Columbia Business School Research Offers New Approach to Financial Reporting that Takes Uncertainty into Account
The International Accounting Standards Board (IASB) recently issued a revised Conceptual Framework for Financial Reporting, which essentially acts as a constitution, setting the bounds for accounting standards worldwide. The Conceptual Framework updates the definition of an asset and a liability, and how these elements are recognized and measured in financial statements. But according to new research by Columbia Business School, the revisions fail to acknowledge uncertainty as a defining feature of financial reporting.
“The central role of accounting is to shed light on uncertainty in investing,” said Stephen Penman, George O. May Professor of Financial Accounting and a Chazen Senior Scholar at Columbia Business School. “This paper goes beyond the IASB’s framework, and provides an alternative approach, which defines levels of uncertainty that can be reasonably booked with assets and liabilities on the balance sheet.”
The significance for financial reporting is that investors face uncertainty in making investments, and so they seek information about that uncertainty. While expected economic benefits are important, so too is the uncertainty that those expected economic benefits may not be realized.
About the Research
The paper, entitled Moving the Conceptual Framework Forward: Accounting for Uncertainty, stems from a discussion Penman and his co-author, Richard Barker of University of Oxford’s Saïd Business School, had at the IASB headquarters in London in 2016. Central to that discussion was the question: What is an asset?
The revised Conceptual Framework takes a balance sheet approach to financial reporting, defining an asset broadly as something that has future benefits. While this approach is a reasonable starting point for identifying and measuring the assets and liabilities of any given company, the researchers contend that it does not consider the implications of uncertainty, which they argue is central to the concept of accrual accounting. Therefore, failing to distinguish uncertain investments from those with less risky outcomes, investors are left without critical information about a company’s complete financial position.
The research considers how accounting can be more informative by measuring uncertainty, and ultimately help financial managers make more informed resource allocation decisions.
A New Approach to Financial Reporting
Because the income statement and the balance sheet are structurally linked, as the Conceptual Framework recognizes, Penman and Barker suggest that the balance sheet approach would be more accurate if it accounted for the consequences reflected in the income statement, including uncertainty and mismatching.
The researchers outline a more comprehensive conceptual approach that links the balance sheet and income statement. By proposing an uncertainty threshold for considering classes of investments that should (or should not) be booked to the balance sheet, they show that the accountant reports a better matching of revenues and expenses—value added from business—in the income statement. Financial managers and investors thus get a clearer picture of performance and of risk.
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