Recurring and Vexatious Issues in Financial Reporting

1
Recurring and Vexatious Issues in Financial
Reporting

• 2nd ESRC/CAIR Conference
• Manchester Business School
• Manchester University
• April 2008
• Katherine Schipper
• Duke University

2
Overview

• Defining control and applying the definition
• Definitions of assets and liabilities
• Separating unit of account issues from
  measurement issues, including the implications of
  fair value measurements
• Recognition
• What is the purpose of recognition criteria?
• What entity should recognize a given item?
• Distinguishing liabilities from equity
• Some final questions to consider

3
What does control mean?

• Control of an entity
• Ability to manage/direct an outcome
• How is this detected?
• Majority ownership of shares?
• But control might not be conveyed by share
  ownership (as in VIEs)
• And control can be latent (obtained by converting
  an instrument), held by a group of related
  parties, or effective (a large minority ownership
  position)
• Control of an asset
• Ability to retain an outcome (perhaps without the
  ability to manage/direct)
• How is this notion of control related to the idea
  of property rights?
• Ability to use, benefit from, transfer and
  exclude others
• Can control exist in the absence of one or more
  of the four elements of property rights?

• Observations
• Inability to define and measure control of an
  entity has led to no consolidation standard to
  replace ARB 51/Interpretation 46R in U.S. GAAP
  and IAS 27/SIC 12 in IFRS
• Inability to define and measure control of an
  asset has led (in the U.S.) to SFAS 140 and its
  related implementation issues

4
Asset definition proposed by the IASB/ FASB
An asset of an entity is a present economic
resource to which, through an enforceable right
or other means, the entity has access or can
limit the access of others.

• Is the fundamental concept access, (having
  access or limiting others access) and a right is
  just one example of how access arises?
• If yes, why give one example of access (a right)
  instead of stating the concept?
• If yes, what are other examples of
  gaining/limiting access?
• Is the idea of access intended to replace the
  notion of control?
• If yes, is the change an improvement?
• Was control too restrictive or too expansive?
• Was control confusing because it has two
  meanings?
• Control as the ability to manage/direct an
  outcome
• Control as the ability to retain that outcome
  (even absent the ability to manage/direct)

• Questions to consider
• What is the practical difference between control
  and access as that term is described in the
  proposed assets definition?
• Would it be preferable to clarify the two
  meanings of control, and specify which is
  intended in a given context, instead of
  abandoning the term?

5
Asset definition access

• Example Option to buy land at a fixed price
• Is the land a present economic resource? Does
  the holder of the option have access to it and
  the ability to control others access?
• If yes, why wouldnt the holder of the option
  record the land?
• Proposed definition does not identify the land as
  the asset to be recorded. Instead, the proposed
  definition appears to follow the current
  derivative accounting model, and discern elements
  in the arrangement other than the land to which
  the entity has access
• Example In a forward sale of corn, the subject
  of the contract (corn) is not relevant. The
  contract creates assets/liabilities in the form
  of promises to stand ready to take delivery or
  promises to stand ready to perform

• Question to consider
• Should there be symmetry?
• If the holder of the option has an asset, does
  the writer of the option have a liability?
• Alternatively does the writer of the option have
  an asset whose value is capped by the exercise
  price?

6
Asset definition present economic resource

• Present economic resource (that can be used in
  commercial activities)
• Does the ability to sell access to a future
  stream of cash that is likely to occur create an
  asset?
• Example An entity has access to its own future
  revenues even though its customers actually
  determine the exact amounts and timing of those
  revenues. Does the ability to securitize future
  revenues create an asset (i.e., the ability to
  sell the access is the economic resource)?
• Note that the entity does not control the
  revenues, because it cannot compel the customers
  to buy.
• Does spending to develop intangible productive
  capacity which is expected to be usable in
  commercial activities create an asset?
• Example In-process RD is viewed as an asset in
  recently issued guidance on applying the purchase
  method, while the same spending outside a
  business combination is not.
• In neither case is there an item that can be
  currently used in commercial activities, so what
  is the present economic resource?
• Is it sufficient that the entity can (at least in
  principle) sell the in-process RD?
• The entity clearly has control and access but
  does it have a present economic resource?

7
Liability definition proposed by the IASB/FASB
A liability is a present economic burden for
which the entity has a present obligation.

• What is encompassed by present economic burden?
• Could it be either a cash outflow or a reduced
  cash inflow?
• However, reduced cash inflow implies a
  benchmark, relative to which the entity is worse
  off
• What defines that benchmark?
• Does writing a fixed price call option on an
  entitys own shares create a liability?
• Does receiving a payment not to take an action
  (e.g., enter a market) create a liability (or a
  revenue/gain)?

• Question to consider
• Are the ideas behind cash outflow and reduced
  cash inflow conceptually distinct, so that they
  should receive different accounting treatments?
• Cash outflow gt transfer of assets
• Reduced cash inflow gt opportunity cost

8
Liability definition present obligation

• Present obligation
• If the liabilities definition is intended to
  parallel the assets definition, should the notion
  of an obligation parallel the notion of access?
• Do the expectations of others (e.g., employees,
  customers) about how an entity will act create a
  present obligation for the entity to act
  according to those expectations?
• Expectations based on past behavior
• Expectations based on what is economically
  advantageous

• Questions to consider
• How if at all should expectations be included in
  elements definitions?
• If expectations can create liabilities can they
  also create assets?
• Is there a difference between expectations about
  how others will behave (e.g., customers will
  continue to buy) and expectations about how the
  entity will behave (e.g., the entity will
  continue to provide postretirement benefits)?

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Other questions to consider

• What exactly is the problem with the current
  definitions?
• Too many assets and liabilities recognized or too
  few?
• Recognized too early or too late?
• Failure of representational faithfulness?
• Recognizing the wrong items or measuring items
  the wrong way?
• Distinguishing between liabilities and equity?
• Would the proposed definitions solve these
  problems (without creating others)?
• How long (and detailed) should an asset or
  liability definition be?
• Example Proposed assets definition is either 30
  words or three paragraphs. Is a definition that
  requires three paragraphs of explanation
  desirable? workable?
• Can financial statement elements be defined in
  isolation?
• Is it necessary to have explicit consideration of
  recognition, measurement and the unit of account?

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Can measurement affect the unit of account?

• Assume an obligation can be settled with the
  counterparty for 100 (the face value) or
  transferred to another entity of comparable
  credit quality for 95
• Examples checking accounts (demand deposits),
  certain mandatorily redeemable shares and certain
  cash balance pension obligations

• Questions to consider
• Is this a matter of defining the unit of account,
  so that accounting must identify an embedded
  intangible asset that causes the 5 difference?
• Is this a matter of fair value ? settlement value
  (because of market participants expectations
  about the counterpartys behavior)?
• What would the counterparty to the 100
  arrangement show as its asset (is symmetry
  necessary)?
• The counterparty has privileged access to 100.
  Must the provider of the privileged access have
  an obligation of the same magnitude?

11
Can measurement affect the unit of account?

• Assume an asset such that
• In order to operate the asset the entity must
  agree to disassemble and clean up at the end of
  the service life
• The asset cost is 200 but because of the
  disassembly and cleanup obligation the fair value
  is 150

• Questions to consider
• Is this an asset with an embedded performance
  obligation and if so should the obligation be
  separately recognized?
• Is this an asset that is impaired as soon as it
  is placed in service?
• Does intent matter? For example, does it matter
  whether the entity must agree (e.g., because of a
  law or regulation) or intends to
  disassemble/clean up because that is economically
  necessary?

12
Measurement issues fair value

• Fair value measurement is based on expectations
  about the future
• Does this characteristic threaten the definitions
  of assets and liabilities which refer to present
  resources and obligations?
• Example Ability to sell an uncertain stream of
  cash flows whose existence, amount and timing can
  be estimated, and whose actual outcomes are
  determined by others actions
• Do some unit of account vs. measurement questions
  arise because some arrangements have both
  positive and negative cash flows?
• Examples obligations with embedded intangible
  assets, assets with embedded obligations
• Should the positive versus negative cash flows be
  separated for accounting purposes, or netted?
• Fair value of the entire arrangement is a net
  amount that would reflect the net of the positive
  and negative cash flows
• Separate accounting gt separate recognition of
  items that are economically linked and may not be
  able to be separately settled or transferred
• Netting gt must identify the boundaries of the
  arrangement
• Example 1 pension assets netted against pension
  obligations
• Example 2 obligations under secured borrowing
  netted against the collateral

13
Recognition criteria

• Is the purpose of recognition criteria to place
  restrictions beyond the elements definitions on
  what is accounted for in the financial
  statements?
• If yes, why do this?
• Asymmetry (conservatism)
• If the credit is to revenues, should special
  conditions be imposed?
• Measurement uncertainty (imprecise measure)
• Holding measurement uncertainty constant, too
  hard to measure (cost to measure prohibitive)
• How should recognition and derecognition criteria
  be related?
• Recurring issue in accounting for financial asset
  transfers
• Appears also in variants of defeasance accounting
  (e.g., recognize the net pension obligation, not
  the gross liability and assets)

• Question to consider
• The outcome of not recognizing an item because of
  measurement uncertainty is the same as recording
  the item at zero. Under what circumstances is
  this desirable?

14
Recognition criteria

• Should cost benefit considerations be included in
  recognition criteria?
• Examples of costs and benefits
• Out of pocket cost (paid ultimately by
  shareholders)
• Presumably these shareholders (as well as
  creditors) receive benefits from improved
  financial reporting
• Cognitive burden on preparers and auditors
• Cognitive burden on financial statement users
• Understand complicated reports
• Learn new accounting, as standards change
• Better allocation of capital (easier to discern
  where to invest and where not to invest)
• Better reporting of performance
• Reduced information risk should reduce the costs
  of debt and equity capital

Question to consider What is the nature and
magnitude of a cost that would justify not
recognizing an item that meets the definition of
a financial statement element?
15
Recognition issue whose asset/liability is it?

• Should definitions specify who should record an
  asset or liability?
• Why would an asset, once held, be more likely to
  be assigned to a Transferor (relative to one
  never held)?
• Why does accounting analyze the Transferees
  rights to determine the Transferors accounting?
• Example (from U. S. GAAP)
• Interpretation 46R/SFAS 140 effects
• Example An arrangement fails sale accounting
  because assets are not bankruptcy remote
  (although Transferor is far from insolvency).
  However, Transferor cannot access the cash flows
  of the assets (they have been sold to Investors).
  Should Transferor record the assets and the
  liabilities associated with this arrangement?

Question to consider Does abandoning the notion
of control as an accounting criterion result in
an entity recognizing too many assets and
liabilities?
16
Distinction between liabilities and equity

• Is this distinction
• Necessary?
• Practicable?
• Outmoded because of developments in financial
  instruments?
• Should there be a new element?
• Requires two distinctions, not one
• Does not suggest how to classify the payouts
  (e.g., subtraction in determining income vs.
  distribution of income)
• Why stop at just one new element?
• Should there be just two elements (assets and
  claims)?
• Does not suggest how to classify the payouts
• Does not suggest how to measure (and remeasure)
  claims
• Places burden on financial statement users
• Leverage analysis requires separating fixed
  claims from residual claims
• Solvency analysis requires determining which
  claims can lead to insolvency
• Estimating fundamental (intrinsic) value requires
  identifying which claims are residual

17
Distinction between liabilities and equity

• Should a liabilities definition be useful for
  distinguishing debt from equity (current
  proposals do not seem to have this
  characteristic)?
• Would separating more instruments into components
  be helpful?
• REO approach (in the FASBs Preliminary Views)
  separate instruments into equity and a loan based
  on contingent claims asset pricing
• Under this approach a written call option an
  asset (loan) equity
• Or, would less separation be helpful? Two
  extremes to consider
• Only ownership matters (any dilutive arrangement
  is liability)
• Only solvency matters (any arrangement that does
  not require assets to settle is equity)

• Questions to consider
• Does the existence of 62 pieces of guidance in US
  GAAP on issues related to debt versus equity
  raise questions about practicability?
• Would a simpler approach that focuses on
  dilution (the basic ownership approach in the
  FASBs Preliminary Views) be preferable?
• Easier to implement?
• Not representationally faithful?
• Should expectations about the entitys behavior,
  or market participants behavior, affect the
  liability versus equity distinction?
• Examples Expectations that an issuer will pay
  preferred dividends or a holder will exercise an
  in-the-money call option on shares

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Some final questions to consider

• Why hasnt financial reporting solved these
  issues?
• Issue identificationdifficult to determine
  precisely what is the problem
• Problems shift as new instruments and new
  commercial arrangements are created
• Unambiguous conceptual solutions lacking
• Difficult to work out definitions and
  recognition/measurement guidance
• Example Liability definitions based on either
  solvency or dilution are conceptually defensible,
  so which is preferred?
• Due process
• A given proposal is exhaustively reviewed by
  constituents with strong views on that proposal
  (but who may be indifferent to other standard
  setting issues)
• Constituents do not agree with fundamental
  aspects of the FASBs and IASBs conceptual
  frameworks
• Constituents may object to conceptually sound
  proposals on pragmatic grounds
• Increases income volatility
• Requires investments in information systems
• Requires learning new concepts or measurements