Research Insights: A Study of the Replacement of “Reliability” by “Faithful Representation” in the IASB/FASB Conceptual Framework
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Carsten Erb and Christoph Pelger. “‘Twisting words?’: A Study of the Construction and Reconstruction of Reliability in Financial Reporting Standard-Setting.” Accounting, Organizations and Society 40 (2015): 13-40.
In 2010, as part of their convergence agenda following the Norwalk agreement, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) published the result of their joint project on the revision of the conceptual framework. In the revised framework, the qualitative characteristic of “reliability” was replaced by “representational faithfulness.” This change is notable because reliability was previously deemed one of the most important concepts of financial reporting. In particular, the idea of a trade-off between relevance and reliability was abundant in accounting discourses. The IASB and FASB justified the replacement as a mere clarification of terminology, which they viewed as necessary due to a perceived diversity of understandings and misunderstandings of the term “reliability”.
Research Approach and Research Questions
Our qualitative empirical study regards qualitative characteristics such as reliability as social constructs. Hence, they are subject to different interpretations which may develop and change over time. Relying on accounting literature, documents from the due process of the framework project, and interviews with key actors from the IASB, we meticulously traced the development of “reliability” from its historical origins in early financial accounting discourses to its abandonment during the recent framework project. Our analysis focused on two research questions:
- How and why did reliability emerge as a qualitative characteristic in standard setting?
- Why was “reliability” abandoned and replaced by “faithful representation?”
We identified traditional notions of verifiability and objectivity as antecedents of reliability in early (normative) discourses on financial accounting theory. These concepts were evolutionarily linked to accounting practice, which is reflected in early accounting theorists’ statements of the prevalence of objectivity, understood as transaction-based accounting corroborated by available evidence. Thus, notions of objectivity/verifiability, which also provided an immediate link to auditing, aimed at the minimization of subjectivity in the preparation of accounts.
In accounting literature, the understanding of these early notions gradually changed. First, in the academic discourses of the 1960s, objectivity was reframed from its evidence-based definition to a more abstract “consensus by different observers.” Second, the advent of the decision usefulness orientation, i.e., the focus on investment decisions by capital providers, an idea developed by academics, led to the promotion of the concept of relevance and conceptually reduced the relative importance attributed to considerations of verifiability or objectivity.
In the Statement of Financial Accounting Concepts No. 2—the US conceptual framework published in 1980—“reliability” was introduced as an umbrella term comprising both the traditional practitioner idea embodied in the concept of verifiability and the more recent academic notion of faithful representation. The concept of faithful representation originated in the natural sciences and was taken up by accounting academics in the 1970s mainly to conceptually justify the increasing use of current value measurement in financial accounting. In this line, current values were regarded to better depict a company’s “economic reality” from the perspective of decision usefulness. Introducing “reliability” as a compromise between traditional and more recent concepts served the purpose of giving the FASB the opportunity to move away from traditions of historical cost-based accounting.
However, in discussions of standard setters and constituents, the aspect of faithful representation was often neglected. Instead, “reliability” was mostly employed by sceptics of current/fair value accounting, associating “reliability” with the traditional meaning of verifiability/objectivity. This also underlines that the conceptual reconstructions surrounding the introduction of “reliability” in the conceptual framework primarily took place at the level of abstract academic theorizing, while actual accounting practice was hardly affected.
The rising importance of fair value accounting in International Financial Reporting Standards and US Generally Accepted Accounting Principles since the 1990s led the boards to rethink the concept of reliability. The joint framework revision gave the IASB and FASB the chance to replace “reliability” with “faithful representation,” a concept which imposed less conceptual limitations to fair value accounting. However, our study finds that the boards’ attempt to alter traditional practical understandings by using ever-higher levels of abstraction led to very different views among constituents and board members about what “faithful representation” means and what it implies. “Faithful representation” is, in particular, more detached from practitioners’ thinking, which was responsible for the large opposition to the renaming of “reliability” during the boards’ due process. Many of those comment letters pointed out that “faithful representation” was, compared to “reliability,” less clear and linked the change to “faithful representation” to increasing fair value measurement.
While the constituents’ opposition remained unsuccessful in stopping the change to “faithful representation”, the material effect of the replacement remains unclear. At least, there has not been a significant increase in fair value accounting since the publication of the revised framework. At a broader level, our study concludes that the very abstract character of the concepts in the framework might give rise to more general questions about the usefulness of high-level conceptual activities by standard setters.