1000 WORD ESSAY

© 1998 American Accounting Association Accounting Horizons Vol. 12 No. 2 June 1998 pp. 161-162

American Accounting Association's Financiai Accounting Standards

Committee Thomas J. Linsmeier, Chair; James R. Boatsman;

Robert H. Herz; Ross G. Jennings; Gregory J. Jonas; iViark iH. Lang; Kathy R. Petroni; D. Shores; James iVi.Wahien

Criteria for Assessing the Quaiity of an Accounting Standard

Overall Decision Criterion A high quaUty accounting standard improves financial reporting by enhancing fi-

nancial statement users' abilities to make investment and credit decisions.

Basic Issues In implementing this criterion to evaluate proposed accounting standards, we con-

sider the following issues. 1. Does the proposed accounting standard address a deficiency in the financial report-

ing model? We believe high quality accounting standards should promptly address significant deficiencies in the financial reporting model. Deficiencies in the report- ing model can arise, for example, from significant changes in methods of doing busi- ness (e.g., using derivatives to manage market risks) and significant changes in the economic environment (e.g., growth in the service sector of the economy). The fi- nancial reporting model should refiect the economic effects of such changes on a timely basis. More generally, we believe the financial reporting model should be modified in a timely manner whenever current reporting standards are found inad- equate for investment and credit decisions.

2. Does the proposed accounting standard correct the perceived deficiency in financial reporting by improving financial statement users' abilities to mxike investment and credit decisions? We believe a high quality accounting standard will improve financial statement users' abilities to make investment and credit decisions if, in part, it improves the overall relevance, reliability and comparability (includ- ing the international comparability) of reported information. In markets that are imperfect or incomplete, investors and creditors require measures (or esti- mates) of firms' economic activities and events. In such markets, choices among

The principal author is Thomas J. Linsmeier.

•'•̂ ^ Accounting Horizons / June 1998

alternative measurements provided by financial accounting systems often involve a trade-off between relevance, reliability and comparability. A high quality ac- counting standard makes these trade-offs by providing guidance that maximizes the informativeness of financial reporting information.

3. Do expected benefits from issuing the proposed standard exceed expected costs? We believe a high quality accounting standard should improve capitaJ allocation deci- sions sufficiently so that benefits of the new standard exceed costs. Capital alloca- tion decisions improve significantly when new accounting information leads to de- creased information risk and costs of capital, producing increased economic output and efficiency. A good accounting standard will enable decision makers to assess more accurately the economic health and performance of firms. As a result, decision makers will perceive some firms to be economically stronger and others to be eco- nomically weaker. These economic consequences of the accoimting change are the mechanism by which new accounting standards improve capital allocation deci- sions and, thus, should support rather than prevent issuance of the standard. Other costs associated with implementing a new standard (e.g., preparation, proprietary and potential litigation costs) also should not prevent issuance of the standard, as long as the expected benefits derived fi-om improved capital allocation decisions exceed these costs.

Evaluation Criteria In evaluating each of the three basic issues described above, we primarily consider

whether the proposed accounting standard is consistent with both academic research and the FASB's "Conceptual Framework" underlying financial reporting. 1. When academic research is relevant, we believe a high quality standard should be

informed by and consistent with the results of such research. Research can be rel- evant to the standard-setting process when it provides models, theories and/or em- pirical evidence, which explore the relation between accounting information and various economic metrics (e.g., stock prices, stock returns, bid-ask spreads, cost of capital, market risk, credit risk, solvency, etc.). Research has the potential to in- form standard-setting decisions by both suggesting economic factors and providing empirical evidence directly relevant to assessing whether a proposed accounting standard (1) addresses a deficiency in the financial reporting model, (2) improves financial statement users' abilities to make investment and credit decisions, and (3) has economic benefits exceeding economic costs.

2. We believe a high quality standard should be consistent with the FASB's "Concep- tual Framework" because we believe standards based on internally consistent rea- soning are most likely to improve financial statement users' abilities to make in- vestment and credit decisions. The "Conceptual Framework" provides the FASB with a common foundation and basic reasoning on which to develop proposed ac- counting standards. As such, determining whether the proposed accounting stan- dard is consistent with the "Conceptual Framework" allows us to (1) understand the basis for the Board's conclusions, (2) examine potential strengths £ind weak- nesses in the reasoning behind the proposed standard, and (3) identify inconsisten- cies between the proposed standard and other standards which define the current reporting model.