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:

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.

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

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'":

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."^[12]

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

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."^[15] His prescription for accountants was to use principle in its most commonly understood sense of being more fundamental and enduring than rules and conventions.

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."^[17] 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.

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,"^[18] 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')."^[19] 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."^[20]

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:

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.

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:

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

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:

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.

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.'"^[26]

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.

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.

"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."^[29] 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.

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.'"^[30] 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."

Three less ambitious efforts in 1937 and 1938—eight principles in Gilbert R. Byrne's prize-winning essay,^[31] nine accounting principles and conventions in D. L. Trouant's book, Financial Audits,^[32] and six accounting principles in A. C. Littleton's "Tests for Principles"^[33]—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."^[34] 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.

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."^[35]

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."^[36]

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."^[37] 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.

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.^[38]

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,^[39] 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).

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.

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.^[41]

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."^[42]

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,"^[43] 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."^[44] "[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."^[45]

****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,^[46] 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,^[47] 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."^[48] 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.^[49]

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"^[50] 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.

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."^[51]

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.

During the 21 years that the Committee on Accounting Procedure was issuing the ARBs, the AAA revised its 1936 "A 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":

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 1935,^[52] 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."^[53]

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.

"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, page 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, page 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 (page 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),^[54] 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.

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"^[55]—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 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:

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 (pp. 2-32–2-45 of this chapter). They have proven to be of minimal help in actually resolving difficult accounting issues.

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 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 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 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 3–5 of APB Statement 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.^[79]

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:

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

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 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.

The introduction to the definitions of assets and liabilities in APB Statement 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:

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:

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 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?

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.

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

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.

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.

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."^[93] 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:

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."^[95]

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."^[96]

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:

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

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:

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:

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

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.

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 the 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:

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:

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:

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:

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.

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.

His intermediate accounting textbook, published a mere dozen years after the monograph, was entitled Asset Accounting.^[109]

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.

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:

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.

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.

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."^[120] That question was the first issue in the Discussion Memorandum.

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.

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.

Accounting Research Bulletins:

Although Concepts Statements 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" (page 35 of the Discussion Memorandum; quoted earlier on this page) and then used the most fundamental definitions—assets and liabilities—in defining all of the other elements. 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 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.

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.

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."^[125] 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."^[126]

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.^[127] 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

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.^[128]

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.

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:

Concepts Statement 1 was unequivocal in identifying information about income as most useful to investors, creditors, and other users:

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 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 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.

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 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,

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 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 3 would be too great a change from past practice to be adopted in a single step. Thus, Statement 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.

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 1, like all of the Concepts Statements, contains an appendix on its background (paragraphs 57–63).

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:

None of the other nine objectives of the Study Group was adopted in recognizable form in Concepts Statement 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.

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 4 in December 1980. After Concepts Statement 4 was issued, the FASB changed the key term from nonbusiness to not-for-profit organizations.

Concepts Statement 1 and Concepts Statement 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 1, paragraph 9). Thus, Concepts Statement 1 describes the highly developed exchange economy of the United States, in which:

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 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 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.

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.

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

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 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.

Concepts Statement 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

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 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).

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

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,

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 4 identifies the evaluation of management stewardship and performance information as an objective of the financial reporting of not-for-profit organizations:

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 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 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:

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).

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 1 says, financial reporting is not financial analysis:

Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, is described as a bridge between Concepts Statement 1 and the other Statements on elements of financial statements, recognition and measurement, and display. It connects the Statements on objectives, which concern the purposes of financial reporting, with the later Concepts Statements and Standards Statements, which deal with how to attain those purposes, by sharing "with its constituents [the Board's] thinking about the characteristics that the information called for in its standards should have. It is those characteristics that distinguish more useful accounting information from less useful information" (paragraph 1).

When Concepts Statement 2 was issued, the Board noted that its discussion of the qualitative characteristics referred primarily to business enterprises but that it had tentatively concluded that the qualities also applied to the financial reporting of not-for-profit organizations. In Concepts Statement 6, in 1985, the Board formally amended Concepts Statement 2 to apply to both business enterprises and not-for-profit organizations by giving it a new paragraph 4:

Accountants are required to make a large number of choices—about the criteria by which assets and liabilities and revenues and expenses are to be recognized and the attribute(s) of assets and liabilities to be measured; about whether to allocate; about methods of allocation; about the level of aggregation or disaggregation of the information to be disclosed in financial reports. Accounting standards issued by the designated standards-setting body narrow the scope for individual choice, but accounting choices will always have to be made, whether between choices for which no standard has been promulgated or between alternative ways of implementing a standard.

By defining the qualities that make accounting information useful, Concepts Statement 2 is intended to enable the Board and its staff to provide direction for developing accounting standards consistent with the objectives of financial reporting, which are oriented toward providing useful information for making investment, credit, and similar decisions:

Concepts Statement 2 examines the characteristics that make accounting information useful, and the FASB has gone to considerable effort to lay out what usefulness means. Usefulness for making investment, credit, and similar decisions is the most important quality in its "Hierarchy of Accounting Qualities": "The characteristics of information that make it a desirable commodity guide the selection of preferred accounting policies from among available alternatives.... Without usefulness, there would be no benefits from information to set against its costs. The hierarchy is represented in [Exhibit 2.3]" (Concepts Statement 2, paragraph 32).

Usefulness is a high-level abstraction. To serve as a meaningful criterion or standard against which to judge the results of financial accounting, usefulness needs to be made more concrete and specific by analyzing it into its components at lower levels of abstraction. The two primary components of usefulness are relevance and reliability. While those concepts are more concrete than usefulness, they are still quite abstract. That is why Concepts Statement 2 focuses at a still more concrete level, where the concepts of predictive value and feedback value, timeliness, representational faithfulness, verifiability, neutrality, and comparability together serve as criteria for determining information's usefulness.

For accounting standards setting, usefulness cannot be interpreted to mean whatever a particular individual interprets it to mean. A judgment that a piece of information is useful must be the result of a careful analysis that confirms first that the information possesses the qualities at the most concrete level of the hierarchy. Is it timely and does it have predictive or feedback value or both? Is it representationally faithful, verifiable, and neutral? If it has those characteristics, it is relevant and reliable. Only then, if information has survived that kind of examination, can it be deemed useful.

The exhibit also shows two constraints, primarily quantitative rather than qualitative in nature. The pervasive constraint is that the benefits of information should exceed its cost. Information that would be useful for a decision may be just too expensive to justify providing it. The second constraint is a materiality threshold, meaning that "the requirement that information be reliable can still be met even though it may contain immaterial errors, for errors that are not material will not perceptibly diminish its usefulness" (paragraph 33).

Figure 2.3. A hierarchy of accounting qualities. (Source: Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 2, par. 32.) .

The hierarchy distinguishes between user-specific and decision-specific qualities because whether a piece of information is useful to a particular decision by a particular decision maker depends in part on the decision maker. Usefulness depends on a decision maker's degree of prior knowledge of the information as well as on his or her ability to understand it.

Similarly, the ability to understand a pertinent piece of information relates more to the characteristics of users for whom the information is intended than to the information itself. Even though information may be relevant to a decision, it will not be useful to a person who cannot understand it.

In Concepts Statement 1, the Board said that information provided by financial reporting "should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence" (paragraph 34). But information's relevance may transcend the ability of a user to recognize its import:

The two primary decision-specific qualities that make accounting information useful for decision making are relevance and reliability. If either is missing completely from a piece of information, the information will not be useful. In choosing between accounting alternatives, one should strive to produce information that is both as relevant and as reliable as possible, but at times it may be necessary to sacrifice some degree of one quality for a gain in the other.

"To be relevant to investors, creditors, and others for investment, credit, and similar decisions, accounting information must be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations" (Concepts Statement 2, paragraph 47). That definition of relevance is more explicit than the dictionary meaning of relevance as bearing on or relating to the matter in hand. As alluded to earlier, prior knowledge of information may diminish its value but not its relevance and, hence, its usefulness, for it is information's ability to "make a difference" that makes it relevant to a decision.

Statements about relevance of financial statement information must answer the question "relevant to whom for what purpose?" For information to be judged relevant, an object to which it is relevant must always be understood.

To be relevant, information must have predictive value or feedback value or both.

David Solomons, consultant on and major contributor to Concepts Statement 2, said in his book, Making Accounting Policy, that "whereas predictive value is forward-looking and is derived directly from its power to guide decisions, feedback value is derived from what information tells about the past." He gives as an example of a balance sheet item with predictive value the allowance for uncollectible receivables, which is the amount of accounts receivable that is not expected to produce future cash flows. The most important figure in financial statements with feedback value is the earnings figure, which "conveys information about the success of the ventures that have been invested in and also about the performance of the managers who have been responsible for running the business."^[137]

To say that accounting information has predictive value is not to say that in itself it constitutes a prediction (Concepts Statement 2, paragraph 53). Predictive value means value as an input into a predictive process, not value directly as a prediction. It is "the quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or present events" (Concepts Statement 2, glossary). Information about the present state of economic resources or obligations or about an enterprise's past performance is commonly a basis for expectations. Information is relevant if it can reduce the uncertainty surrounding a decision. It is relevant "if the degree of uncertainty about the result of a decision that has already been made is confirmed or altered by the new information; it need not alter the decision" (Concepts Statement 2, paragraph 49).

To be relevant, information also must be timely. Timeliness means "[h]aving information available to a decision maker before it loses its capacity to influence decisions" (Concepts Statement 2, glossary). Information that is not available when it is needed or becomes available only long after it has value for future action is useless. "Timeliness alone cannot make information relevant, but a lack of timeliness can rob information of relevance it might otherwise have had" (Concepts Statement 2, paragraph 56).

Reliability is the quality of information that allows those who use it to depend on it with confidence. "The reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has that representational quality" (Concepts Statement 2, paragraph 59). The hierarchy of qualities decomposes reliability into two components, representational faithfulness and verifiability, with neutrality shown to interact with them.

Representational faithfulness is "correspondence or agreement between a measure or description and the phenomenon it purports to represent. In accounting, the phenomena to be represented are economic resources and obligations and the transactions and events that change those resources and obligations" (Concepts Statement 2, paragraph 63). The FASB's conceptual framework emphasizes that accounting is a representational discipline. It represents things in the financial statements that exist in the real world. Therefore, the correspondence between the accounting representation and the thing being represented is critical.

Concepts Statement 2 uses an analogy with mapmaking to illustrate what it means by representational faithfulness:

Just as the lines and shapes on a road map represent roads, rivers, and geographical boundaries, so also descriptions and amounts in financial statements represent cash, property, sales, and a host of things owned or owed by an entity as well as transactions and other events and circumstances that affect them or their values. The items in financial statements have a higher degree of reliability as quantitative representations of economic things and events in the real world—and therefore more usefulness to investors and other parties interested in an entity's activities—if they faithfully represent what they purport to represent. Since the benefit of the information is representational and not aesthetic, to take "artistic license" with the data decreases rather than increases its benefit. Just as a cartographer cannot add roads, bridges, and lakes where none exist, an accountant cannot add imaginary items to financial statements without spoiling the representational faithfulness, and ultimately the usefulness, of the information.

Striving for representational faithfulness does not comprehend creating an exact replica of the activities of an enterprise. Perfect information is as beyond the reach of accountants as it is of nonaccountants.

Completeness of information is an important aspect of representational faithfulness, and thus of reliability, because if financial statements are to faithfully represent an enterprise's financial position and changes in financial position, none of the significant financial functions of the enterprise or its relationships can be lost or distorted. Completeness is defined as "the inclusion in reported information of everything material that is necessary for faithful representation of the relevant phenomena" (Concepts Statement 2, glossary). Financial statements are incomplete, and therefore not representationally faithful, if, for example, an enterprise owns an office structure but reports no "building" or similar asset on its balance sheet.

Completeness also is necessary to relevance, the other primary quality that makes accounting information useful:

Although completeness implies showing what is material and feasible, it must always be relative. Financial statements cannot show everything or they would be prohibitively expensive to provide.

Verifiability is "the ability through consensus among measurers to ensure that information represents what it purports to represent or that the chosen method of measurement has been used without error or bias" (Concepts Statement 2, glossary). Verifiability is an essential component of reliability—to be reliable, accounting information must be both representationally faithful and verifiable: "The reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has that representational quality" (Concepts Statement 2, paragraph 59). Verifiability fulfills a significant but relatively narrow function.

Three ideas are the focus of the discussion in Concepts Statement 2 of verifiability and its relation to reliability:

In present practice, for example, the result of measuring the quantity of an inventory is directly verifiable, while the result of measuring the carrying amount or book value of the inventory is only indirectly verifiable—the auditing process checks on the accuracy or verity of the inputs and recalculates the outputs but does not verify them.

It makes a difference to the reliability of accounting information whether an accounting measure itself is verified or only the procedures used to obtain the measure are verified because even if disagreements about choice of method and relevant inputs are ignored or resolved, merely rechecking the mechanics does not verify the representational faithfulness of the measure, leaving its reliability in doubt.

The distinguishing characteristic of accounting measures that normally are directly or separately verifiable as representing what they purport to represent is that they measure market prices in transactions between independent entities (Concepts Statement 2, paragraphs 65 and 67). Two or more independent measurers are likely to obtain essentially the same measures in each instance, and the separate measures will tend to cluster. Some will show more dispersion than others, and relatively few, if any, will be as tightly clustered as separate measures of cash, but whether or not they reasonably represent what they purport to represent is verifiable.

The distinguishing characteristic of accounting measures whose representational faithfulness normally cannot be verified because only the procedures used to obtain the measure are verifiable is that they result from allocations, which interpose between the resulting measures and the market prices on which they are based a calculation or other means of allotting the cost or other past price to time periods or individual assets. As a result, the inputs and procedures of the allocation process often are readily verifiable, but the outputs—the resulting measures—are not (Concepts Statement 2, paragraphs 65–67). Two or more independent measurers are unlikely to obtain essentially the same measures in each instance, and the separate measures will tend to be dispersed or scattered rather than clustered. The reliability of the accounting measures themselves cannot be verified because verifying only the procedures that produced them does not confirm or substantiate their representational faithfulness.

Since the point is likely to be misunderstood, it should explicitly be noted that the inability to verify the representational faithfulness of an accounting measure does not necessarily mean that the measure does not represent what it purports to represent. It generally means only that no one can know the extent to which the measure has or does not have that representational quality. Since the extent to which it represents faithfully the economic phenomenon it purports to represent is unknown, however, the measure cannot accurately be described as reliable.

Concepts Statement 2 also uses the difference between verifying a measure and verifying the method used to obtain it to show that reliability requires both representational faithfulness and verifiability. It illustrates how an accounting measure may be unreliable despite the verifiability of the allocation process that produced it using as an example the once-widespread practice, proscribed by FASB Statement No. 5, Accounting for Contingencies, for reasons described earlier in this chapter, of accruing "self-insurance reserves" by recognizing an annual expense or loss equal to a portion of expected future losses from fire, flood, or other casualties. Expectations of future losses could be actuarially computed for an enterprise with a large number of "self-insured" assets, and the methods of allocating expected losses to periods could be readily verified. Nevertheless, the representational faithfulness of the resulting measures would be extremely low, if not missing entirely. The "reserve for self insurance" in a balance sheet was a "what-you-may-call-it"—a deferred credit that did not qualify as a liability because the "self-insured" enterprise owed no one the amount of the reserve, or anything like it—and the allocated expense or loss in an income statement reported hypothetical effects of nonexistent transactions or events in years in which the enterprise suffered no casualties and, except by coincidence, grossly underreported losses incurred in years in which the enterprise's uninsured assets actually were damaged or destroyed by fire, flood, earthquake, hurricane, or the like.

Since the representational faithfulness of measures resulting from allocation procedures cannot be verified by rechecking the mechanics of how the measures were obtained, so-called historical cost accounting and other systems or models that depend heavily on allocations of prices in past transactions generally are considerably less reliable than is usually supposed. Concepts Statement 2 puts in perspective the oft-heard generalization that historical costs are "hard" information while current market prices are "soft" information—that historical cost information is reliable while current price information is not:

Considerable confusion about reliability of accounting information results from the propensity of accountants and others to use reliable, objective, and verifiable interchangeably even though the three terms are not synonyms if used precisely. Reliable is a broader term than verifiable, comprising not only verifiability but also representational faithfulness. Objective is a narrower term than verifiable. It means being independent of the observer, implying that objective accounting information is free of measurer bias—not affected by the hopes, fears, and other thoughts and feelings of the measurer—but saying little or nothing about measurement bias. "Objectivity" and "objective" should assume the narrower meaning in accountants' vocabularies and be replaced by "verifiability" and "verifiable" to describe measures whose representational faithfulness can be confirmed through consensus of independent measurers and thus are reliable.

Neutrality is concerned with bias and thus is a factor in reliability of accounting information. It is the "absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of behavior" (Concepts Statement 2, glossary). Accounting information is neutral if it "report[s] economic activity as faithfully as possible, without coloring the image it communicates for the purpose of influencing behavior in some particular direction" (paragraph 100).

A common perception and misconception is that displaying neutrality means treating everyone alike in all respects. It would not necessarily show a lack of neutrality to require less disclosure of a small company than of a large one if it were shown that an equal disclosure requirement placed an undue economic burden on the small company. Solomons says that neutrality "does not imply that no one gets hurt." His response to the argument that accounting policy can never be neutral because in any policy choice someone gets his or her preference and someone else does not clarifies the meaning of neutrality:

Neutrality requires that information should be free from bias toward a predetermined result, but that is not to say that standards setters or those who provide information according to promulgated standards should not have a purpose in mind for financial reporting. Accounting should not be without influence on human behavior, but it should not slant information to influence behavior in a particular way to achieve a desired end.

Former Board member Arthur R. Wyatt emphasized the crucial nature of the quality of neutrality in Concepts Statement 2 to the FASB's process and to the widespread acceptability of its resulting standards:

The Board unequivocally rejected the view that financial accounting standards should be slanted to foster a particular government policy or to favor one economic interest over another:

On several occasions, Donald J. Kirk, former Board chairman, also made the point that neutrality is essential to fulfilling the objective of providing relevant and reliable information to investors, creditors, and other users, and to prevent standards setting from becoming an exercise in directing resources to a preferred group. For example:

Neutrality in standards setting is so significant that it has been incorporated into the FASB's Mission Statement, and Concepts Statement 2 itself explains why neutrality is so critical to the Board and to the standards-setting process. The first and last words in the section entitled "Neutrality" are:

Comparing alternative investment or lending opportunities is an essential part of most, if not all, investment or lending decisions. Investors and creditors need financial reporting information that is comparable, both for single enterprises over time and between enterprises at the same time. Comparability is a quality of the relationship between two or more pieces of information—"the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena" (Concepts Statement 2, glossary). Comparability is achieved if similar transactions and other events and circumstances are accounted for similarly and different transactions and other events and circumstances are accounted for differently.

Comparability has been the subject of much disagreement among accountants. Some have argued that enterprises and their circumstances are so different from one another that comparability between enterprises is an illusory goal, and to include it as an aim of financial reporting is to promise to investors and creditors something that ultimately cannot be delivered. In that view, the best that can be hoped for is that individual enterprises will use their chosen accounting procedures consistently over time to permit comparisons with other enterprises and that honorable auditors will be able to attest to the consistent application of "generally accepted accounting principles."

The problem with that view of comparability is that it allows an excessive degree of latitude in reporting practice. It was the dominant view during the 1930s and 1940s and did permit, or even encouraged, the proliferation of alternative accounting procedures that characterized the period, many in situations in which few significant differences in enterprises or circumstances were ever reasonably substantiated. The result was an intolerable lack of comparability, which was responsible for much of the criticism directed toward financial accounting and eventually led to the replacement of the Committee on Accounting Procedure by the APB.

Today, with the objectives of financial reporting focused on decision making, comparability is one of the most essential and desirable qualities of accounting information. Investors and creditors can no longer be expected to tolerate blanket claims of differences in circumstances to justify undue use of alternative accounting procedures. Only actual differences in transactions and other events and circumstances warrant different accounting.

Concepts Statement 2 notes that the need for comparable information is a fundamental rationale for standards setting:

Some critics have focused on the standards setter's pursuit of comparability, calling it "uniformity," and mistakenly implying that standards are issued to require all enterprises to use the same accounting methods despite underlying differences. Comparability is, however, the antithesis of uniformity:

In fact, uniformity of practice may be a greater threat to comparability than is too much flexibility in choice of accounting method. Investors and creditors can often discern and compensate for lack of comparability caused by alternative procedures, but they usually have no way of detecting a lack of comparability caused by forced uniformity of practice.

Consistency, meaning "conformity from period to period with unchanging policies and procedures" (Concepts Statement 2, glossary), has long been regarded as an important quality of information provided by financial statements. For example, it was an explicit part of the recommendation of the Special Committee on Cooperation with Stock Exchanges in 1932 (pp. 2-4 to 2-116 of this chapter). Auditors are required to point out changes in accounting principles or in the method of their application that have a material effect on the comparability of a client's financial statements.

Consistent use of accounting methods, whether from one period to another within a single firm or within a single period across firms, is a necessary but not a sufficient condition of comparability. Consistency in applying accounting methods over time contributes to comparability, provided that the methods consistently applied were reasonably comparable to begin with. Lack of comparability will never be transformed into comparability by consistent application. If what is measured and reported has representational faithfulness, an accurate analysis of similarities and differences will be possible, and comparability is enhanced. However, in the same way that lack of timeliness can deprive information of relevance it might otherwise have had, inconsistent use of comparable information can ruin whatever comparability the information might otherwise have had.

Concern for consistency does not mean that accountants should not be open to new and better methods and standards. A change need not inhibit comparability if its effects are properly disclosed.

A word needs to be said about conservatism, an important doctrine in most accountant's minds, but not a separate qualitative characteristic in the FASB's hierarchy of qualities that make accounting information useful. The FASB has described conservatism as "a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in business situations are adequately considered" (Concepts Statement 2, paragraph 95). That is quite different from the traditional meaning of conservatism in financial reporting, which usually connoted deliberate, consistent understatement of net assets and profits, summed up by the admonition to "anticipate no profits but anticipate all losses." That view developed during a time when balance sheets were considered the primary (and often only) financial statement, and bankers or other lenders were their principal external users. Since understating assets was thought to provide a greater margin of safety as security for loans and other debts, deliberate understatement was considered a virtue.

The traditional application of conservatism introduced into reporting a preference "that possible errors in measurement be in the direction of understatement rather than overstatement of net income and net assets" (APB Statement 4, paragraph 171). In practice that often meant depressing reported net income by excessive depreciation or undervaluation of inventory or deferring recognition of income until long after sufficient evidence of its existence became available.

That kind of conservatism has now become discredited because it conflicts with the information's comparability, with its representational faithfulness and neutrality, and thus with its reliability. Any kind of bias, whether overly conservative or overly optimistic, influences the timing of recognition of net income or losses and may mislead investors as they attempt to evaluate alternative investment opportunities. Information that adds to uncertainty is inimical to informed and rational decision making and betrays the fulfillment of the objectives of financial reporting.

The final item on the hierarchy, characterized as a constraint or threshold for recognition, is materiality, which is a quantitative, not a qualitative, characteristic of information. Materiality judgments pose the question: "Is this item large enough for users of the information to be influenced by it?" (Concepts Statement 2, paragraph 123). Materiality means:

Popular usage of "material" often makes it a synonym for "relevant," but the two are not synonymous in Concepts Statement 2. Information may be relevant in the sense that it is capable of making a difference and yet the amounts involved are immaterial—too small to matter in a decision. To illustrate the difference between materiality and relevance, Concepts Statement 2 (paragraph 126) provides an example of an applicant for employment who is negotiating with an employment agency. On one hand, information about the nature of the duties, salary, hours, and benefits is relevant, as well as material, to most prospective employees. On the other hand, whether the office floor is carpeted and whether the cafeteria food is of good quality are relevant, but probably not material, to a decision to accept the job. The values placed on them by the applicant are too small to influence the decision.

However, materiality judgments go beyond magnitude itself to the nature of the item and the circumstances in which the judgment has to be made. Items too small to be thought material if they result from routine transactions may be considered material if they arise in abnormal circumstances. Therefore, one must always think in terms of a threshold over which an item must pass, considering its nature and the attendant circumstances as well as its relative amount, that separates material from immaterial items.

Where the threshold for recognition occurs with regard to a materiality decision is a matter of judgment. Many accountants would like to have more quantitative guidelines or criteria for materiality laid down by the SEC, the FASB, or other regulatory agency. The FASB's view has been that materiality judgments can best be made by those who possess all the facts. In recognition of the fact that materiality guidance is sometimes needed, the appendices to Concepts Statement 2 include a list of quantitative guidelines that have been applied both in the law and in the practice of accounting. However, if and when those guidelines specify some minimum size stipulated for recognition of a material item, they do not preclude recognition of a smaller segment. There is still room for individual judgment in at least one direction.

Information is subject to the same pervasive cost-benefit constraint that affects the usefulness of other commodities: Unless the benefits to be derived from information equal or exceed the cost of acquiring it, it will not be pursued. Financial information is unlike other commodities, however, in being a partly private and partly public good since "the benefits of information cannot always be confined to those who pay for it" (Concepts Statement 2, paragraph 135), and the balancing of costs and benefits cannot be left to the market.

Cost-benefit decisions about accounting standards generally have to be made by the standards-setting body—now the FASB. Both costs and benefits of accounting standards cut across the whole spectrum of the Board's constituency, with the benefits only partly accruing to those who bear the costs and the balance between costs and benefits reacting very imperfectly to supply and demand considerations. Moreover, individuals, be they providers, users, or auditors of accounting information, are not in a position to make cost-benefit assessments due to lack of sufficient information as well as probable biases on the matter.

Cost-benefit decisions are extremely difficult because both costs and benefits often are subjective and difficult or impossible to measure reliably. Cost-benefit analysis is at best a fallible tool. Although the Board is committed to doing the best it can in making cost-benefit assessments and Board members indeed have taken the matter seriously in facing the question in several standards in which it has arisen, cost-benefit measures and comparisons are too unreliable to be the deciding factor in crucial standards-setting decisions.

In the 25 years since the Trueblood Study Group, and later the FASB, authoritatively clarified the objectives of financial reporting and the consequent primacy of usefulness of financial information for decision making, an evolution in accounting thought has slowly taken place:

The qualitative characteristics have also had an impact on practice. Former FASB vice chairman Robert T. Sprouse, in an appearance at a Harvard Business School conference entitled "Conceptual Frameworks for Financial Accounting" in October 1982, described their contribution to accounting debate:

Concepts Statement No. 3, Elements of Financial Statements of Business Enterprises, issued in December 1980, defined 10 elements: assets, liabilities, equity, investments by owners, distributions to owners, and comprehensive income and its components: revenues, expenses, gains, and losses. The Statement introduced the term "comprehensive income," the name adopted by the Board for the concept that was called "earnings" in Concepts Statement 1 and the other conceptual framework documents previously issued, including the Tentative Conclusions on Objectives of Financial Statements of Business Enterprises (December 1976); the Discussion Memorandum, Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement (December); and the Exposure Draft, Objectives of Financial Reporting and Elements of Financial Statements of Business Enterprises (December 1977). As its title shows, the first Exposure Draft in the conceptual framework project dealt with both objectives and elements.

During 1978, the Board divided the subject matter of the Exposure Draft. One part developed into Concepts Statement 1 on objectives, and another part became the basis for a revised Exposure Draft, Elements of Financial Statements of Business Enterprises, which was issued in December 1979. The substance of that Exposure Draft became Concepts Statement 3.

The Board's work on not-for-profit reporting was advancing concurrently, and Concepts Statement No. 4, Objectives of Financial Reporting by Nonbusiness Organizations, was issued with Concepts Statement 3 in December 1980. The four Concepts Statements constituted a single conceptual framework for financial accounting and reporting by all entities. The Board voiced its expectation in Concepts Statements 2 and 3 that the qualitative characteristics and definitions of elements of financial statements should apply to both business enterprises and not-for-profit organizations.

The Board saw no need for two separate statements on elements as it had for the objectives.

To solicit views on applying the qualitative characteristics and definitions of elements to both business enterprises and not-for-profit organizations, the Board issued an Exposure Draft, Proposed Amendments to FASB Concepts Statements 2 and 3 to Apply Them to Nonbusiness Organizations, in July 1983. The Board reaffirmed the conclusion that the qualitative characteristics applied to not-for-profit organizations and issued a revised Exposure Draft, Elements of Financial Statements, in September 1985. Concepts Statement No. 6, Elements of Financial Statements, was issued in December 1985, superseding Concepts Statement 3 and extending that Statement's definitions to not-for-profit organizations. Most of Concepts Statement 3 was carried over into the parts of Concepts Statement 6 concerned with business enterprises or with both kinds of entities. Paragraph numbers were changed, however, because Concepts Statement 6 has numerous paragraphs that relate only to not-for-profit organizations or that explain how the definitions in Concepts Statement 3 apply to not-for-profit organizations.

Concepts Statement 6 defines the same 10 elements of financial statements that Concepts Statement 3 had defined: Seven are elements of the financial statements of both business enterprises and not-for-profit organizations—assets, liabilities, equity (business enterprises) or net assets (not-for-profit organizations), revenues, expenses, gains, and losses; and three are elements of financial statements of business enterprises only—investments by owners, distributions to owners, and comprehensive income. The Statement also defines three classes of net assets of not-for-profit organizations, characterized by the presence or absence of donor-imposed restrictions, and the changes in those classes during a period—changes in permanently restricted, temporarily restricted, and unrestricted net assets. For business enterprises, equity is defined only in total.

To try to avoid later confusion, Concepts Statement 6 is precise about what is an element and what is not. For example, cash, inventories, land, and buildings are items that fit the definition of assets, but they are not elements. Assets is the element:

The Statement then emphasizes that the elements in financial statements stand for things and events in the real world:

The definitions are of the real-world things and events, not of what is recognized in financial statements. That is, the definition of assets, for example, refers to assets such as the inventory in the warehouse, not to the word "inventory" and the related amount in the balance sheet.

A thing or event and its representation in financial statements commonly are called by the same name. For example, both the amount deposited in a checking account and its representation in the balance sheet are called cash in bank.

Elements of financial statements are of two types: those that constitute financial position or status at a moment in time and those that are changes in financial position over a period of time. Assets, liabilities, and equity or net assets describe levels or amounts of resources or claims to or interests in resources at a moment in time. All other elements—revenues, expenses, gains, and losses (and for business enterprises, comprehensive income, and investments by and distributions to owners)—describe the effects of transactions and other events and circumstances that affect an entity over a period of time. The interrelation between the two types of elements is called articulation:

The elements of financial statements are defined in relation to particular entities, which may be business enterprises, not-for-profit organizations, other economic units, or people. For example, items that qualify as assets under the definition are assets of particular entities.

There is no more fundamental concept in accounting than assets. Assets, or economic resources, are the lifeblood of both business enterprises and not-for-profit organizations. Without assets—to exchange for, combine with, or transform into other assets—those entities would have no reason to exist.

Because the concept of assets is so fundamental, one would think that the issue of what is or is not an asset would have been settled long ago. All accountants claim to know an asset when they see one, yet differences of opinion arise about whether some items called assets are assets at all and should be included in balance sheets. Those differences of opinion surfaced at the FASB's first hearings, as already described, and those experiences convinced early Board members that workable definitions of assets and liabilities were imperative.

The FASB decided on the conceptual primacy of assets and liabilities, meaning that the definitions of all the other elements of financial statements are derived from the definitions of assets and liabilities. Since the definition of assets is critical, Concepts Statement 6 provides a carefully worded definition with three essential facets, adds nine paragraphs explaining the characteristics of assets, and devotes a significant part of Appendix B to the Statement to elaborating the concept of assets. All of those sections are part of the definition of assets.

The definition of assets is in paragraph 25:

The definition indicates the appropriate questions to ask in trying to decide whether or not a particular item is an asset: Is there a future economic benefit? If so, to which entity does it belong? What made it an asset of that entity?

Assets commonly are items that also can be characterized as economic resources—the scarce means through which people and other economic units carry out economic activities such as consumption, production, and exchange. All economic resources or assets have "service potential" or "future economic benefit," the scarce capacity to provide services or benefits to the people or other entities that use or hold them.

All value of economic (scarce) goods and services derives ultimately from the utility of consumers' goods and services, which are used primarily by individuals and families. Their capacity to satisfy human needs or wants creates demand not only for them but also for the producers' goods and services, used primarily by business enterprises and other producers, that provide economic benefit by being used, directly or indirectly, to produce consumers' goods and services or other producers' goods and services. Cash is the asset par excellence because of what it can buy. "It can be exchanged for virtually any good or service that is available or it can be saved and exchanged for them in the future" (Concepts Statement 3, paragraph 23) and is the medium for settling most liabilities.^[147]

At least two questions need to be asked about the presence or absence of future economic benefit to determine whether or not an entity has an asset: Did the item obtained by an entity truly represent a future economic benefit in the first place, and does all or any of the future economic benefit to the entity remain at the time the issue of its being an asset is considered?

Concepts Statement 6 says that most assets presently included in financial statements qualify as assets under its definition because they have future economic benefits (paragraph 177). They include cash, accounts and notes receivable, interest and dividends receivable, and investments in the securities of other entities. Inventories of raw materials, work-in-process, and finished goods and productive resources such as property, plant, and equipment also qualify as assets, but some "assets" that have often been described in accounting literature as "deferred costs" or "deferred charges to revenues" either fail to qualify as assets or may perhaps represent assets but cannot reliably be recognized as assets.

Deferred costs that fail to qualify as assets are what-you-may-call-its—deferred costs that do not represent economic resources but are said to be assets "because they must be deferred and matched with future revenues to avoid distorting net income." For reasons described earlier, the Board firmly rejected the argument that "costs are assets," and Concepts Statement 6 is explicit:

Deferred costs that may or may not represent assets are victims of the pervasive uncertainty in business and economic affairs that often obscures whether or not some items have the capacity to provide future economic benefits to an entity and thus should be recognized as assets. A question arises whether an item received should be recognized as an asset or as an expense or loss if the value of future benefit obtained is uncertain or even doubtful or if the future benefit may be short-lived or of highly uncertain duration. Expenditures for research and development, advertising, training, development of new markets, relocation, and goodwill are examples of items for which management's intent clearly is to obtain or augment future economic benefits but for which there is uncertainty about the extent, if any, to which the expenditures succeeded in creating or increasing future economic benefits. That uncertainty led to FASB Statement No. 2, Accounting for Research and Development Costs, in which the Board for primarily practical reasons required entities to recognize the expenditures as expenses or losses rather than as assets. If research and development or advertising costs actually result in new or greater future economic benefit, that benefit qualifies as an asset. The practical problems are in determining whether future economic benefit is actually present and in quantifying it, especially if realization of benefits is far down the road, or perhaps never.^[148]

Services provided by other entities can be assets of an entity only momentarily as they are received and used, and they commonly are recognized as expenses when received, but the right to receive services for specified or determinable future periods qualifies as an asset.

The definition defines assets in relation to specific entities. An asset is an asset of some entity. No asset can simultaneously be an asset of more than one entity, although some physical assets may provide future economic benefits to two or more entities at the same time. That is, some assets comprise separable bundles of benefits that may be unbundled and held simultaneously by two or more entities so that each has an asset. For example, a building may provide future economic benefits to its owner, to an entity that leases space in it, and to an entity that holds a mortgage on it. Each has an interest in a different aspect of the same building, and each expects to receive cash flows from having one or more of the bundles of benefits.

An entity must control an item's future economic benefit to be able to consider the item as its asset. To enjoy an asset's benefits, an entity generally must be in a position to deny or regulate access to that benefit by others, for example, by permitting access only at a price.

An entity usually gains the ability to control an asset's future economic benefits through a legal right. However, an entity still may have an asset without having an enforceable legal right to it if it can obtain and control the benefit some other way, for example, by maintaining exclusive access to the asset's benefits by keeping secret a formula or process.

Items become assets of an entity as the result of transactions or other events or circumstances that have already occurred. An entity has an asset only if it has the present ability to obtain that asset's future economic benefits. If an entity anticipates that it may in the future control an item's future economic benefits but as yet does not have that control, it cannot claim that item as its asset because the transaction, other event, or circumstance conferring that control has not yet occurred.

Similarly, once acquired, an asset continues as an asset of an entity as long as the transactions, other events, or circumstances that use up or destroy its future economic benefit or deprive the entity of its control are in the future.

The definition of liabilities in paragraph 35 of Concepts Statement 6 has the same structure as the definition of assets in paragraph 25. The parallelism of the two definitions was deliberate.

Paragraph 36 describes the three characteristics that an item must possess to be a liability:

The definition prompts the following questions when trying to decide if a particular item constitutes a liability: Is there an obligation requiring a future sacrifice of assets? If so, which entity is obligated? What past transaction or event made it a liability of that entity?

Liabilities commonly arise as the consequence of financial instruments, contracts, and laws invented to facilitate the functioning of a highly developed economy by permitting delays in payment and delivery in return for interest or other compensation as the price for enduring delay. Entities routinely incur liabilities to acquire the funds, goods, and services they need to operate and just as routinely settle the liabilities they incur, usually by paying cash. For example, borrowing cash results in an obligation to repay the amount borrowed, usually with interest; using employees' knowledge, skills, time, and effort results in an obligation to pay compensation for their use; or selling products with warranties results in an obligation to pay cash or to repair or replace the products that prove defective. Liabilities come in a vast array of forms, but they all entail a present obligation requiring a nondiscretionary future sacrifice of some economic benefit:

Although most liabilities arise from exchanges between entities, most of which are contractual in nature, some obligations are imposed by laws or governmental regulations that require sacrificing assets to comply.

Receipt of proceeds—cash, other assets, or services—without an accompanying cash payment is often evidence that a liability has been incurred, but it is not conclusive evidence. Other transactions and events generate proceeds—cash sales of goods or services or other sales of assets, cash from donors' contributions, or cash investments by owners—without incurring liabilities. Liabilities can be incurred without any accompanying receipt of proceeds, for example, by imposition of taxes. It is the obligation to sacrifice economic benefits in the future that signifies a liability, not whether proceeds were received by incurring it.

Most liabilities presently included in financial statements qualify as liabilities under the definition because they require a future sacrifice of assets. They include accounts and notes payable, wages and salaries payable, long-term debt, interest and dividends payable, and obligations to honor warranties and to pay pensions, deferred compensation, and taxes. Subscriptions or rents collected in advance or other "unearned revenues" from deposits and prepayments received for goods or services to be provided are also liabilities because they obligate an entity to provide goods or services to other entities in the future. Those kinds of items sometimes have been referred to as deferred credits or reserves in the accounting literature.

A liability entails an obligation—legal, moral, or ethical—to one or more other entities to convey assets to them or provide them with services in the future. Not all probable future sacrifices of assets are liabilities of an entity. An intent or expectation to enter into a contract or transaction to transfer assets does not constitute a liability until an obligation to another entity is taken on.

The obligation aspect of liabilities is not emphasized as strongly in the definition in the Concepts Statement as it perhaps might have been. The Board became enamored with making the one-sentence definitions of assets and liabilities parallel to accentuate the symmetry between future benefits of assets and future sacrifices of liabilities.

The definition of an asset emphasizes its "service potential" or "future economic benefit," "the scarce capacity to provide services or benefits to the entities that use them" (paragraph 28), the common characteristic possessed by all assets. The definition of a liability puts first "future sacrifices of assets" to make it parallel with the asset definition, but it would have been more precise to focus on an entity's obligation to another entity to transfer assets or to provide services to it in the future. Future sacrifices of assets, after all, are the consequence—not the cause—of an obligation to another entity. Liabilities are present obligations of a particular entity to transfer assets or provide services to other entities in the future requiring probable future sacrifices of economic benefits as a result of past transactions or events.

Some kinds of assets and liabilities are mirror images of one another. Receivables and payables are the most obvious example. Entity X has an asset (a receivable) because Entity Y has a liability (a payable) to transfer an asset (most commonly cash) to Entity X. Unless Entity Y has the liability, Entity X has no asset. Those relationships hold for rights to receive and obligations to pay or deliver cash, goods, or services. In fact, they hold for most contractual relationships involving a right to receive and an obligation to deliver. Receivables and payables cancel each other in national income accounting, for example, leaving land, buildings, equipment, and similar assets as the stock of productive resources of the economy.

Most kinds of assets are not receivables, and a host of assets have no liabilities as mirror images. For example, the benefit from owning a building does not stem from an obligation of another entity to provide the benefit. The building itself confers significant benefits on its owner. The owner may, of course, enhance the benefits from the building by obtaining the right to services provided by others, who incur corresponding obligations, but that is a separate contractual arrangement involving both rights and obligations for the contracting parties.

Consequently, the Board's concern with the symmetry between the future benefits of assets and the future sacrifices of liabilities tended to overshadow the obligation to another entity that is the principal distinguishing characteristic of a liability. The definition of liabilities in Concepts Statements 3 and 6 and the accompanying explanations might well have profited from a brief description such as that in FASB Statement No. 5, Accounting for Contingencies, paragraph 70.

Items become liabilities of an entity as the result of transactions or other events or circumstances that have already occurred. An entity has a liability only if it has a present obligation to transfer assets to another entity. Budgeting the payments required to enact a purchase results neither in acquiring an asset nor in incurring a liability because no transaction or event has yet occurred that gives the entity access to or control of future economic benefits or binds it to transfer assets.

Once incurred, a liability remains a liability of an entity until it is satisfied, usually by payment of cash, in another transaction or is otherwise discharged or nullified by another event or circumstance affecting the entity.

The word "probable" is included in the asset and liability definitions with its general, not accounting or technical, meaning and refers to that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved.^[151] Its use was intended to indicate that something does not have to be certain or proved to qualify as an asset or liability. The first Exposure Draft did not contain the word "probable." It identified assets with "economic resources—cash and future economic benefits—" saying that a "resource other than cash ... must, singly or in combination with other resources, contribute directly or indirectly to future cash inflows ..." and identified liabilities with "obligations ... to other entities," saying that "the obligation must involve future sacrifice of resources ..." ^[152] The Board received many comment letters that said, in essence, "almost nothing can ever be an asset or liability because you have said that it has to be certain, and everything except cash is uncertain."

The Board thus inserted "probable" into the definition, but perhaps "expected" would have been a better word. As long as someone thinks that an item has value and is willing to pay for it, the item has value and meets the definition of assets, even if the expectation turns out to have been mistaken. It is easy to read more into the use of "probable" than was intended. "Probable" is not an essential part of the definitions; its function is to acknowledge the presence of uncertainty and to say that the future economic benefits or sacrifices do not have to be certain to qualify the items in question as assets and liabilities, not to specify a characteristic that must be present.

Although the application of the definitions of assets and liabilities commonly requires some assessment of probabilities, degrees of probability are not part of the definitions. The degree of probability of a future economic benefit (or of a future cash outlay or other sacrifice of future economic benefits) and the degree to which its amount can be estimated with reasonable reliability, both of which are required to recognize an item as an asset (or a liability), are recognition and measurement matters.

The asset and liability definitions screen out items that lack one or more of the three essential characteristics that assets and liabilities, respectively, must possess. Assets and liabilities have other features that help identify them. Assets may be acquired at a cost, tangible, exchangeable, or legally enforceable. Liabilities usually require the obligated entity to pay cash to one or more entities and are also legally enforceable. However, the difference between those features and the three characteristics identified by Concepts Statement 6 as essential to assets and liabilities is that the absence of a nonessential feature, by itself, is not sufficient to disqualify an item from being an asset or liability. For example, absence of a market price or exchangeability of an asset does not negate future economic benefit that can be obtained by use of the asset instead of by its exchange, although it may cause recognition and measurement problems. In contrast, absence of even one of the three essential characteristics does preclude an item from being an asset or liability:

Equity of business enterprises and net assets of not-for-profit organizations have the same definition.

Nevertheless, both terms should be used with care to assure that the referent is clear. Differences between business enterprises and not-for-profit organizations and the ways they carry out their respective missions, particularly the relative importance of transactions with owners to business enterprises and of gifts or donations to not-for-profit organizations, result in significant differences between the equity or net assets of the two kinds of entities.

Thus, whether a particular use of either equity or net assets refers to a business enterprise or a not-for-profit organization often is significant to investors, creditors, and other resource providers.

A footnote referenced to paragraph 50 notes that although the terms are interchangeable, "[t]his Statement generally applies the term equity to business enterprises, which is common usage, and the term net assets to not-for-profit organizations, for which the term equity is less commonly used." That terminology has the advantage of being both common and consistent, but what assures consistent clarity of meaning is Concepts Statement 6's careful use of the terms. It usually gives the complete names—equity of a business enterprise and net assets of a not-for-profit organization—using the shortcuts "equity" and "net assets" only if the referent is clear from the context. As a result, even if it interchanged the terms—net assets of a business enterprise or equity of a not-for-profit organization—the meaning would still be unmistakable.

Although the term wealth is not part of most accountants' technical vocabularies, as explained earlier the definitions of the elements of financial statements in Concepts Statement 6 (carried over from Concepts Statement 3) make an enterprise's wealth and changes therein the major subject matter of financial accounting and reporting. The definitions of assets, liabilities, and equity in Concepts Statement 6 are all in terms of wealth. The Statement identifies assets with "economic resources.... the scarce means that are useful for carrying out economic activities, such as consumption, production, and exchange," whose "common characteristic ... is 'service potential' or 'future economic benefit,' the scarce capacity to provide services or benefits to the entities that use them" (Concepts Statement 6, paragraphs 27 and 28). That is, the definition of assets refers to economic resources, rights to economic resources, and other things in the real-world environment in which financial accounting and reporting takes place that constitute wealth, and the definition of liabilities refers to obligations to transfer wealth to other entities. As a result, the definition of equity or net assets refers to net wealth of a business enterprise or a not-for-profit organization, and the remaining definitions refer to increases and decreases in wealth over time.

Equity of business enterprises represents the ownership interests of those who invest funds in a business enterprise with the expectation of obtaining a return on their investment as a result of the enterprise's operating at a profit. Since equity ranks after liabilities as a claim to or interest in the assets of the enterprise, it is a residual interest. Changes in it result from profits and losses as well as from investments by and distributions to owners. Equity is often referred to as "risk capital," for in an uncertain world owners not only benefit if an enterprise is profitable but also are the first to bear the risk that an enterprise may be unprofitable.

Liabilities and equity are mutually exclusive claims to or interests in an enterprise's assets by other entities, and liabilities take precedence over ownership interests. Although the line between equity and liabilities is clear in concept, it increasingly has been obscured in practice by introduction of financial instruments having characteristics of both liabilities and equity. Convertible debt instruments and redeemable preferred stock are common examples of securities with both debt and equity characteristics, which may cause problems in accounting for them.

Equity of a business enterprise is increased and decreased by investments by owners and distributions to owners—unique transactions "between an enterprise and its owners as owners rather than as employees, suppliers, customers, lenders, or in some other nonowner role" (Concepts Statement 6, paragraphs 60 and 68).

Not-for-profit organizations (pp. 2-96–2-97 of this chapter) have no comparable transactions.

A business enterprise may make discretionary distributions to owners, usually by the formal act of declaring a dividend, but it is not obligated to do so. Many enterprises have several classes of equity, each with different priority claims on enterprise assets in discretionary distributions or in the event of liquidation, depending on the degree to which they bear relatively more of the risk of unprofitability. All classes of equity depend to some extent on enterprise profitability for distributions of assets, and no class has an unconditional right or absolute claim to the assets of an enterprise except in the event of liquidation of the enterprise, and even then, owners must stand behind creditors, who have a priority right to enterprise assets (Concepts Statement 6, paragraph 62).

Investors, creditors, and others focus on comprehensive income to help them assess an enterprise's prospects for generating net cash inflows because, in the long run, it is through comprehensive income that they obtain a return on their investments, loans, or other association with an enterprise. Thus, the Concepts Statements recognize the significance of income and information about income of an enterprise to investors, creditors, and others.

Concepts Statement 6 defines comprehensive income as

Comprehensive income and investments by and distributions to owners—class B in Exhibit 2.4—account for all changes in equity of a business enterprise during a period. The exhibit not only distinguishes the sources of changes in equity in class B from each other but also distinguishes them from other transactions and events affecting the enterprise during a period. Class A comprises exchange transactions that change assets or liabilities, or both, but do not change equity. They are common in most business enterprises. Events in class C are less familiar—changes within equity that do not affect assets or liabilities or change the amount of equity, such as stock dividends, conversions of preferred stock into common stock, and some stock recapitalizations.

Figure 2.4. Transactions and other events that change assets, liabilities, and equity of business enterprises. (Source: Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 6, par. 64.)

Concepts Statements 3 and 6 define the components of comprehensive income—revenues, expenses, gains, and losses—as well as comprehensive income (paragraph references are from Concepts Statement 6):

Revenues and expenses represent actual or expected cash inflows and outflows usually associated with the ongoing major operations and earning and financing activities of an enterprise, leaving other more peripheral and incidental changes in equity to be described as various kinds of gains and losses.

The definitions of revenues, expenses, gains, and losses are less precise and serve a different purpose than the definitions of the six elements described in the preceding pages—assets, liabilities, equity, investments by owners, distributions to owners, and comprehensive income. Those six constitute the complete set of definitions of fundamental elements of financial statements of business enterprises. They are mutually exclusive and collectively are both necessary and sufficient to account for the wealth and net wealth of an enterprise at any time and for all changes in its net wealth during a period, including the changes comprising profit or loss (or income) for the period.^[154]

In contrast, distinctions between revenues and gains and between expenses and losses are not needed to determine comprehensive income. Since comprehensive income is determined by changes in assets and liabilities, it can be derived without separating it into its various components.

Revenues, expenses, gains, and losses are useful not to define comprehensive income but to show how it is obtained.

Definitions of the components of comprehensive income are significant because to satisfy the objectives of financial reporting, that is, to provide information intended to be useful to investors and creditors in assessing an enterprise's performance or profitability, requires more information about comprehensive income than just its amount. Investors and creditors want and need to know how and why equity has changed, not just the amount that it has changed. The sources of comprehensive income are significant to those attempting to use financial statements to help them with investment, credit, and similar decisions.

Comprehensive income is an all-inclusive income concept and results from many and varied sources. The primary source of comprehensive income is an enterprise's major or central operations, but income also can often be generated by peripheral or incidental activities in which an enterprise engages. Moreover, the economic, legal, social, political, and physical environment in which an enterprise operates creates events and circumstances—such as, price changes, interest rate changes, technological changes, impositions of taxes and regulations, discovery, growth or accretion, shrinkage, vandalism, thefts, expropriations, wars, fires, and natural disasters—that can affect comprehensive income but that may be partly or wholly beyond the control of individual enterprises and their managements (Concepts Statement 6, paragraphs 74 and 75; the examples are from paragraph 32).

Those many and varied transactions and other events that constitute sources of comprehensive income—central and peripheral, planned and unplanned, controllable and noncontrollable—result in receipts that may differ in stability, risk, and predictability. Thus the desire for information about the various sources of comprehensive income underlies the distinctions between revenues, expenses, gains, and losses.

Different components of income are useful to distinguish revenue generated from the production and sale of products from return on investments in marketable securities in an income statement. The primary purpose of separating comprehensive income into revenues and expenses and gains and losses is to make the display of information about an enterprise's sources of comprehensive income as useful as possible.

A not-for-profit organization has no ownership interests that can be sold or transferred or that convey entitlement to a share of a residual distribution of resources in the event of liquidation of the organization. It thus does not receive investments of assets by owners and is generally prohibited from distributing assets as dividends to its members or officers. Increases in its net assets result from receipt of assets from resource providers who expect to receive neither repayment nor return on the assets. However, some resource providers may impose permanent or temporary restrictions on the uses of the assets they contribute to be able to influence an organization's use of those assets. Thus, Concepts Statement 6 (paragraphs 92–94) divides net assets of not-for-profit organizations into three mutually exclusive classes—permanently restricted net assets, temporarily restricted net assets, and unrestricted net assets. Restrictions restrain the organization from using part of its resources for purposes other than those specified, for example, to settle liabilities or to provide services outside the purview of the restrictions.

Briefly, permanently restricted net assets is the part of net assets resulting from inflows of assets whose use by the organization is limited by donor-imposed stipulations that neither expire nor can be satisfied or otherwise removed by any action of the organization. Stipulations that require resources to be permanently maintained but that permit the organization to use the income derived from the donated assets are often called endowments.

Temporarily restricted net assets is the part of net assets governed by donor-imposed stipulations that can expire or be fulfilled or removed by actions of the organization in accordance with those stipulations. Once the stipulation is satisfied, the restriction is gone.

Unrestricted net assets is the part of net assets resulting from all revenues, expenses, gains, and losses that are not changes in permanently or temporarily restricted net assets. The only limits on unrestricted net assets are the broad limits encompassing the nature of the organization, which are specified in its articles of incorporation or bylaws, and perhaps limits resulting from contractual agreements (for example, loan covenants) entered into by the organization in the course of its operations.

Although a not-for-profit organization does not have ownership interests or comprehensive income in the same sense as a business enterprise, to be able to continue to achieve its service and operating objectives, it needs to maintain net assets such that resources made available to it at least equal the resources needed to provide services at levels satisfactory to resource providers and other constituents. To assess an organization's success at maintaining net assets, resource providers need information about the components of changes in net assets—revenues, expenses, gains, and losses. The definitions of revenues, expenses, gains, and losses of business enterprises also apply to not-for-profit organizations and

A not-for-profit organization's central operations—its service-providing efforts, fund-raising activities, and most exchange transactions—by which it attempts to fulfill its service objectives are the sources of its revenues and expenses. Gains and losses result from activities that are peripheral or incidental to its central operations and from interactions with its environment, which give rise to price changes, casualties, and other effects that may be largely beyond the control of an individual organization and its management.

Concepts Statement 6 also defines several "terms of art" or significant financial accounting and reporting concepts that are used extensively in the conceptual framework.

Transactions and other events and circumstances affecting an entity is a phrase used throughout the conceptual framework to describe the sources or causes of changes in assets, liabilities, and equity. Real-world occurrences that are reflected in financial statements divide into two categories: events and circumstances. They can be further divided into this hierarchy:

Events are by far the most important, encompassing external happenings, including transactions, and internal happenings. The breakdown of events into those various components highlights differences that are important to financial accounting.

Transactions are external events that include reciprocal transfers of assets and liabilities between an entity and other entities called exchanges and nonreciprocal transfers between an entity and its owners or between an entity and entities other that its owners in which one of the participants is often a passive beneficiary or victim of the other's actions:

Investments by and distributions to owners are nonreciprocal transfers because they are events in which an enterprise receives assets from owners and acknowledges an increased ownership interest or disperses assets to owners whose interests decrease. They are not exchanges from the point of view of the enterprise because it neither incurs any obligations nor sacrifices any of its assets in exchange for owners' investments, and it receives nothing of value to itself in exchange for the assets it distributes with the payment of a dividend.

Circumstances, in contrast, are not events but the results of events. They provide evidence of often imperceptible events that may already have happened but that are discernible only in retrospect by the resulting state of affairs. They are important in financial reporting because they often have accounting consequences.

The objectives of financial reporting are served by accrual accounting, which generally provides a better indication of an entity's assets, liabilities, and performance than does information about cash receipts and payments. Accrual accounting is defined in paragraph 139 of Concepts Statement 6:

Accrual accounting is based not only on cash transactions but also on all the transactions, events, and circumstances that have cash consequences for an entity but involve no concurrent cash movement. By accounting for noncash assets, liabilities, and comprehensive income, accrual accounting links an entity's operations and other transactions, events, and circumstances that affect it with its cash receipts and outlays, thereby providing information about its assets, liabilities, and changes in them that cannot be obtained by accounting only for its cash transactions.

Concepts Statement 6 also provides technical definitions of the following procedures used to apply accrual accounting [emphasis added]:

That is a narrow definition of matching, similar to the definitions of Herman W. Bevis and George O. May (pp. 2-37 to 38 of this chapter). The definition excludes from matching the systematic and rational allocation of revenues or costs to periods by a formula and makes matching a single process in measuring comprehensive income, not a synonym for the entire periodic income determination process, as it commonly has been.

Concepts Statement 6 also includes an example on debt discount, premium, and issue cost (paragraphs 235–239) to illustrate precise technical differences between some of those terms.

Recognition decisions often cannot be separated from measurement decisions, particularly if the decision relates to when to recognize changes in assets and liabilities. Recognition and measurement were eventually combined in the conceptual framework because most Board members became convinced that certain recognition questions, which were among the most important to be dealt with, were so closely related to measurement issues that it was unproductive to try to handle them separately. The product of that union was Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, issued in December 1984.

Concepts Statement 5 includes concepts that relate recognition and measurement to the earlier Concepts Statements. For example, it is the part of the conceptual framework in which the FASB describes the financial statements that should be provided and how those financial statements contribute to the objectives of financial reporting.

To satisfy the objectives of financial reporting—to provide information that is useful to investors and creditors and other users in making rational investment, credit, and similar decisions; to provide information to help them assess the amounts, timing, and uncertainty of prospective net cash inflows to an enterprise; and to provide information about the economic resources, claims to those resources (obligations to transfer resources to other entities and owners' equity), and changes in and claims to those resources—requires a full set of articulated financial statements that report:

Figure 2.5. Information useful for investment, credit, and similar decisions. (Source: Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5, par. 5.)

A full set of financial statements provides information about an entity's financial position and changes in its financial position. Financial position, as depicted in a balance sheet, is determined by the relationship between an entity's economic resources (assets) and obligations (liabilities), leaving a residual (net assets or owners' equity). In addition, information about earnings, comprehensive income, cash flows, and transactions with owners are different kinds of information about the effects of transactions and other events and circumstances that change assets and liabilities during a period—that is, they are information about different kinds of changes in financial position.

Not all information useful for investment, credit, and similar decisions that financial accounting is able to provide can be reported in financial statements. Concepts Statement 5 includes a diagram (Exhibit 2.5) illustrating the many kinds of information that investors and creditors may contemplate consulting when deciding whether to invest in or loan funds to an enterprise. Financial statements provide only part of the information useful for investment, credit, and similar decisions. Financial reporting also encompasses notes to financial statements and parenthetical disclosures, which provide information about accounting policies or explain information recognized in the financial statements. Supplementary information about the effects of changing prices or management discussion and analysis provides information that may also be relevant for making decisions but is deemed not to meet the criteria necessary for recognition in financial statements. Financial statements are unique because the information they provide is distinguished by its capacity and need to withstand the scrutiny of accounting recognition.

Concepts Statement 5, expanding the one-sentence definition in Concepts Statement 3, defines recognition as

A slight shift in emphasis discloses another characteristic of recognition: "Recognition attempts to represent or depict in financial statements the effects on an entity of real-world economic things and events.^[155] That description is congruent with the idea expressed throughout the conceptual framework that financial reporting is concerned with providing information about things and events that occur in the real world in which accounting takes place.

Concepts Statement 5 affirms the value of information disclosed in notes or other supplementary information as essential to understanding the information recognized in financial statements, but it also makes it clear that

Although information provided by notes to financial statements or by other means is valuable and ought to be made available to investors, creditors, and other users, it is not a substitute for recognition in the body of financial statements with the amounts included in the financial statement totals.

Concepts Statement 5 says that a full set of financial statements should report both comprehensive income and earnings. Since the distinction between comprehensive income and earnings in the Statement is another manifestation of the difference of opinion about whether income is an enhancement of wealth (command over economic resources) or an indicator of performance of an enterprise and its management, the Statement implies that financial statements should report both kinds of information. Present practice reports neither earnings nor comprehensive income, although a statement of net income based on present generally accepted accounting principles may report either or both if there are no changes in accounting principles or no holding gains or losses reported as direct increases or decreases in equity instead of in net income.

Comprehensive income was defined in Concepts Statement 3 as an all-inclusive income concept:

Comprehensive income is the only concept of income defined in the FASB's conceptual framework.^[156] Although Concepts Statement 5 referred a half dozen times to "the concept of earnings" and gave earnings much more attention than comprehensive income, neither Concepts Statement 5 nor any other Concepts Statement defined earnings or its close relative net income. Instead, Concepts Statement 3, paragraph 1, footnote 1 [carried over into Concepts Statement 6], explained that the Board had changed to comprehensive income the name of the concept that was called earnings in Concepts Statement 1 and other conceptual framework documents previously issued and had reserved the term earnings for possible use to designate a component part of comprehensive income.

Later, Concepts Statement 5 did use the term earnings to describe a component part of comprehensive income that corresponds to net income in current practice, except that it excludes the so-called catch-up adjustment required by paragraph 19(b) of APB Opinion No. 20, Accounting Changes, to be included in net income.^[157]

The Concepts Statements describe but do not define earnings and net income because they cannot be defined. Both result from applying generally accepted accounting principles and are determined by what is done in practice at a particular time—the meaning of each changes with changes in generally accepted accounting principles. Thus, paragraph 35 of Concepts Statement 5 says:

Those kinds of arguments also have been advanced urging exclusion of recurring gains and losses that increase the volatility of reported net income, and the FASB has to some extent responded. For example, FASB Statement No. 12, Accounting for Certain Marketable Securities (1975), and FASB Statement No. 52, Foreign Currency Translation (1981), excluded from net income certain holding gains and losses (gains and losses from holding assets or owing liabilities while their prices change). Briefly, Statement 12 required the carrying amount of a marketable equity securities portfolio to be the lower of its aggregate cost and market value but required that changes in the carrying amount of a noncurrent marketable equity securities portfolio "be included in the equity section of the balance sheet [that is, not included in net income] and shown separately" (paragraph 11). Similarly, Statement 52 provided that "translation adjustments [as defined in the Statement] shall not be included in determining net income but shall be reported separately and accumulated in a separate component of equity" (paragraph 13). The Board had taken a step away from the APB's decision to make reported net income all-inclusive—"net income should reflect all items of profit and loss recognized during the period with the sole exception of the prior period adjustments" (APB Opinion No. 9, Reporting the Results of Operations [December 1966], paragraph 17)—and had set the stage for the distinction between earnings and comprehensive income that it made in Concepts Statement 5.

As might have been expected, comprehensive income generally has been criticized for being too inclusive, among other things including volatile holding gains and losses that are excluded from net income or earnings. For example, John W. March's dissent to Concepts Statement 5 reflected the common view that periodic income determination should focus on performance rather than report gains and losses from all sources that increase or decrease wealth. These are the first and penultimate paragraphs of his dissent:

As March suggested, Concepts Statement 5 contains good, brief descriptions of the goal of periodic income determination in the minds of those who think it should focus on performance.

Concepts Statement 5, as noted earlier, devoted much more attention to earnings than to comprehensive income, and for more than 10 years the Board did nothing more about its conclusion that a full set of financial statements reports comprehensive income (paragraph 13). Most people had, to their knowledge, never seen a statement that reports comprehensive income and may have had difficulty picturing it and its relation to an income statement in present practice.

As a result of Statements 12 and 52 and other FASB Statements of which they were forerunners, net income is less all-inclusive than it was, say, after issuance of APB Opinion 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). Since the FASB has not required a statement of comprehensive income, pronouncements such as Statements 12 and 52 that exclude volatile holding gains and losses from net income and bury them directly in equity have made it possible for many U.S. enterprises to report periodic income that reflects their domestic and foreign operations as less risky than they actually are.

That may be about to change. The Board recently has been talking about how to report both earnings, or its close relative net income, and comprehensive income and has issued an Exposure Draft, Reporting Comprehensive Income (June 20, 1996).^[160] The Board's effort seems to have been encouraged by Financial Reporting in the 1990s and Beyond (1993), a report by the Financial Accounting Policy Committee of the Association for Investment Management and Research (AIMR) intended to express the views of AIMR members on financial reporting.

Maintenance of capital is a financial concept or abstraction needed to measure comprehensive income. Since comprehensive income is a residual concept, not all revenues of a business enterprise for a period are comprehensive income because the sacrifices necessary to produce the revenues must be considered. Capital used up during the period must be recovered from revenues or other increases in net assets before any of the return may be considered comprehensive income. A concept of capital maintenance is critical for distinguishing an enterprise's return on investment from return of investment because an enterprise receives a profit or income—a return on investment—only after its capital has been maintained or recovered.

Two major concepts of capital maintenance exist, the financial capital concept and the physical capital concept (which is often described as maintaining operating capability, that is, maintaining the capacity of an enterprise to provide a constant supply of goods or services).

In Concepts Statement 5, the Board decided that the concept of financial capital maintenance is the basis for a full set of articulated financial statements.

Financial capital maintenance can be measured either in units of money (for example, nominal dollars) or in units of constant purchasing power (e.g., 1982–1984 dollars or 2007 dollars).

The Board rejected the physical capital concept, which holds that

The general procedure for maintaining physical capital is to value assets, such as inventories, property, plant, and equipment at their current replacement costs and to deduct expenses, such as cost of goods sold and depreciation, at replacement costs from revenues to measure periodic return on capital. The increases and decreases in replacement costs of those assets while they are held by the enterprise are included in owners' equity as a "capital maintenance adjustment" rather than in return on capital as "holding gains and losses." The idea underlying the measurement of return on capital in the physical capital concept is that increases in wealth that are merely increases in prices of things that an enterprise must continue to hold to engage in operations do not constitute return on capital but part of the capital to be maintained.

The principal difference between the two concepts is in the treatment of holding gains and losses resulting from the effects of price changes during a period on assets while held and on liabilities while owed.

By definition, recognition includes the depiction of an item in both words and numbers. The need to quantify the information about an item to be recognized introduces the issue of its measurement.

Attribute is defined and explained in footnote 2 to paragraph 2 of Concepts Statement 1:

Since recognition often involves recording changes in assets and liabilities, it often raises the question of whether the amount of an attribute should be changed or whether a different attribute should be used in its place. In any event, since the changes in an asset or liability and in the attribute occur at the same time, it is often difficult to separate recognition from measurement problems.

Five different attributes of assets and liabilities are used in present accounting practice. The following is based on paragraph 67 of Concepts Statement 5, which describes the attributes and gives examples of the kinds of assets for which each attribute is commonly reported:

The preceding pages have described several areas in which Concepts Statement 5 has furthered the conceptual framework, at least to some extent—in identifying what a full set of financial statements comprises, in expanding and clarifying what constitutes recognition, in explaining the relationship between comprehensive income and its component part, earnings, and in endorsing financial capital maintenance.

Although the Statement's name implies that it gives conceptual guidance on recognition and measurement, its conceptual contributions to financial reporting are not really in those two areas. As a result of compromises necessary to issue it, much of Concepts Statement 5 merely describes present practice and some of the reasons that have been used to support or explain it but provides little or no conceptual basis for analyzing and attempting to resolve the controversial issues of recognition and measurement about which accountants have disagreed for years.

The FASB knew all along that recognition and measurement concepts would be controversial. Each component of the conceptual framework—the objectives, the qualitative characteristics, the elements of financial statements, recognition and measurement—is successively less abstract and more concrete than the one before. Recognition and measurement are the most concrete and least abstract of the components because they are necessarily at the point at which concepts and practice converge. They are the components in which practicing accountants have been most interested because they determine what actually gets into the numbers and totals in the financial statements. While few practitioners may be interested in what they may see as abstractions—such as objectives, qualitative characteristics, and definitions—most are interested in a change in revenue recognition or the measured attribute of an asset, or perhaps in reporting the effects of inflation, and they usually feel that they have a vested interest in the Board's decisions regarding recognition and measurement and in resisting changes that may adversely affect their future reporting.

Accountants have strongly held, and ultimately polarizing, views about which is the most relevant and reliable attribute to be measured and about the circumstances needed for recognizing changes in attributes and changes in the amounts of an attribute. Proponents of the present model—which often is mislabeled historical cost accounting because it is actually a mixture of historical costs, current costs, current exit values, net realizable values, and present values—fiercely defend it and broach no discussion of alternatives for fear that any change would portend its abandonment in favor of current value accounting, a term that is used generically to refer to the continuous use of any attribute other than historical cost. Similarly, proponents of various current cost or current value models are equally unyielding, often almost as critical of other current value or current cost models that compete with their own favorite model as they are of the historical-cost model for its failure to recognize the realities of changing values and changing prices.

The Board was as badly split on recognition and measurement as the constituency. Although most Board members could see the deficiencies in the current model, a majority of the Board could not accept a current value or current cost measurement system, even at a conceptual level. Therefore, instead of indicating a preferred accounting model or otherwise offering conceptual guidance about measurement, Concepts Statement 5 merely acknowledged that present practice consists of a mix of five attributes for measuring items in financial statements and said that the Board "expects the use of different attributes to continue" (paragraph 66). Beyond that, it said that "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), which was extremely weak guidance. Whereas a neutral exposition of alternatives was appropriate for a Discussion Memorandum, a litany of present measurement practices with neither conceptual analysis or evaluation nor guidance for making choices was not proper for a Concepts Statement.

In merely describing current practice, Concepts Statement 5 is a throwback to statements of accounting principles produced by the "distillation of experience" school of thought—an essentially practical, not a conceptual, effort. Its prescriptions for improving practice are reminiscent of those of the Committee on Accounting Procedure or the APB: Measurement problems will be resolved on a case-by-case basis. Unfortunately, that approach worked only marginally well for those now-defunct bodies.

Oscar Gellein called the discussion of recognition in the Exposure Draft that ultimately became part of Concepts Statement 5 "a helpful distillation of current recognition practices." However, he also saw that the Statement would not advance financial reporting in the area of recognition and measurement:

David Solomons criticized Concepts Statement 5 for distorting the process of formulating future accounting standards.^[162] He noted that in several places it asserts that concepts are to be developed as the standards-setting process evolves, citing these examples:

Solomons was not at all persuaded by the Board's apparent argument, represented by those excerpts, that concepts could be a by-product of the standards-setting process:

Concepts Statement 5 almost seems to have anticipated the challenges to its legitimacy as a Statement of recognition and measurement concepts and capitulated in its second and third paragraphs, which could serve as its epitaph:

Concepts Statement 5 does make some noteworthy conceptual contributions—they are just not on recognition and measurement.

The Statement addresses the following fundamental questions relevant to determinations that use future cash flows and present value techniques:

Present value techniques (discounting using the compound interest formula) are used for the purpose of incorporating in accounting determinations the time value of money. The time value of money refers to the fact that the earlier money is to be obtained, the more valuable the prospective receipt is; and the later money needs to be paid, the less burdensome the obligation to pay it is. Those facts are reflected in accounting determinations involving future cash receipts or future cash payments that incorporate present value techniques. The Board justifies its consideration of present value techniques based on the facts that present value is one of the foundations of economics and corporate finance, that the computation of present value is part of most modern asset-pricing models, and that the present value of future cash flows is implicit in all market prices.

The Board does not say what the implicit relationship is. It is the following: (1) The seller believes that the present value of the future cash receipts the seller could obtain in the future from using the object being sold is less than the amount of money represented by the price involved in the sale or less than the present value the seller could receive from an alternative investment the seller could make with the proceeds of sale—that is why the seller is willing to sell at the price of the sale—and (2) the buyer believes that the present value of the future cash receipts the buyer will receive in the future from using the object being sold is more than the amount of money represented by the price involved in the sale—that is why the buyer is willing to buy at the price of the sale. Thus, the price of the sale does not equal the present value as seen by either the buyer or the seller.

The Statement illustrates the time value of money with (1) an asset with a contractual cash receipt of $10,000 due in one day, certain of receipt (though nothing about the future is certain); (2) an asset with a contractual cash receipt of $10,000 due in 10 years, certain of receipt; (3) an asset with a contractual cash receipt of $10,000 dues in one day, with the receipt to be equal to or less than $10,000; (4) an asset with a contractual cash receipt of $10,000 due in 10 years, with the receipt to be equal to or less than $10,000; and (5) an asset with an expected cash receipt of $10,000 due in 10 years, with the receipt to be at least $8,000 but not more than $12,000. By reporting the assets all at the amounts contracted or expected to be received, they would all be reported at the gross amounts of $10,000. That would be misleading, because they are not economically the same—they differ on timing and certainty of receipt—and a buyer who wants to maximize his or her resources would not agree to pay the same amount for all of the assets.

Discounting the gross amounts $10,000 using present value techniques and discount rates and periods that reflect the diverse timing and diverse certainty of receipt of the assets would reflect the time value of money and work to counteract the misleading effect. The following are the elements of such a present value calculation:

Fair value incorporates all of those elements. When used in accounting determinations at initial recognition and fresh-start determinations, present values are used only to approximate fair values that cannot be determined directly from the market.

The Board states that the fair value, if determinable, would encompass the consensus view of those interested in buying the asset, of the asset's utility, future cash flow, uncertainties surrounding the cash flows, and discount in the price demanded for the uncertainties. (There is, however, no such consensus view. There is only one view for each prospective buyer, which differs among prospective buyers. The term consensus implies that the prospective buyers agree. The fair value is the maximum price any prospective buyer would be willing to pay for the asset, not a consensus price.)

The usual determination of the amount of an asset at initial recognition is its cash price in the exchange in which it is acquired if it is acquired in an exchange in which there is a cash price (the Board notes an exception related to unstated rights or privileges described in APB Opinion No. 21).

If an asset is acquired other than in such an exchange, the Board states that its amount should be determined when acquired at fair value. If the asset is acquired in a nonmonetary exchange, its amount should be determined to be the fair value of the asset surrendered to obtain it, in conformity with APB Opinion No. 29.

Fair value can be determined most satisfactorily by reference to the price in a recent exchange for cash involving an asset similar to the asset whose amount is being determined. If there is no such exchange, the Board contends that amounts may have to be determined by estimating the future cash flows involved with the asset and applying present value techniques. The objective in determining the discount rate in the present value calculation is that contained in APB Opinion No. 21:

The principles that apply to determinations at initial recognition apply equally for fresh-start determinations. Because an asset subject to a fresh-start determination is not then acquired in an exchange involving a cash price, its amount cannot be determined directly at such a price. Determining its amount is necessarily confined to concepts involving fair value, as discussed above for assets acquired other than in exchanges involving a cash price.

The Board lists the following existing accounting conventions alternative to fair value that incorporate the elements of a present value calculation listed above to diverse extents: value-in-use (entity-specific determinations), effective-settlement determinations for liabilities, and cost-accumulation or cost-accrual determinations. Each of those conventions contains factors that are specific to the reporting entity: It adds factors not contemplated in the price of an exchange involving the kind of asset involved and assumptions of the entity's management not made by buyers and sellers in the market, or it excludes factors contemplated by buyers and sellers in the market, or both. The alternative conventions are related to the fact that the best estimate by the entity's management of the present value of uncertain future cash flows may differ from the fair value of those cash flows. The reasons the management's expectations might differ from those expected by buyers and sellers in the market include:

Those items represent contemplated future comparative advantages enjoyed by the reporting entity relative to the asset or liability over those enjoyed by other buyers or sellers in the market. If the amount of an asset or liability is determined at initial recognition or at a fresh start using one of those alternative conventions and the offset to the amount is to revenue or expense, the contemplated future comparative advantage is reported in income at initial recognition or fresh-start determination. If the amount of an asset or liability is determined at those times using fair value, the contemplated future comparative advantage is reported in the periods in which it realizes assets or settles liabilities at amounts that differ from fair value.

Some suggest that the amounts of assets and liabilities be determined at initial recognition or at a fresh start at amounts that incorporate the contemplated future comparative advantages, because they contend that that would better help users of financial statements assess the amounts and timing of prospective cash receipts to them. The FASB points out, however, that such reporting ignores the uncertainties involved in the prospective cash flows. It further points out that though knowledge of management's expectations is often useful and informative, the market is the final arbiter of asset and liability values, and that fair value, which incorporates those values, results in neutral, complete, and representational faithful determinations of the economic characteristics of the asset or liability. Further, the alternative conventions imply various discount rates, such as an asset-earning rate, an incremental-borrowing rate, or an embedded interest rate, with no conceptual basis for choosing among them. For all of those reasons, the FASB has decided that, as stated above, the amount of an asset or liability should be determined at initial recognition or at a fresh start at fair value. It points out, however, that a lack of other data might sometimes require incorporating the expectations of the reporting entity's management in implementing the fair value principle.

To implement the determination of fair value using present value techniques, the risk-free interest rate must be determined, future cash flows must be estimated, the uncertainty involved in those cash flows must be estimated, and other factors affecting the estimated cash flow, such as possible variations in their amounts or timing, illiquidity, or market imperfections, must be considered. There are two ways to incorporate those factors in the calculation. First, the uncertainty and the other factors may be used to determine risk-adjusted estimates of the future cash flows and the pure risk-free interest rate applied to them. Second, the risk-free interest rate may be adjusted for the uncertainty and the other factors to determine a risk-adjusted interest rate and applied to the unadjusted estimated future cash flows.

Before getting into the details of determining the factors required for the calculation of present value, the Board lists general principles to follow to avoid biasing the calculation:

If the asset or liability consists of contractual cash flows (a promised series of future cash receipts or payments), they should be used as the future cash flows in the calculation. A single interest rate, often described as "the rate commensurate with the risk," is consistent for assets and liabilities with contractual cash flows with the manner in which marketplace participants describe assets and liabilities, such as a "12 percent bond." Such an approach is useful for determinations in which comparable assets and liabilities can be observed in the marketplace.

However, that approach is unsuited for complex problems of amount determination, including determination of the amounts of nonfinancial assets and liabilities for which there is no market for the asset or liability or for a comparable asset or liability. If no contractual cash flows are involved, the cash flows must be estimated. To determine the present value of such an asset or liability, the observable rate of interest of a comparable asset or liability must be used. The comparable asset or liability must have cash flows whose characteristics are similar to those of the asset or liability whose amount is being determined. The following must be done to do so:

In complex situations, the future cash flows should be determined by the expected cash flow approach. That approach uses the sum of probability-weighted amounts in a range of possible estimated amounts. The Board illustrates that as follows for uncertain amounts. The probabilities of cash flows are $100 with a probability of 10 percent, $200 with a probability of 60 percent, and $300 with a probability of 30 percent. The expected cash flow is ($100 × 10%) + ($200 × 60%) + ($300 × 30%) = $220. It illustrates that for uncertain timing of receipts or payments as follows. An estimated cash flow of $1,000 may be received or paid in one year with a probability of 10 percent, in two years with a probability of 60 percent, or in three years with a probability of 30 percent. The comparable interest rates are 5 percent for one year, 5.25 percent for two years, and 5.5 percent for three years. The expected present value is ([$1,000 discounted at 5% for one year = $952.38^[164]] × 10%) + ([$1,000 discounted at 5.25% for two years = $902.73^[165] × 60%) + ([$1,000 discounted at 5.5% for three years = $851.61^[166] × 30%) = $95.24 + $541.64 + $255.48 = $892.36.

Those illustrations go beyond the use of present value techniques for "contractual rights to receive money or contractual obligations to pay money on fixed or determinable dates" (APB Opinion No. 21, par. 2). Such techniques cannot reflect uncertainties in timing. Calculations such as those illustrated are not routinely used by accountants. They are required, however, in determinations of pensions, other postretirement benefits, and some insurance liabilities. They are allowed for determination of impairment of long-lived assets and estimating the fair value of financial instruments. The Board answers those who may object to applying probabilities to highly subjective estimates of future cash flows by stating that the approach without applying probabilities uses the same subjective estimates without the "computational transparency" of the illustrated approach.

The Board discusses these situations as examples in which the information needed to implement the calculations is limited:

Obtaining the data to make such complex calculations can be expensive. The Board states that, as usual, the cost of implementing this technique should be commensurate with the benefits to be obtained from it by the users of financial statements.

The Board notes objections to the expected cash flow technique in selected circumstances. For example, an asset or liability has an expected cash flow of $10 with a 90 percent probability and an expected cash flow of $1,000 with a 10 percent probability. The technique arrives at a fair value of ($10 × .9) + ($1,000 × .1) = $109. They say that represents neither the $10 nor the $1,000. The Board says the $109 represents the fair value, which neither the $10 nor the $1,000 represents.

Statement of Concepts No. 7 focuses on determination of amounts, not on recognition. In contrast, FASB Statement of Standards No. 5 and FASB Interpretation No. 14 focus on recognition of loss "contingencies." (That is a misnomer. Statement No. 5 calls for recognition of a loss if it is probable that an asset has been impaired or a liability or an increase in a liability has been incurred and that future events will confirm the loss. There is nothing contingent about such events.) Nevertheless, the Statements interact.

For example, determining the fair value of a loan involves expectations about potential default, but recognizing a loss under Statement No. 5 requires that it be probable that a loss has been incurred. The Board presents an illustration that it states raises issues that are "intractable" and beyond the scope of Statement No. 7. If the preceding illustration is changed to make the 90 percent probability a cash flow of $0, the expected cash flow is $100 but Statement No. 5 would seem to call for recognition of the liability at $0. Or, if a reporting entity had 10 potential liabilities with the characteristics of this illustration with the outcomes of the 10 independent of one another, some would conclude that a probable loss is $1,000, because one in 10 will probably materialize. Statement No. 5 would on that basis report a loss of $1,000, but Statement No. 7 would report no loss.

Some losses are reported by adjustment to the existing amortization or reporting convention not involving a current interest rate, not through a fresh-start determination. Such adjustments are beyond the scope of Statement No. 7. A fresh-start determination such as required by FASB Statement of Standards No. 121 is consistent with Statement No. 7.

FASB Interpretation No. 14 prescribes a determination of an amount equal to the minimum value in the range involved. That is inconsistent with Statement No. 7.

The fair value estimate should include the amount sellers are able to receive for bearing the risk inherent in the cash flows from the asset, if it is identifiable, determinable, and significant. Including an arbitrary adjustment for risk or arbitrarily excluding an adjustment for risk in unacceptable. Matrix pricing, option-adjusted spread models, and fundamental analysis are ways to estimate the risk adjustment. However, if no reliable estimate of the risk premium can be obtained or if it is small compared with the potential error in estimating the future cash flows, the risk-free interest rate may be preferable to use.

The uncertainty involved in the risk of owning the asset should be described clearly. For example, a lender on 1,000 loans may set the interest rate based on the view that some loans will default, whereas another lender on 1,000 loans may set the interest rate based on the view that 150 loans will default. Determination of the present value in those situations should make the distinction.

A purchaser of an asset with a given certain expected future cash flow would pay more for the asset than for an asset with the same expected future cash flow but that involves uncertainty. That is because people prefer to avoid uncertainty (are "risk-averse"). For that reason, the Board concludes that uncertainty should be factored into determination of present value to approximate fair value. The risk premium, the premium for uncertainty, is often difficult to determine. The Statement describes approaches to the problem, including portfolio theory, behavioral finance theory, and the Capital Asset Pricing Model, including problems with and disputes over each.

Calculations to determine fair values in the absence of readily observable market values, whether to determine future cash flows or present values, use estimates and therefore are inherently imprecise. Nevertheless, though different conclusions may be reached about the amount and timing of future cash flows and adjustments for uncertainty and risk, the use of expected future cash flows and simplifying assumptions permits the determination of present values that are sufficiently reliable and much more relevant than undiscounted amounts.

The Statement discusses techniques to estimate the fair value of a liability at initial recognition or at a fresh start. The objective is to estimate the value of the assets to either settle the liability with the holder or transfer the liability to an entity of comparable credit standing. One way is to estimate the price at which the liability can be sold as an asset to another entity. The other way is to estimate the price the reporting entity would have to pay another entity to assume the liability. Both of those involve the credit standing of the reporting entity. The price at which the liability can be sold or that the reporting entity would have to pay another entity to assume the liability is affected by the perceived risk of holding the liability as an asset. The greater the perceived risk, the less another entity would agree to pay to obtain the liability as an asset (the greater the required effective interest rate), and vice versa.

In complex liabilities, such as a liability with a range of possible outflows, the effect of risk may be more effectively included by computing expected cash flows.

Including the reporting entity's credit standing in the determination of the amount at which to report a liability at initial recognition and at a fresh start has been controversial, with some contending that such reporting involves a paradox—income is reported when the reporting entity's credit standing declines. The FASB is adamant, however: "... there is no rationale for why, in initial or fresh-start measurement, the recorded amount of a liability should reflect something other than the price that would exist in the marketplace."^[167] In fact, Lorensen has presented such a rationale, an argument in favor of reporting a liability at its risk-free funding rate.^[168]

The FASB goes on to disagree that there is a paradox:

The main objection to the FASB's defense is that it relies on the effects on parties separate from the reporting entity: the creditors and the shareholders. The financial report on a reporting entity should be solely about effects of events on the reporting entity, not on any other entity. Regardless of changes in the values of claims to the creditors or rights of shareholders, the reporting entity has the same obligation to make the same payments, unchanged by changes affecting the creditors or shareholders.

The FASB states that the reporting entity's reported shareholders' equity "may appear" to increase using the kind of reporting it prefers in the face of a decline in the credit standing of the reporting entity. In fact, it does increase. The FASB says that the increase probably is offset by losses that may have occasioned the decline in credit standing. The message is that it is correct to, in effect, reverse reporting such losses. No justification for such a reversal is offered or apparent.

Though, as the FASB states, the marketplace evaluates the quality of the respective cash flows of the Class One and Class Two liabilities it illustrates as similar to one another, their promised cash flows are different, because their interest payments are different, reflecting the difference in the credit standing between the times they were incurred. Under the reporting recommended by Lorensen, they would appear different. Were their required cash flows the same, they would appear the same under the reporting recommended by Lorensen.

All methods of so-called systematic and rational allocation use formulas selected at the beginning of the periods of allocation. They are said to report changes in value, utility, or substance of assets and liabilities over time, though the FASB states that "they are not measurements." Interest methods of allocation use the compound interest formula, for example, for amortization of discount or premium as prescribed by APB Opinion No. 21. They are considered most relevant to circumstances in which a borrowing and a lending is involved, similar assets or liabilities are allocated using the interest method, a set of estimated future cash flows is closely associated, and the calculation at initial recognition was based on present value.

Applying an interest method of allocation requires description of the kind of cash flow (promised, expected, etc.), the kind of interest rate to be used (effective or other), application of the rate (constant effective or a series of annual), and how to report changes in the amount or timing of the estimated cash flows. Changes in market interest rates are ignored. Changes in estimates of cash flows are included in a fresh-start calculation or affect the interest amortization plan. The plan may be affected by a prospective approach, computing a new effective interest rate, a catch-up approach, adjusting the carrying amount of the asset or liability to the amount it would have been had the new estimate been made originally, or a retrospective approach based on actual cash flows to date and newly estimated remaining cash flows. The FASB expresses a preference for the catch-up approach. Though some consider the retrospective approach best, the cost of applying it may be prohibitive.