In the paper, Hicksian Income in the Conceptual Framework, which is forthcoming in Abacus, my co-authors (Michael Bromwich and Richard Macve both at the London School of Economics) and I provide an analytical and critical case study of the use of income theory in accounting policy making.
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are undertaking a joint project to converge and improve their respective conceptual frameworks for financial accounting and reporting. The overall approach was outlined in an important paper Revisiting the Concepts in May 2005 (FASB/IASB, 2005) which emphasized that ‘to be principles-based, standards cannot be a collection of conventions but rather must be rooted in fundamental concepts’. At the time of issue this was presented as an authoritative manifesto of how the two Boards intended jointly to undertake this convergence and improvement, based on and building on their existing frameworks, even though there had not been any prior exposure to allow public comment as to whether some more radical approach would be appropriate.
In our paper, we focus primarily on what appears to be—and was predicted in that 2005 paper to continue to be—the bedrock of the Boards’ ongoing development of the converged framework, namely the conceptual ‘primacy of assets’ (p.9) as elements of financial statements. We question the claim in the 2005 ‘manifesto’ that this primacy is derived from Professor Sir John Hicks’s (1946) definition of ‘income’ (p.7; p.18). We support the use of accounting theory by standard setters and practitioners, provided that the theories they choose are considered in their entirety, and do not have their elements cherry-picked opportunistically to suit standard setters’ immediate objectives. Moreover, theory is best understood as a whole, in spirit and nuance, instead of taking short quotations and interpreting them out of context.
We argue that Hicks’s (1946) analysis does not provide a conceptual basis for the FASB/IASB’s exclusive focus on a balance sheet approach to the financial reporting. Nor does it help address the difficult problem of measuring and reporting business performance and identifying drivers of value creation. Boards should try to understand the practical roles of conventions in financial reporting and how and when they might be modified to serve the legitimate interests of interested parties (e.g., by reducing apparent inconsistencies that no longer serve any purpose). However, the corporate structure of these Boards, designed for debating technical issues, may not necessarily equip them to address such challenges. The ultimately political nature of the social welfare issues may be better suited for broader social institutions reflecting social norms of the kind that the idea of ‘generally accepted’ accounting principles was originally meant to encapsulate.
How to construct useful, practicable, and broadly accepted financial reports may require evolution as well as design (e.g., Basu et al., 2009). Whether it is desirable for the Boards themselves to converge towards becoming one, monopolistic standard setter remains an open question. Clearly the Boards’ unsuccessful appeal in FASB/IASB (2005) to the claimed objectivity of Hicksian income as an unambiguous foundation for financial accounting and reporting fails to resolve these issues.
The full paper is available for download here.