible, be useful for those and similar uses and purposes.

However, accrual accounting provides measures of [income] rather than evaluations of management's performance, estimates of “earning power,” predictions of [income], assessments of risk, or confirmations or rejections of predictions or assessments. Investors, creditors, and other users of the information do their own evaluating, estimating, predicting, assessing, confirming, or rejecting. For example, procedures such as averaging or normalizing reported [income] for several periods and ignoring or averaging out the financial effects of “nonrepresentative” transactions and events are commonly used in estimating “earning power.” However, both the concept of “earning power” and the techniques for estimating it are part of financial analysis and are beyond the scope of financial reporting. [paragraphs 47 and 48; income has been substituted for earnings, which the Board replaced with comprehensive income after Concepts Statement No. 1]

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Table of Contents for Chapter 2: Framework of Financial Accounting Concepts and Standards: A Historical Perspective

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2.1 Financial Accounting and Reporting