Reliability Makes Accounting Relevant: A Comment on the IASB Conceptual Framework Project

Abstract

In July 2013, the International Accounting Standards Board (IASB) welcomed comments to their discussion paper A Review of the Conceptual Framework for Financial Reporting. We argue that the IASB should revisit its decisions about the concepts of reliability and prudence, to address the inherent accounting issue of moral hazard. Within the contexts of goodwill and securitization accounting, we illustrate how reliability and prudence can help standard-setters to identify standards that can address moral hazard. We further illustrate the pervasiveness of moral hazard, using the context of executive compensation arrangements. Ultimately, we conclude that a strong conceptual framework should enhance the credibility of financial reporting. We view this as the fundamental role of accounting.

Acknowledgements

Andrew Bauer is grateful for financial support from the University of Illinois at Urbana–Champaign. Patricia O'Brien is grateful for financial support from the Ernst & Young Professorship at the University of Waterloo, and from the Social Sciences and Humanities Research Council of Canada. Umar Saeed declares that the opinions expressed in this paper do not represent those of the Province of Ontario.

Notes

¹ Paragraph numbers on quoted text refer to the July 2013 Discussion Paper, IASB (2013).

² For example, in their book on the research process within humanities disciplines, Booth et al. (2003) describe the necessity and means of vetting sources for relevance and for reliability.

³ For simplicity of exposition, we assume that the secured assets are loans, and that the loan originator creates the securitization transaction. In general, a wide variety of assets have been securitized, and often securitizations involve intermediaries such as investment banks. These variations do not change the substance of our message.

⁴ See Brisley (2006) for a brief review of theoretical and empirical arguments in this area, and for a theoretical model that shows vesting conditions of traditional stock options provide weak, if any, long-term incentives.

⁵ We emphasize that our concern is with users devising alternative measures, and not with managers reporting measures that fall outside of Generally Accepted Accounting Principles (GAAP). The former are manifestations of user mistrust of the reported numbers. The latter are subject to all the moral hazard issues we raise in this paper.