Accounting and Business Research. The Conceptual Framework as a guide for future standard setting or only a justification of current practice?

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1 The Conceptual Framework as a guide for future standard setting or only a justification of current practice? Journal: Accounting and Business Research Manuscript ID: ABR--0.R Manuscript Type: Special Issue Keywords - Group : Financial accounting Keywords - Group : Discursive logical argument ADD your Keywords: conceptual framework, balance sheet approach, assets, liabilities

2 Page of 0 Accounting and Business Research 0 0 The Conceptual Framework as a guide for future standard setting or only a justification of current practice? An analysis of the asset and liability definitions in the current and new Conceptual Framework. Abstract In this paper, we evaluate whether the IASB s efforts to develop a new Conceptual Framework (CF) are aimed at developing a robust and consistent basis for future standard setting, thereby guiding standard setting decisions in complex and controversial areas, or whether the development of the new CF is only a political step aimed at legitimising existing standards. We therefore investigate the impact of the definitions and recognition criteria for assets and liabilities in the existing and new CF concerning recognition of assets and liabilities under IFRSs. We conclude that, in an area where standards have clearly diverged from the CF in the past, by not consistently applying probability thresholds, the new CF legitimises the existing standards that did not apply this threshold. Furthermore, the inclusion of more judgemental criteria of relevance and faithful representation would also legitimise existing standards, which currently do not recognise items that do meet the revised definition of an asset or a liability. Altogether, we conclude that the IASB s proposals in relation to assets and liabilities legitimise existing standards and create the appearance of coherence rather than actually serving as robust guidance for consistent future standard setting. Keywords: conceptual framework, balance sheet approach, assets, liabilities, IFRS JEL classification: M

3 Page of Introduction In the Discussion Paper ( the DP ) about the Conceptual Framework ( the CF ) (IASB b), the International Accounting Standards Board (IASB) continues to focus on the balance sheet. The definition, recognition and measurement of assets and liabilities form the basis for the IASB s standard setting. Income and expenses are derived from this. Although this approach has been criticized (e.g, see Dichev 0), the IASB clearly does not intend to apply a fundamentally different approach in the new CF. Since under this approach the whole accounting model is built on the definitions and principles for recognition of assets and liabilities, the robustness, understandability and consistent application of these definitions and principles are crucial. However, an analysis of standard setting and interpretation activities in recent years shows that the IASB and IFRS Interpretations Committee (IFRS IC) have struggled with the existing definitions and recognition criteria and with fitting their intended outcomes into these definitions and criteria. In its project on liabilities, aimed at the revision of IAS Provisions, Provisions, Contingent Liabilities and Contingent Assets, the IASB proposed that the probability threshold would be removed from the standard and that a provision would be recognised when () the entity has a present obligation and () a reliable estimate can be made of the amount of the obligation. The new standard proposed that a probable outflow threshold not be included and that, instead, uncertainty about the amount and timing of outflows should be reflected in the liability s measurement at its expected value. The removal of a probability threshold would not be in line with the existing CF, and many respondents have expressed concerns about this proposal. The project was put on hold in, but only after the IASB published a Staff Paper stating that it intented to make the same probability assessment as required under current IAS part of the Refer to

4 Page of 0 Accounting and Business Research 0 0 assessment to determine whether an obligation actually exists, i.e. part of existence uncertaintly instead of outcome uncertainty. However, this was not clear from the initial proposals. In the project on Leases, the IASB had to significantly change its view on what constitutes a liability under the CF between the initial proposals and its revised Exposure Draft, which appeared in. The application of the definitions to regulatory assets and liabilities, complex financial instruments and non-financial liabilities also continues to raise questions and trigger debate. This is apparent, for instance in questions raised to the IFRS IC, where the issue of regulatory assets and liabilities has been brought forward twice (issues IAS - and IAS -) and where the matter of economic compulsion and substance (see for example issue IAS -) as well as other questions on the application of IAS Financial Instruments: Presentation have been raised. For rate-regulated activities, after having published an Exposure Draft in 0, the IASB has not yet been able to develop a standard to identify when an asset or a liability exists resulting from rate regulation. It has therefore decided to develop an interim standard that allows new IFRS adopters to continue applying local GAAP for this aspect when certain criteria are met while it works on a permanent solution. The classification of financial instruments as debt or equity resulted in the inclusion of an exception in IAS for puttable financial instruments as well as the release in 0 of a Discussion Paper, Financial Instruments with Characteristics of Equity, which explores alternative approaches to the distinction between debt and equity. The IFRS IC issued IFRIC on Levies in and concluded that economic compulsion and the going concern assumption do Refer to See

5 Page of not justify recognition, under IAS, of liabilities that are triggered by operating in a future period (IFRS IC, ). The CF is intended to be a coherent conceptual basis for the IASB in developing accounting standards, and the new definitions and recognition criteria for assets and liabilities as proposed in the Discussion Paper should provide clearer guidance to solve issues in areas such as leases, rateregulated activities and non-financial liabilities (IASB ). In this paper, we analyse the IASB s application of the existing CF and current efforts in developing a new CF in light of this ambition. Specifically, we analyse whether the IASB has actually used the existing CF as the basis for standard setting decisions in the past and is developing the new CF as an internationally accepted sound basis for the future development of consistent accounting standards based on newly developed concepts or whether the IASB is primarily legitimising previously made standard setting decisions via the new CF in order to create the appearance of a coherent conceptual basis. For this purpose, we focus on a key aspect of the IASB s approach to accounting, which is the definition and recognition of assets and liabilities. In Section, we discuss general academic literature about the existing CF and difficulties with its application in today s accounting as well as literature that focuses on the intentions that a standard setter may have with the development of a CF. In Section, we analyse in detail how the definitions and recognition criteria for assets and liabilities from the current CF have been applied by the IASB in developing accounting standards in the past decades, and how this has been We do not argue that the balance sheet approach is the preferred approach and should prevail in standard setting. In fact, we believe that more weight should be assigned to the presentation of performance in the financial statements and that a more balanced approach, in which stand-alone definitions of income and expenses would be as important as the definitions of assets and liabilities, could result in more relevant financial statements. However, these views are beyond the scope of this paper.

6 Page of 0 Accounting and Business Research 0 0 evaluated in academic literature. The insights that are obtained from this analysis are important for understanding how the IASB uses the CF in its actual standard setting activities and to place the development of the new CF in the context of the possible intentions that the IASB, according to the literature, could have with its development of this new CF. In Section, we analyse how the revised definitions will affect standard setting and how existing standards would be affected if the IASB were to align existing standards with the new CF, again aimed at placing the IASB s development efforts in the context of the possible intentions with a CF as identified in academic literature. In Section we present our conclusions. We conclude that the perceived inconsistencies in current IFRS are the result of frequent but not consistent departures from key aspects of the CF s definitions of assets and liabilities in the past. By changing the CF on those aspects where standards and the CF have diverged in the past, the new CF would align a number of the existing standards and the new definitions of assets and liabilities. Furthermore, the IASB proposes applying judgemental criteria for recognition, thereby allowing itself greater flexibility than in the past to justify non-recognition of items that now meet the definition of an asset or a liability under the new CF but are not recognized under existing standards. Finally, we conclude that the new CF will not provide fundamentally new insights that solve ongoing discussions about, for instance, rate-regulated activities, deferred taxes, nonfinancial liabilities or intangible assets. We therefore conclude that the new CF legitimises existing standards and will create the appearance of coherence, but does not provide a sound conceptual basis that is better than the existing CF as a guide for the IASB in developing consistent accounting standards. The DP is a first step in the process of developing a new CF, whereby the IASB is explicitly seeking external input (DP par..). As a result of this input, the IASB may further develop its views, and the new CF will likely differ from the initial views expressed in the DP. In our view,

7 Page of our analysis provides relevant input into this process; also, our analysis and conclusions based on the DP are not meant to prejudge the IASB and the new CF prior to the IASB s completion of its due process and the finalisation of the new CF.. The role and function of the Conceptual Framework The difficulties the IASB has experienced in applying the existing CF have been recognised in the academic literature. Booth (0) identifies inconsistencies in the current CF leading to inconsistent accounting standards, while Newberry (0, p. ) asks how conceptually robust accounting standards [can] be derived from an incoherent framework?. According to Bradbury (0), the CF has inadequately dealt with complex financial instruments, resulting in significant deviations from the CF in standard setting. Barker and McGeachin () believe that inconsistencies in the reporting of assets and liabilities arise because the IASB does not distinguish between measurement (observable measures) and estimation. McGregor and Street (0) state that the IASB must deal with issues in the context of an outdated CF that does not reflect current thinking owing to a failure to regularly revisit the CF. These and similar complaints about the current basis for the IASB s standard setting has resulted in a call to the IASB to prioritise the development of an updated CF that can serve as the foundation for future standard setting (Jones and Wolnizer 0; Whittington 0; respondents to the IASB s Agenda Consultation IASB ). The DP is a next step in achieving such a CF. According to the DP par.., the primary purpose of the revised Conceptual Framework is to assist the IASB by identifying concepts that it will use consistently when developing and revising IFRSs. According to Solomons (), a good CF will help in economizing efforts and in gaining consistency, will improve communication and will be a defence against politicisation.

8 Page of 0 Accounting and Business Research 0 0 This function of the CF is also identified by Walker (0), who suggests that the CF can assist the IASB in identifying existing standards that are inconsistent with the concepts, in improving and developing standards, and can provide a guide to practitioners in case of new situations not dealt with in existing standards. Others are more sceptical about the role of the CF as a solid basis for future standard setting. According to Peasnell (), in a situation where a standard setter is dependent on the goodwill of companies, regulators and others (in the IASB s case, politicians) to embrace and support its standards, it needs flexibility to negotiate as part of its standard setting process. According to Gerboth (), a CF cannot and should not avoid or foreclose relevant debate among professionals about what is proper accounting for specific situations and transactions by agreeing on abstract principles in advance. Rather than a technical or functional role, Hines (, ) and Peasnell () see the development of a CF as a strategic, political step that creates the appearance of a coherent basis for standard setting aimed at gaining credibility and legitimacy. Walker (0) also notes that the CF development process can be aimed at legitimising existing standards. Newberry (0) believes that a coherent and up-to-date CF, and accounting standards that are developed consistently with this CF, should not be expected, given the continuously changing reporting environment and political influence. She holds that the IASB uses bits and pieces from an incoherent CF to justify individual standard setting decisions, and that the IASB does not necessarily strive for coherence and consistency. According to Dean and Clarke (0), previous efforts to develop a CF by other standard setters have focused on explaining existing practice rather than on developing concepts to which new standards should conform. O Brien (0) is of the opinion that also the first phases of developing a new CF by the IASB were aimed

9 Page of at eliminating concepts such as stewardship and reliability that do not support the direction that the Board has already taken in actual standard setting. According to the DP par.., the IASB s aim is to select concepts that will result in financial statements that meet the objective of financial reporting, not to justify existing requirements and practice in line with the objective that Jones and Wolnizer (0), Whittington (0) and others see for it. However, the UK s Financial Reporting Council s (FRC) is not convinced that the IASB is delivering on its promise (FRC, p. ): Principles should not be discarded or diluted merely because they are inconsistent with standards: still less should the Conceptual Framework be reverse engineered to provide a rationalisation for existing standards. In the following sections, we analyse the IASB s current efforts to develop a new CF in the context of the two scenarios described above. Is the IASB only legitimising previously made standard setting decisions, creating the appearance of a coherent basis, or is it developing an internationally accepted sound basis for the future development of accounting standards that will help it solve important issues that it currently faces during its standard setting process? In order to assess the IASB s proposals against these questions, it is important to understand how the IASB has applied the existing CF in developing standards in the past and to place the concepts proposed in the new CF in context of the existing standards. We address this in paragraph.. The current Conceptual Framework and its impact on the recognition of assets and liabilities in standard setting Under the current CF, an asset is defined as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity and a liability

10 Page of 0 Accounting and Business Research 0 0 as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Furthermore, according to the current CF, an asset or a liability is only recognised when an inflow or outflow of future economic benefit is probable. According to Hellman (0), such probability thresholds are a reflection of prudence. Prudence was included as a qualitative characteristic in the CF (par. ), although the CF also warns against excessive prudence, but it was removed from the CF because it conflicts with neutrality. However, the parts of the CF dealing with the definitions and recognition criteria have not yet been amended and the probability thresholds for assets and liabilities were thus retained. According to the current CF par. (IASB ), the definitions of assets and liabilities (as well as equity) underlie the review of existing standards and the development of new standards. Income and expenses follow from the definitions of assets and liabilities, and par. of the current CF stresses that the application of the matching concept in relation to expenses does not allow for the recognition of items in the balance sheet that do not meet the definition of assets or liabilities. In this section, we analyse how, in standard setting, the IASB has translated the current definitions and recognition criteria from the CF into assets and liabilities that are or are not recognised under existing IFRSs. We also refer to Table in Section for an overview of the conclusions based on our analysis. Property, plant and equipment (IAS, IAS, IAS ) According to IAS par., the cost of an item of property, plant and equipment shall be recognised as an asset if and only if it is probable that future economic benefits associated with the item will flow to the entity. In relation to property, plant and equipment, the IASB has thus applied the CF definitions and recognition criteria in standard setting. However, assets that are acquired under lease contracts are often not recognised. Under IAS, some leased assets

11 Page of (financial leases) are accounted for as assets, but in practise, the majority of leases are classified as an operating lease and not accounted for on the balance sheet. Furthermore, IAS allows for onbalance sheet recognition of investment property leased under an operating lease, under the condition that it is measured at fair value. The CF does not support the distinctions made between various leases in IAS and IAS, and the IASB (0) has concluded that leased assets meet all the elements of the definition of an asset in the CF: As a result of a past event, the lessee controls (the right to use) the asset, and economic benefits are expected to flow from the use of the asset. The IASB thus concluded that not recognising assets leased under operating leases is not in accordance with the CF. This view is shared by Booth (0), who states that a lessee acquires control over the leased asset even though it does not acquire legal ownership and that, since (legal) ownership is not part of the definition of an asset, a leased asset meets the definition of an asset. Intangible assets (IAS, IFRS ) According to IAS par., intangible assets are only recognised if it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity. The general requirement in IAS is thus similar to the requirement for property, plant and equipment in IAS. However, in the remainder of the standard, and related requirements in IFRS Business combinations, various requirements are included that may result in the recognition of intangible assets that do not meet the CF definitions and recognition criteria as well as the exclusion of intangible assets that do meet the definition of an asset. First, recognition of internally-generated intangible assets is generally not allowed in IAS. The standard explicitly forbids recognition as an asset of internally-generated goodwill, brand names, customer lists and similar items. The only internally-generated intangible asset that can be capitalised is an intangible asset that arises from an internal development project, but only when various criteria are met which in practice often results in capitalisation of only a limited portion of all of an entity s

12 Page of 0 Accounting and Business Research 0 0 expenditure on research and development. Furthermore, capitalisation is limited to the expenditures incurred as of the date that the capitalisation criteria are met, which means that even when the capitalisation criteria are met, the intangible asset is not recognised at its cost but only at a portion of its cost (IAS par. ) Some agree with the IASB s decision to preclude many intangible assets from capitalization. According to Penman (0), intangible assets that are not legal rights (e.g. patents) are not specific enough to have an observable value attached to them, and therefore recognition would result in speculative values on the balance sheet, which do not add informational value to analysts. Walker and Oliver (0) are of the opinion that capitalising software development costs does not result in reliable information, and recommend that expenditures on software development are expensed as incurred. However, the lack of recognising many intangible assets on the balance sheet has been criticised (Penman 0). Lev (0) holds that on-balance sheet presentation is required to solve the issue of partial, inconsistent and confusing information about these important assets, while Eckstein (0) concludes that the objective of providing relevant information mandates the recognition of intangible assets. Many studies present evidence that intangible asset values are relevant for investor decision-making. Research includes Lev and Sougiannis () on estimated R&D assets, Aboody and Lev () and Mohd (0) on capitalised software development costs, Kallapur and Kwan (0) on recognised brand values, and Barth et al. () on estimated brand values. Furthermore, Wyatt (0) concludes that management decision-making about the recogntion of intangible assets reflects their insights in the underlying economics of the entity. It is therefore concluded that even though reliability may be a concern, recognised amounts are reliable enough to be relevant, and that not recognising a wide range of intangible assets eliminates relevant information from the financial statements.

13 Page of IAS thus prohibits recognition of internally-generated intangible assets that do meet the definition of an asset and for which the academic literature shows that their values are relevant for decision-making. At the same time, IFRSs require on-balance sheet recognition of the same type of items when they are acquired, even if they do not meet the CF definition of an asset. According to IAS and IFRS, intangible assets acquired separately or in a business combination must always be recognised as separate assets, and no separate assessment is made about whether future economic benefits are probable. This may result in intangible assets recognised on the balance sheet of an entity for which it is not probable that future economic benefits will flow to the entity. An example is the acquisition of early-stage research and development (IPR&D) directly or as part of a business combination in the pharmaceutical industry. While generally no assets are recognised for IPR&D projects carried out inside a pharmaceutical company, given the low probability of success, such assets would be recognised for acquired IPR&D. Similarly, goodwill, brand names, customer lists and similar items are not recognised when internally generated, but are recognised when they are acquired. Such difference in accounting treatment for internallydeveloped intangible assets and acquired intangible assets is not based on the CF. Bloom (0) holds that there is no difference between internally-generated goodwill and acquired goodwill, except that there are more practical difficulties with recognition of internally-generated goodwill on balance than recognition of acquired goodwill, and double entry bookkeeping justifies capitalisation of acquired goodwill, but not internally-generated goodwill. Furthermore, since acquired goodwill is not amortised under IFRS, it is gradually replaced by internally-generated goodwill over time. Whether acquired goodwill meets the definition of an asset under the CF at all is an open question and subject to debate. In the Basis for Conclusions on IFRS Business Combinations, the IASB concludes that goodwill meets the definition of an asset even though goodwill partially consists of

14 Page of 0 Accounting and Business Research 0 0 items that are not controlled by the entity, such as a well-trained workforce and loyal customers (IFRS, BC ). Cortese-Danile and Gornik-Tomaszewinski (0) are of the view that, on this topic under US GAAP, the FASB made a sophisticated argument that goodwill meets the definition of an asset and meets the criteria of relevance and reliability. However, Booth (0) is explicit in his view that goodwill is not controlled by the entity and does not meet the definition of an asset in the CF. Although future economic benefits may be expected, goodwill consists of unidentified items and not of rights that are controlled by the entity. Ma and Hopkins () go even further in stating that, if anything, there may be arguments to recognise internally-generated goodwill, because it relates to the earnings capacity of the entity s existing assets, but not for acquired goodwill, since acquired goodwill relates to synergies that must be realised after the business combination has been completed and are not present in the acquiree s existing operations at the acquisition date. Goodwill is linked to the other assets acquired in a business combination rather than being an asset on a standalone basis meeting the definition of an asset in the CF. From a separate financial statements perspective, goodwill is part of the cost of the subsidiary and is thereby captured in the cost of an identifiable and separately recognisable asset. Similarly, in the separate financial statements, internally-generated goodwill can be recognised on the balance sheet as part of the value of the subsidiary, because subsidiaries can be valued at fair value in the separate financial statements. However, this is not relevant for the application of the CF definitions and recognition criteria in the consolidated financial statements. The best arguments for recognising acquired not internally-generated goodwill as an asset in the consolidated financial statements under IFRS seem to be convenience, avoidance of an unidentified difference in the double entry bookkeeping system, and the fact that immediate recognition as an expense in the income statement is not a very attractive alternative for companies. Goodwill paid in acquisitions can involve significant amounts related to individual transactions which are of a non-recurring nature and which can result in significant losses in the

15 Page of period in which such an acquisition occurs. Capitalizing such goodwill avoids earnings volatility as a result of acquisitions until a goodwill impairment is recognised in a future year. Recognising expenditures on the internal generation of goodwill and various other intangible assets as an expense in the income statement is less harmful for entities, because the expenditure is incurred over time instead of at once and does not result in earnings volatility. Those expenses can to a certain extent be influenced by management to manage earnings and are (as a result) more predictable and stable over time. As such, recognised goodwill from acquisitions has the nature of a deferred cost, capturing the amount that is paid for anything other than identifiable assets that meet the CF recognition criteria, rather than that of an asset by itself, in accordance with the definition and recogniton criteria in the existing CF. Financial assets (IAS, IAS, IAS, IFRS, IAS ) For financial assets, no recognition threshold is defined in IFRS. All financial assets are recognised (initially) at fair value, which generally equals cost, plus in certain cases transaction costs when the entity becomes part of the contract or acquires its interest in an associate or joint venture. Probabilities of inflows are reflected in the price that the buyer and seller agree or the fair value that is calculated. This inconsistency between IAS and the CF has also been identified by Bradbury (0), who holds that the discussions about the accounting for financial instruments shows that the CF needs significant modification. As a result, financial assets may be recognised even though inflows from the asset are not probable. An entity may for instance acquire an out-of-the-money option (derivative) to buy an interest in a non-listed company. The option currently has a % change of becoming in-themoney before maturity and cannot be sold to another party. Such an option will have a positive fair value and should be recognised at fair value under current IAS, whereas it does not meet

16 Page of 0 Accounting and Business Research 0 0 the requirement of probable future inflows. For derecognition of financial assets, IAS moves to a risks and rewards model and, depending on the situation, substantially all risks and rewards must have been transferred before a financial asset is derecognised. The difference between the recogntion criteria and derecognition criteria means that one entity may recognise an asset for certain contractual rights and obligations, whereas another entity does not simply because they arrived at the (exact equal) situation via a different route. The economic position of an entity that has sold the right to the cash flows from its receivables but retains the collectability risk is for instance similar to the economic position of an insurance company that has absorbed the collectability risk of another entity s receivables. However, under current IFRS, the first entity will not derecognise its receivables, because it has not transferred the risks and rewards, whereas the insurance company will not recognise the receivables of all entities to which it has provided an insurance for the collectability risk. The difference is caused by the fact that the recognition criteria for financial instruments do not mirror the derecognition criteria. IFRS requires recognition at fair value of contingent consideration to be received for a business that is disposed of even if the inflow is not probable. However, IAS only allows for recognition of a receivable for products or services sold when the inflow is probable and certain other criteria are met, effectively setting the hurdle at a higher than probable level. In its project to develop a new revenue recognition standard, the IASB initially proposed to remove such thresholds, but thresholds were reintroduced in relation to collectability and variable consideration in. Refer to

17 Page of Inventories (IAS ) IAS does not specifically include a probability threshold for the recognition of inventory as an asset on the balance sheet. Given the definition of inventory, items that are held for sale or in the process of production, and the requirement to value inventory not higher than net realisable value, this will however not be likely to result in items recognised as assets if an inflow of future economic benefits is not probable. Financial liabilities (IAS, IAS, IAS, IFRS ) According to IAS and IAS, a liability must be recognised for all financial instruments for which the entity may be required to settle its obligation in cash or another financial asset. Similarly to financial assets, IAS does not apply a recognition threshold and that may for instance result in the recognition of liabilities for out-of-the money derivatives for which an outflow of economic benefits to settle them in the future is not probable, but which nevertheless have a fair value. According to Barker and McGeachin (), this conflicts with a strict application of the CF. Furthermore, IFRS requires the recognition of liabilities for contingent consideration at fair value irrespective of the probability of a future outflow of economic benefits. Instruments for which the entity can avoid settlement do not result in the recognition of a liability. As confirmed by the IFRS IC, economic compulsion is not taken into account when assessing whether a liability exists. As a result, many instruments for which future cash outflows from the entity to the holder are expected by both the entity and the holder are not recorded as liabilities, because the payment is avoidable. Examples include ordinary shares for which dividends may be expected under the stated dividend policy but not required, and various types of (hybrid) bonds on See

18 Page of 0 Accounting and Business Research 0 0 which interest is only payable when dividends are paid and for which the payment of interest may or may not be incentivised via contractual terms. As discussed by Beaver () and Murray (), a complexity in the discussion on the recognition of liabilities is that, in many cases, a mix of past and future events affects the final settlement of an entity s liabilities. First, a liability must have its basis in the past and be the result of some past event. The recognition of liabilities relies on the identification of the critical event in a continuum of events that triggers the initial recognition of the liability versus other events that affect its measurement. The IASB s approach to financial liabilities focuses on the settlement of a liability being unconditional and unavoidable, which results in a bright-line distinction that has been exploited for structuring hybrid financial instruments such that they meet the definition of equity even if payment of interest and principal is highly probable given certain incentives built into the agreement. As we will show, a less strict definition of unavoidable is applied in other standards that also require constructive obligations to be recognised as a liability. A contract may entail the obligations for the entity to issue equity instruments of the entity. According to IAS, such contracts qualify as a liability unless the contract is settled by issuing a fixed number of shares at a fixed price. According to Bradbury (0), this approach defines equity more directly than in the CF, which defines it as a residual; recognition of liabilities for the obligation to issue shares is therefore at odds with the existing CF. More generally, Bradbury (0) notes that the existing CF is not helpful in dealing with complex hybrid financial instruments. Schmidt () is of the view that a robust principle must be developed for the accounting for such instruments and must be part of the CF, in order to avoid structuring and the need for a range of exceptions at standard level. An example is the exception for the classification of puttable shares. Furthermore, Schmidt () mentions economic compulsion as an example of an aspect for which a principle must be found.

19 Page of For many companies, material obligations result from lease contracts. As noted by the IASB (0) and Loftus (0), such obligations meet all the criteria to be recognised as a liability on the balance sheet. However, under IAS, only a subset of lease obligations that is, those arising from financial lease contracts are recognised as liabilities. The IASB (and FASB) project to develop a new lease standard under which such liabilities are recognised again showed how the IASB has difficulties in reaching well-supported and widely accepted accounting principles based on the concepts in the CF. In the original proposals (IASB ), the IASB concluded that an entity should recognise a liability for all expected future lease payments over the expected lease term, including contingent rentals and payments that only become due when extension options are used. Many respondents commented that recognising liabilities that are avoidable is inconsistent with other standards and that options to extend a lease do not meet the definition of a liability under the CF, because options represent rights and not present obligations. In the revised Exposure Draft (IASB a), the IASB now proposes to only include the unavoidable payments over the non-cancellable lease term unless the entity has a significant economic incentive to extend the lease. This definition of liability is much closer to the IAS definition, although it does include an aspect of economic compulsion that must be ignored under IAS. Provisions (IAS, IFRS ) IAS includes a probable outflow threshold for the recognition of provisions that fall within this standard s scope. The project that was aimed at removing this threshold received negative responses and was put on hold in (see Section and Rees 0). However, the recognition threshold does not apply to obligations that normally fall within the scope of IAS when they are acquired as part of a business combination. IFRS requires recognition of contingent liabilities on the balance sheet irrespective of their probability. Furthermore, although the CF gives

20 Page of 0 Accounting and Business Research 0 0 the same threshold for assets and liabilities, IAS requires a higher level of certainty (virtually certain) for assets to be met than for liabilities (probable, defined as more likely than not). In addition to legal obligations, IAS also requires the recognition of liabilities for constructive obligations. According to IAS, an established pattern of past practice or published policies can create expectations with the counterparty requiring the recognition of a liability. As a result, the definition of an obligation under IAS can be broader than the definition in IAS in certain aspects (not only contractually or legally unavoidable obligations, but also those arising from past practice or published policies) and more limited in other aspects (only liabilities for which an outflow of economic benefits is probable are recognised). Employee benefits (IAS, IFRS ) Both IAS and IFRS do not include a specific probable outflow threshold for the recognition of liabilities for bonuses and cash-settled share based payments. Although IAS does refer to expected payments, liabilities are recognised when employee services are received, even when the payment is not yet probable (for instance because it is dependent on a certain share price increase, share price development compared to a group of peer companies, or a specific event such as a succesful IPO). Furthermore, contrary to IAS, IFRS par. requires the entity to consider its past practice or stated policy of settling in cash and whether it generally settles in cash even if it is not required to. As a result, a similar obligation towards the holder of a financial instrument who received this instrument in his or her position as employee may be classified as a liability, whereas the same instrument is classified as equity when it is held by another party. Deferred and accrued income and costs (IAS, IAS, IAS, IFRIC, IAS ) Various IFRSs require accrual or deferral of costs or revenues. For instance, IAS and IFRIC may require deferral of revenues until certain conditions are met. IAS requires accrual or

21 Page of deferral of operating lease income or expenses to straight-line total income or expenses over the lease term. This includes lease incentives and, for lessors, the cost of negotiating and arranging an operating lease (IAS par., 0 and ). According to IAS par., contract costs related to a construction contract, including the cost of securing the contract (IAS par. ), are deferred and spread over the construction period to achieve the recognition of both revenues and costs in accordance with the project s completion stage. Furthermore, IAS par. focuses on the matching principle and states that government grants are recognised in the income statement over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate. These standards focus on the income statement and the earnings process and may result in assets or liabilities that do not meet the CF definition of an asset or a liability since an inflow or outflow of economic benefits is not expected. Although the obligation to provide goods or services in the future would generally satisfy the definition of a liability, the recognition and measurement of such liabilities in current IFRSs is primarily focused on the earnings process instead of on the definition of an asset or a liability. According to Samuelson (), with reference to the FASB s CF, the liability should reflect the probable future outflow of economic benefits (sacrifices) that are required to fulfil the obligation. Depending on the probability of a refund of an advance payment and whether the seller has an opportunity cost of foregone revenues (when the sale prevents him or her from selling to others), the liability may be significantly lower than the deferred revenues recognised today or may not even exist. The IASB s focus on the earnings process may result in different accounting for the same obligation, depending on whether the obligation arose from an earnings process or otherwise. This is illustrated by the following example:

22 Page of 0 Accounting and Business Research 0 0 Retailer A has a temporary offering based on which a customer who buys a bottle of shampoo receives a voucher that is attached to that bottle and entitles the customer to a 0% discount on a bottle of conditioner which he can use the week thereafter. In week, retailer A sold 0,000 bottles of shampoo, and the retailer estimates that 0% of the customers will use the voucher to buy a discounted bottle of conditioner in week. Retailer A will still make a profit when a bottle of conditioner is sold at a 0% discount. As part of a marketing campaign, in week, retailer B has distributed vouchers to the households in the area around its store. It has distributed 0,000 vouchers that entitle the (potential) customer to a 0% discount on a bottle of conditioner when he or she comes to the store with the voucher in week. The retailer estimates that 0% of the (potential) customers that receive a voucher will use it to buy a discounted bottle of conditioner in week. Retailer B will still make a profit when a bottle of conditioner is sold at a 0% discount. At the end of week, both retailer A and retailer B expect to be obliged to sell 0,000 bottles of conditioner at a 0% discount in week and make a profit on those sales. Based on IFRIC, an interpretation of IAS, retailer A must recognise a liability for its obligation to deliver bottles of conditioner in the future at a discount. Since retailer B s obligation does not arise from a sales transaction, retailer B does not recognise a liability because the future sale of conditioner to customers with a voucher does not result in an outflow of economic benefits. Although the economic position of retailer A and B at the end of week is exactly the same, the accounting for the obligation is different, depending on whether the obligation arose from a sales process or otherwise. According to Samuelson (), this is due to the fact that, in certain standards (e.g. IAS ), the focus is on the earnings process at the expense of appropriate application of the definitions of an asset and a liability. The ongoing discussions about rate-regulated activities have

23 Page of a similar background, with proponents of a focus on the earnings process and matching versus proponents of a strict application of the definition of assets and liabilities. Also in relation to assets, Samuelson () notes that the current definitions mix the concept of stocks (assets) with flows and allow for deferral of cost based on the expectation that they will be recovered by future economic benefits. He is of the view that the primary focus in the definition of an asset should be on the (property) right of the entity, and that all deferred costs that are not rights of the entity should be eliminated from the balance sheet. His view is shared by Chambers () who criticises the current model and states that (p. ) assets, once considered by accountants to be exchangeable goods and rights, came to be described as unamortized costs, which are not real world phenomena and (p. ) no-one drives to work in a probable future benefit. Deferred tax assets and liabilities (IAS ) According to IAS, deferred tax liabilities are recognised for all taxable temporary differences, except when certain specific exceptions apply. However, deferred tax assets are only recognised when future taxable profits are probable. The standard thus only applies the probability threshold from the CF to assets and not to liabilities. Furthermore, the various exceptions to the standard, such as the initial recognition exception, indicate that the purpose of deferred taxes is primarily to match the income tax effect in the income statement to the profit before tax as determined under IFRS rather than to recognise assets and liabilities that meet the definition of the CF. The comprehensive interperiod income tax allocation model behind IAS has been subject to debate and analysis by various academics see, for instance, Chambers (), Barton (0), Buckley (), and Guenther and Sansing (00). In light of the definitions of an asset and a liability, it is interesting to see that many analyses and discussions focus on the question whether it would be appropriate to apply a matching principle to income taxes. Those in favour of the recognition of

24 Page of 0 Accounting and Business Research 0 0 deferred income taxes consider income tax as an expense to which the matching principle should be applied, whereas others view income tax as a distribution similar to dividends for which a matching concept is inappropriate. This angle in the discussion suggests that accounting for deferred tax is indeed driven by a matching principle rather than by pure application of the definitions of an asset and a liability. Furthermore, Guenther and Sansing (00) argue that differences between tax and book depreciation result in temporary differences but are not associated with future tax cash flows. According to Loftus (0), deferred tax liabilities do not meet the definition of a liability in the CF, because the entity has no present obligation to the tax authorities, and instead are deferred debits. According to Chambers (), the comprehensive interperiod income tax allocation model currently used in IAS can therefore only be justified based on prudence. Others have tried to shed light on this matter by investigating the value relevance of deferred tax assets and liabilities. Some find evidence that deferred taxes are relevant (e.g. Ayers ; Amir and Sougiannis ), but others find some contrary evidence (e.g. Amir et al. ; Chludek ). The research of Laux () provides some explanation for the mixed results found in the past. He concludes that the value relevance depends on whether deferred tax is predictive of future tax cash flows. He distinguishes between transactions that are accounted for in the financial statements at a later date than they appear in the tax return (TAX-first) and those that are recognised in the financial statements first and appear in the tax return at a later date (GAAP-first), and concludes that only deferred taxes resulting from GAAP-first events are predictive of future tax cash flows, whereas deferred taxes resulting from TAX-first events are not. Following the findings of Laux (), only GAAP-first deferred taxes meet the definition of an asset or a liability (given that they are expected to result in a future tax cash flow), whereas TAX-first

25 Page of deferred taxes are deferred debits used for achieving a match between accounting income before tax and the income tax expense. Two main observations arise from the research into the accounting for deferred taxes. First, the current accounting model for deferred taxes used in IAS contains elements of conservatism. Second, the model results in deferred debits that do not result in de facto tax cash outflows and thus do not meet the criterion of an expected future outflow of economic benefits in the CF. One might argue that deferred tax assets and liabilities represent the fact that future tax payments will be lower or higher than the expected tax payment based on IFRS profit and statutory tax rates. However, this in itself does not justify the recognition of an asset or a liability. Deferred tax assets are for instance not recognised either when other tax facilities are applied (resulting in an expected future effective tax rate below the statutory tax rate) or simply because an entity is, for tax purposes, located in a country in which lower taxes are paid than elsewhere. On a very similar topic regulatory assets and liabilities the IASB and IFRIC have taken the approach of a more strict application of the definition of an asset and a liability. On this topic, it has been concluded that the right to charge higher tariffs in the future or the obligation to charge lower tariffs in the future are not assets and liabilities as defined in the CF (unless it results in the obligation to deliver at a loss). Furthermore, the many exceptions in the standard, like the initial recognition exception for assets or liabilities acquired outside a business combination and for goodwill, indicate that this rationale does not drive deferred tax accounting. The only justification for deferred taxes that can be found in the standard is the matching of income and (tax) expenses. See