2007 Reports

On the Balance Sheet-Based Model of Financial Reporting

Dichev, Ilia D.; Penman, Stephen H.

The FASB adopted a balance sheet-based model of financial reporting about 30 years ago, and this model has been gradually expanded and solidified to become the required norm around the world today. Currently, the FASB and the IASB are re-considering their Conceptual Framework, and this is the right time to have a much-needed debate about the proper conceptual foundations of accounting. This paper argues that the balance sheet orientation of accounting standard-setting is flawed, for the following reasons: 1. Accounting is supposed to reflect business reality, and thus the essential features of the financial reporting model need to reflect the essential features of the underlying business model. However, the balance sheet orientation of financial reporting is at odds with the economic process of advancing expenses to earn revenues, which governs how most businesses create value, and which represents how managers and investors view most firms. 2. The adoption of the balance sheet approach was driven by conceptual considerations; standard setters argued that the concept of assets is more fundamental and logically prior to the concept of income. However, this paper argues that the concept of income is clearer and practically more useful than the concept of assets, especially with the recent proliferation of intangible assets. 3. Earnings is the single most important output of the accounting system. Thus, intuitively, improved financial reporting should lead to improved usefulness of earnings. However, the continual expansion of the balance sheet approach is gradually destroying the forward-looking usefulness of earnings, mainly through the effect of various asset re-valuations, which manifest as noise in the process of generating normal operating earnings. During the last 40 years, the volatility of reported earnings has doubled and the persistence of earnings has gone down by about a third, while there is little change in the properties of the underlying business fundamentals. 4. The balance sheet approach has pushed accounting into incorporating more and more valuation estimates into financial reports, creating tautological and dangerous feedback loops between financial markets and the real economy. The paper concludes with two suggestions about a "good" model of financial reporting. The first suggestion is that accounting needs to make a sharp theoretical and practical distinction between operating and financing-type activities and assets, and this distinction needs to be reflected in all financial statements. The second suggestion is that for most firms the accounting for operating activities needs a renewed emphasis on the principle of matching of expenses to revenues.