Advanced Accounting Research
October 5, 2009
FRAME: Our objective is to determine whether or not there are significant conceptual differences between FASB's Concept Statements and the IFRS Framework. In addition, we will assess the president of MCI's preliminary view that IFRS is easier to apply due to the fact that it is principal based instead of rules based like US GAAP.
ANALYSIS: We used the source documents: FASB's Concept Statements and the IFRS Framework to prepare our answers to the questions stated above. We also referred to the class text book, class notes and releases by the IASB and FASB based on staff papers and discussions for further background and insights.
While there are similarities between the two frameworks as outlined in the chart above, such as the subjects contained in the two frameworks, the differences are significant. First, FASB ranks the qualitative characteristics of relevance, reliability, comparability, and understandability while the IFRS does not. Therefore, IFRS does not provide guidance over which point trumps in the event of conflict and essentially leaves this decision up to the preparers of financial statements. Further, FASB states that verifiability is one the components of reliability. Since IFRS does not mention verifiability, perhaps IASB has a different idea of what information is sound enough to be included in financial statements. The absence of verifiability flies in the face of the concept of audited in the United States.
Another area of difference is comprehensive income. FASB states that comprehensive income is a component of the financial statements while IFRS does not. Therefore, it is not clear if certain transactions which would flow through comprehensive income under FASB would flow through income under IFRS, or would simply be omitted?
IFRS has one category of expense, while FASB has categories for expense, loss, and distributions to owners. Therefore, it seems that at certain points on the P&L, income components under FASB would not be comparable to IFRS. Along the same lines, FASB includes equity and investment by owner as separate components of the financial statements, while IFRS only includes equity. It is unclear what level of granularity would be visible to users of financial statements under IFRS.
Finally, IFRS defines profit in terms of Financial Capital Maintenance (profit is earned if the financial amount of net assets at end of period exceeds the net assets at the beginning of period excluding distributions by owners) and Physical Capital Maintenance (profit is earned only if the physical or operating productive capacity at the end of the year). These concepts are absent from FASB's framework and therefore it looks like FASB and IFRS differ on the definition of profit itself.
Our conclusion is that the differences between the two conceptual frameworks outweigh the similarities. Further, due to the more general nature of IFRS, we argue that it is more difficult to apply than US GAAP. There are more situations under GAAP where there is specific guidance offered on the way to proceed. On the other hand, under IFRS, preparers of financial statements are left to use their own judgment in many instances, and risk having that judgment challenged and possibly overturned.
FASB vs. IASB
Some similarities between the IASB and FASB definition of an asset are the references to expected/probable future benefit, as well as the concept of current control as a result of past events. One differentiating point between the definitions is the IASB definition identifies the future benefit as the actual asset while IASB identifies the resource that from which the benefit will be produced as the asset.
In reference to future benefit, each board uses different terminology to describe the benefit- probable versus expected. At first glance it appears to infer differing degrees of judgment or measurement. FASB's intended interpretation of probable "refers to that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved". (2) Given this definition by FASB, it can be concluded that these terms are synonymous and thus we can ignore this difference in our analysis. Under interpretation both definitions any degree of likelihood of the economic benefit greater than zero would constitute an asset. Any future economic benefit that is unlikely though would be discounted to a high degree in valuation of that asset and may lack criteria for recognition if uncertainty pervades measurement.
FASB/IASB vs. Working Group Definition
It is important to note before discussing the Working Group's definition of asset, that in drafting the definition of an asset, the convergence board made the decision that it was preferable to "strive for a relatively brief definition of an asset that is relatively easy to remember, but requires supporting guidance to fully understand it".
The Working Group definition replaces the probable/future benefit concept with "present economic resource." It also does not reference that the control is the result of past events or transactions rather it just states that the entity has control of the resource. The board determined that how an entity came to have a right or access to the present economic resource is irrelevant in determining if an asset exists. The discussion of what led to an entity to have a right or access the economic resource was deferred to future discussion of recognition.
In the Working Group's definition, the resource rather than the future benefit is identified as the asset. This is more similar to the IASB definition than that of FASB. The definition proposed by the Working Group clearly removes the necessary requirement of the need for the economic resource to have been obtained or controlled by the entity. The Working Group replaces this requirement with the condition that the entity have a sole right or access to the resource. This seems to represent a broader application of the definition.
Of the three definitions we prefer the Working Group's definition of an asset. We agree that it is the resource that will provide economic benefit is the asset rather than the future benefit itself. We also agree with the Working Group that past transaction or events that may or may not have transpired leading to the entity to having control, rights or sole access to a resource is irrelevant in determining if an asset is present. We also prefer the use of the term expected rather than probable based in the intended meaning of the terms.
We do disagree however with the board's assertion that it is more preferable to "strive for a relatively brief definition of an asset that is relatively easy to remember, but requires supporting guidance to fully understand it". We feel that by providing definition that can be easily remembered while not fully understood will lead to more misuse and misapplication either knowingly or unknowingly by practitioners than would otherwise be the case.
Application of Definition
Cash - Yes. It is an obvious current economic resource which is the property of the entity which they alone have a right or access to.
A/R - Yes. Accounts receivable are a right to future payment which others do not have the right or other access to.
Uncollectible A/R - Yes. There are opportunities to sell the AR's (factoring) to a firm specializing in uncollectible accounts. There is an opportunity for the firm to generate economic benefit. Our group can also make a case that uncollectible A/R would not be recognized as an asset, since the account cannot be collected because the customer is not able or willing to pay. Therefore, the company has no access to the money that their customer owes to them and this would not fall under the Working Group's definition of an asset.
Raw Material - Yes. These are economic resources which the entity has access to that others do not have that have the ability to generate future cash inflows.
Future A/R - In a competitive market it seems fair to say that an entity does not have sole right or access to customer sales so they would not be considered an asset. In an uncompetitive monopolistic market insulated as such by competition and especially in the case of a government controlled market we would entertain the idea of categorizing future sales to customers as an asset under this definition.
Proven Oil Reserves -Yes, this is an economic resource which the entity has access and rights to that others do not have which has the ability to generate future positive cash flows.
Goodwill - Since entities have to test for goodwill impairment, the BS should represent the fair value of economic benefit which the firm has acquired and expects to benefit from. It is the present value of the future benefit the entity will capture.
FASB vs. IASB
The FASB and IASB definitions are very similar in nature. One noticeable difference is that FASB designates the future economic sacrifice as the liability whereas the IASB defines the obligation that will result in "outflows of resources embodying economic benefits" as the liability. Although this subtle difference is seemingly inconsequential it is a very important fundamental difference.
Both the IASB and FASB, like in the definition of asset, refer to uncertainty of the event that constitutes a liability. FASB uses the term probable and IASB the term expected. We have already concluded that the intended interpretations are again identical in meaning when used in this context. Again, the intended primary focus on the level of uncertainty was deferred by both boards to be addressed in consideration of measurement and/or recognition.
The FASB definition states the probable economic obligation will be distributed to other entities but IASB does not declare the outflow of economic resources will be directed towards an entity. Another slight variation is that the FASB uses a plural noun in its definition of liabilities but IASB uses singular.
FASB/IASB vs. Working Group Definition
The Working Group's definition is more concise. It disregards how the obligation came to be and it assumes the definition of economic benefit implies an outflow of economic resources such as assets or services. Similar to the IASB definition it identifies the obligation as the liability rather than the "probable future sacrifice" as FASB does.
The following definitions are provided by the Boards staff to provide clarification of the intended interpretation of the term liability as drafted by the board.
"Present means that on the date of the financial statements both the economic obligation exists and the entity is the obligor."(3)
"An economic obligation is an unconditional promise or other requirement to provide or forgo economic resources, including through risk protection." (3)
"An entity is the obligor if the entity is required to bear the economic obligation and its requirement to bear the economic obligation is enforceable by legal or equivalent means." (3) It is important to note her that this implied meaning of obligation is noticeably different that of what was previously provided by FASB in Statement of Financial Accounting Concepts No. 6. In concept No. 6 no mention made as to whether the obligation was enforceable. Under the FASB strict definition even that bound by moral responsibility should be considered an obligation.
We prefer the working group's definition of liability compared to the current definitions provided in the framework of both the FASB and IASB. The reasoning for this preference very much resembles our conclusion for the preference of the working group's definition of asset. We think the liability is the obligation rather than the actual expected sacrifice. We think it is inconsequential how a liability came to be in determining if it exists. It may also be too restrictive that the obligee be defined as an entity. Given these characteristics of the working group's definition we find it to be superior to the other two.
We are very critical of one point relating to the working groups definition. There exists an extreme lack of clarity and coherency in defining their idea of unconditional obligation. In the boards discussion notes they mention an unconditional obligation to stand ready for an uncertain event. As explained in discussion notes "The IASB's reasoning implies that a conditional obligation is always associated with an unconditional obligation in contractual settings". We find this to be extremely unintuitive and it creates much confusion in the use of such a brief definition of a liability. The idea seems conceptually superior but work will need to be done to better communicate its meaning.
Application of Definition
A/P - Yes. The company owes another entity money. This is clearly a present economic obligation.
Bank Loan Outstanding - Yes. Same reasoning as above.
Future Inventory Purchases - It depends whether or not the entity is contractually obligated to purchase a certain amount of inventory in the future. If not, then no, since the entity is not obligated to buy the inventory.
Discretionary Employee Bonuses - No, because any present economic obligation the entity has undertaken to compensate employees for discretionary bonuses is not enforceable.
Existing Property Lease - Yes. The lessee has undertaken a contractual obligation and therefore has a present economic obligation to compensate the lessor for the right of the use of property identified in the lease.
Product Warranty Obligation - Yes, the entity that has issued a product warranty has undertaken a conditional obligation to restore economic value to the purchaser of the warranty for any economic loss generated by means of any product malfunction that falls within the scope of the warranty if demanded by the warrantee. The key to identifying this as an liability is specific to the four words of the following definition of economic obligation provided b the working group "An economic obligation is an unconditional promise or other requirement to provide or forgo economic resources, including through risk protection". A product warranty falls under the category of risk protection and therefore should be considered a liability.
Lawsuit Settlement -No, because a present unconditional obligation does not exists.