On the accountability-based conceptual framework of accounting

GUEST EDITORIAL

On the Accountability-Based Framework of Accounting*

Conceptual

A conceptual framework of accounting can be decision based or accountability based. The choice critically affects the resulting framework. A framework that is decision based is centered on the decision maker, namely, the user of accounting information. Suppliers of accounting information might as well be inanimate objects since their interest in the flow of information is not considered in this type of frameworks. A framework built on the accountability relation, on the other hand, focuses on the relation between the accountor, the supplier of the accounting information, and the accountee, the user of the accounting information. In a decision-based framework, the objective of accounting is to provide information useful for economic decisions. It does not matter what the information is about. More information is always preferred to less as long as it is cost effective. Subjective information is welcome as long as it is useful to the decision maker. In an accountability-based framework, the objective of accounting is to provide a fair system of information flow between the accountor and the accountee. It is built upon the accountability relationship between the two parties. Based on the underlying accountability relation, the accountee has a certain right to know; at the same time, the accountor has a right to protect privacy. More information about the accountor is not necessarily better. It is perhaps better from the standpoint of the accountee but not necessarily from the overall accountability relation. Subjective information can seriously damage the interest of the accountor, even if it is highly useful to the accountee. Most conceptual frameworks seem to be decision based. They. are unidirectional-oriented solely toward users. A conceptual framework that is accountability based must weigh the interest ofthe two sides; it is bidirectional. Accounting is, in a sense, a business diary. Any prudent businessman should keep a business diary. However, a diary you keep for your own use would be totally different from the one you would be forced to keep by the Internal Revenue Service. The reality of accounting does not seem to make much sense if it were a

Yuji

Ijiri

is Robert

Administration, * Presented

M. Trueblocd

Carnegie-Mellon at the Conceptual

Professor of Accounting University, Framework

Schenley Conference

Jo~msl of Acccuating and public Policy, 2.75-81(1983) 1983ElpvicrScienaePuMishingCo.,Inc.

@

Park,

and Economics Pittsburgh,

at Harvard

at the Graduate

School of Industrial

PA 15213.

Business School on October

1-2, 1982.

75 02784254/83/$3.00

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Yuji Ijiri

diary you keep for your own use. In that case, first, you would not need any standards or conventions. You could devise your own symbols and give them your own meaning. You could change them whenever you wish. Secondly, you would not have to stick to the observables. You might freely describe the workings of your inner mind in depth, which is what makes the diary valuable to you. Thirdly, you would not have to include certain subjects or topics. You might even decide not to keep a diary at all. The choice is absolutely yours. None of these points seems to be consistent with what we observe in accounting. Accounting is, in fact, like a diary you keep for someone else’s use. This does not mean that the diary you keep for others is not useful for yourself. Nor does it imply that you may not benefit indirectly from keeping it for others. The point is that existing accounting systems would just not make any sense at all if they were to be treated like a diary you keep for yourself. Why do you keep records and provide information for the benefit of someone else? Either you want to do this voluntarily in order to impress, appeal to, and solicit certain actions by others, or you do so involuntarily under force. Why force? Because there is an underlying accountability relation between you and someone else. Based on that relation, you are expected to account for your activities and their consequences to a certain person. You are required to do so, whether you like it or not, and most cases in accounting seem to fall under this category. The accountability relation may exist outside a firm or inside a firm. A firm may be accountable to shareholders, creditors, government, labor unions, consumers, or to the public in general. Within a firm, officers and employees are accountable to their respective supervisors based on the organizational hierarchy of authorities and responsibilities. Under the accountability relation, the accountor is required to provide certain information to the accountee. The accountant then comes between them as a third party in order to assure a smooth flow of the required information. Accounting is not just for the accountee, the recipient of accounting information, nor just for the accountor, the supplier of accounting information. Just as a lease protects the lessee as well as the lessor, accounting protects both parties. It protects the accountee by assuring that the required information will flow to the accountee with the required accuracy and timeliness. It protects the accountor from indiscriminate disclosure requirements by fixing the limit of disclosure. Financial statements define simultaneously what should be disclosed and what need not be disclosed. The accountant uses two basic tools to accomplish these objectivesrecords and reports. Reports are what the accountee is entitled to receive regularly; records are what the accountee is entitled to inspect in the event that certain specified irregularities occur. The reports establish the range of regular disclosure, while the records establish the range of contingent disclosure. The reports are a summary of the records and are founded upon the records. Therefore, the conceptual framework of accounting must cover both the records and the reports.

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The contents of the records and reports are designed to properly account for the financial activities of the accountor and their consequences. They are oriented not only toward the stewardship function of the accountor but also toward the performance evaluation relative to the goal assigned to the accountor based on the underlying accountability relationship. One of the key elements in the accounting reports is, therefore, a performance measure. There are many kinds of information in the accounting records and reports on which the accountor is neutral. Yet there are also many other kinds of information in these documents on which the accountor cannot remain neutral, such as performance measures. In creating this type of information, the accountor, following human nature, tries to present the best performance picture possible, using discretion in recording and reporting the activities whenever he or she can. In the decision-based framework, this can hardly be a problem since the suppliers of information are depicted as if they never care about how their performance is recorded and reported. But an accountabilitybased framework must explicitly take into account the accountor’s desire to present the best performance picture possible. While some room for discretion by the accountor might be inevitable insofar as recording and reporting require human judgement, too much room for discretion by the accountor can destroy the objective of accounting itself since the records and reports would always show the top performance. The accountee’s right to know will suffer when a performance measure loses its discriminating power. Therefore, in the accountability-based framework, objectivity and verifiability of accounting information is not only desirable but indispensable. In this context, objectivity means the independence of the information content from the preparer of the information, that is, the similar or identical information is produced regardless of who prepares it. Verifiability means that the information can be verified at a later point in time, that is, there are sufficient trails to enable anyone to reconstruct the information, should that become necessary. Objectivity and verifiability protect the interest of the accountee by assuring that the information presented to the accountee is reasonably free from any subjective bias on the part of the accountor. At the same time, they also protect the interest of the accountor by assuring that the information prepared by the accountor will not be accused of being biased or misleading. Without objectivity and verifiability, neither the accountor nor the accountee can be certain that fairness is achieved. In fact, in the accountability-based framework, three parties must agree before a proper information system can be established. The accountee must desire to have the information, the accountor must be willing to provide the information, and the accountant must agree that the information can be provided in an objective and verifiable manner. Even if the accountee desires the information and the accountor agrees to provide it, without a proper accounting technology to assure objectivity and verifiability the accountant

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should not become involved. To do so is like marketing unsafe products; sooner or later the accountant will be caught in a legal dispute between the accountor and the accountee. The advancement in accounting technology will enable the accountant to market more and more varieties of information with the required quality assurance, but the accountant should respect the technological limitations of the profession that exist at any point in time. One way of improving objectivity and verifiability is to divide the entire process of measurement into a large number of minute processes, none of which can critically influence the final measurement, that is, to rely on the safety in numbers. Thus, for example, a scoring system in football or baseball is more objective than that in boxing or gymnastics because in the first two sports scoring is done by accumulating a large number of minute decisions on various parts of performance, while in boxing and gymnastics it is done by averaging a small number of decisions on overall performance. As long as the information satisfies the quality of objectivity and verifiability, its contents and the rules of preparation can be anything on which the accountor and the accountee agree. When the needed information cannot be provided in an objective and verifiable manner, the accountant may propose to substitute it by surrogate information that is correlated with the desired information and can still be generated in an objective and verifiable manner. In all such cases, an agreement between the accountor and the accountee on the information content and the rules of preparation is absolutely necessary. When there is an explicit agreement, the accountant has no business getting involved in the issue of whether such information is useful for anything. The accountant may offer suggestions, but presumably the parties who are directly involved in the accountability relation should have a better idea of what is useful and what is not. It is only when such an agreement is not explicitly stated that the acountant must find the underlying intent of the two parties and develop an accounting system accordingly. Relevance, usefulness, or faithful representation of the economic reality and the like become important only in such a situation. In the accountability-based framework, usefulness of accounting information and its relevance to decisions, its faithfulness in representing economic reality, and its other related desirable properties are not of primary importance. An accounting system is a human system, not just an information system. What is important is the usefulness of the accounting system as a whole and not necessarily the usefulness of the accounting information itself. The accounting system can be highly useful to the accountor and the accountee even if no one reads the accounting reports. Like insurance, what is ultimately of use here is the assurance provided by an accounting system of records and reports that things can be accounted for whenever necessary. If the accountor behaves more accountably and the accountee increases the trust on the accountor because of the existence of records and reports, that benefit of the accounting system is of fundamental importance even if neither party reads the records or reports.

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The usefulness of the accounting system, if not necessarily of the accounting information itself, may also be observed frequently where the accountor and the accountee agree to transfer resources between them based on the number generated by the accounting system under an agreed-upon set of rules. As information that represents something retrospectively, such a number may be useless because, for example, it could be the result of adding apples and oranges. However, in terms of what the number does prospectively, it is definitely useful because it is based on this number that the resources are allocated or transferred fairly, where fairness is judged in relation to the agreement. Without such a number, a judgement on what is the fair allocation is an extremely difficult one to make. Prolit sharing, income taxation, cost-plus contracts, rate regulation, and debt covenants based on accounting numbers are all examples of such a use of the accounting system. In the accountability-based framework, the stability of the accounting system is often of crucial importance. Stability goes much beyond consistency and comparability, which are considered to be important qualitative characteristics of accounting information. Even if accounting rules are changed, consistency and comparability of information can be preserved if there is an explicit means of reconciliation by which numbers from one system can be translated into those from another system without error. Unfortunately, in many cases an agreement between the accountor and the accountee cannot be easily changed, even if the accountor and the accountee can mentally adapt to the change in the accounting rules in the use of information. As a result, a change in accounting definitions or rules of measurement can seriously damage the interest of one party for the benefit of the other. Stability of the accounting system means that such a change in the definitions or rules of measurement will not be made unless absolutely necessary. If an accounting system is unstable, the accountor and the accountee sense the risk of relying upon it in developing their agreement and look for other means that are more stable. When the importance of objectivity, verifiability, and stability is recognized, the reason for the persistent use of historical cost in accounting over many centuries may become evident. Historical cost is more objective and verifiable than current cost or other valuation methods based on current market price, mainly because historical cost is based on the actions actually taken by the firm while other methods are based on hypothetical actions that the firm could have taken or is likely to take in the future. Historical cost income is derived as a result of an aggregation of a large number of accountants’ decisions; hence, the result is likely to be more objective than current cost income, in which the choice of current price can affect all the units of the asset on hand simultaneously. Historical cost is a good example of taking advantage of the safety in numbers. As industrial revolution enabled mass production of goods by a large number of average workers, this historical cost principle enables mass production of accounting numbers by a large number of average accountants.

Yuji Ijiri

Furthermore, reporting of historical costs implicitly assures the existence of the records of historical transactions regarding the item because otherwise historical costs cannot be determined. Other valuation methods do not require the history of the item to be valued, only its present status. Numerous contracts and agreements have been written based on accounting numbers such as earnings-per-share, net working capital, or book value of the shareholders’ equity. They mostly rely on the convention of historical cost measurements; hence, a change in this convention can drastically affect the interest of the accountor and the accountee in many cases-possibly another reason for the persistent use of historical cost in accounting. While objectivity, verifiability, and stability are the inportant characteristics of the accounting system, they are not the objective of the accounting system itself; they are rather the technical constraints the system must satisfy. The objective of the accounting system is, as stated before, to provide a fair system of information flow between the accountor and the accountee. Fairness is therefore, the funadamental goal that the accounting system strives to achieve. A comparison between fairness in the accountability-based framework and usefulness in the decision-based framework reveals the basic difference between the two frameworks. The accountability-based framework warns that information should not be given to the accountee just because it is useful to the accountee; it should flow from the accountor to the accountee only when such a flow is judged to be fair. The decision-based framework does not require that this judgment be made. The accountor can suffer a variety of losses in recording and reporting certain information. The mechanical cost of preparing records and reports as well as getting them audited, the potential loss of the accountor’s competitive advantage, and the cost of possible misuse of information and the resulting litigation are some examples. The time that the accountor must divert to record keeping from engaging in productive activities is also an important element of cost. But the most serious danger involves the impact of overaccountability on the motivation of the accountor. Requiring a minuteby-minute recording of one’s activities, to take an extreme case, is the surest way of converting motivated managers to mechanical robots. This is because the feeling of being trusted is often essential to motivation, and requirements of recording and reporting stem, more or less, from the lack of complete mutual trust. Although it is easy to identify fairness as being the primary objective under the accountability-based framework, it is extremely difficult to define what is and what is not fair in order to assist the accountant in developing a fair accounting system. Some philosophers allege that humans are destined to be free or even condemned to be free when they have to distinguish right from wrong. It appears that accountants are likewise destined to be free in facing the decision of what is and what is not fair. Accountants suffer from this freedom. They seek to be bound by such things

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as cultural conventions, legal precedents, economic theories, accounting principles, auditing standards, or anything that can reduce their unwanted freedom. Yet they are ultimately free and hence they must take responsibilities for their choice. They cannot hide behind the fairness under the generally accepted accounting principles or the so-called GAAP-fairness, as evidenced by the famous (or infamous, depending upon how you view it) Continental Vending Machine Company case. They must directly deal with fairness per se. An impossible task? Perhaps, although some guidelines on fairness can be developed, as evidenced by Aristotle’s principle of proportionality, or the common-sense notion of not changing the rule in the middle of a game. In any event, the task of providing information useful for economic decisions is not easy, but it is child’s play compared to the agony of finding a thin line of fairness between the conflicting interest of the two parties. One thing is clear, however. A solution to a problem cannot be obtained without lirst stating what the problem is. If the above accountability view is a reasonably accurate reflection of the reality of accounting, then a conceptual framework of accounting should clearly spell out the problem even if the solution may not be evident. Indeed, it is the world of I and You, not the world of I and It with which the accountant must deal. Accounting should be defined, explained, and taught as such. To do otherwise is not only misleading to the public but also dangerous to the accounting profession because it widens the gap between what accounting really is and what the public thinks accounting is. Yuji Ijiri Carnegie Mellon Pittsburgh, PA

University