In 2010, as the world was reeling from the global financial crisis, the body that determines generally accepted accounting principles for listed corporations in America dropped the principles of “reliability” and “verifiability” as necessary properties of accounting. Why did it do that? A new paper offers a possible explanation.
Editor’s note: This short piece is an excerpt of a full-length article to published in a dedicated issue of the journal Accounting, Economics, and Law: A Convivium in early 2022.
Imagine you are a parent concerned about the low level of mathematics attainment in your child’s school. You raise this concern with the school’s board. The board proposes using a new technology—a smartphone app—that is said to improve children’s learning in mathematics. A number of experts emerge to support the school board. The app plan is launched.
The school year progresses and it becomes apparent that the app isn’t improving mathematics learning outcomes. Over time, it also becomes clearer that the “experts” are not in fact independent; they are affiliated with the app’s manufacturers. You start to worry. “Was the school board conned, or worse, co-opted, by vested interests?”, you wonder. You raise this new suspicion with the school board. The board declares that the app’s objective was never to improve mathematics learning outcomes; rather, it was to help students adopt new technologies. This is indeed what the app is doing, they note, and your worry is therefore unwarranted.
Would you be satisfied? I expect not. The school board’s position defies basic principles of accountability. The school board has arbitrarily shifted its justification for the app to avoid being held to account on its original justification.
Yet, the above scenario is similar to what we experienced in 2010 from the Financial Accounting Standards Board (FASB), the body that determines generally accepted accounting principles (GAAP) for listed corporations in America. GAAP are amongst the rules that are expected to hold corporations and their managers to account for their control over our collective savings and investments in the economy.
Regulators and Conceptual Veiling
To guide its work, the FASB developed, soon after its establishment in the 1970s, a “conceptual framework,” a constitution-like document that sets out the fundamental principles of accounting. In 2010, the FASB revised this conceptual framework to drop the principles of “reliability” and “verifiability” as necessary properties of accounting. This shift was especially jarring, as both features have long been viewed (well before the FASB’s own framework) as existential to accounting. After all, there are many competing channels beyond accounting for corporate information provision, including management’s own pro-forma disclosures: what gives GAAP numbers their comparative advantage is that they are reliable and verifiable.
In explaining its changes, the FASB argued that the term reliability had come to be misunderstood in practice to mean, among other things, objective measurement. The FASB claimed that its original intent had always been for reliability to be understood as “faithful representation”—a phrase it defined self-referentially as an accounting estimate that “represent[s] what it purports to represent.” In this sense, the FASB argued that the shift away from reliability simply clarified the original meaning.
Some prominent observers of the change, including one former member of its sister rule-maker, the International Accounting Standards Board (IASB, which determines GAAP for many non-US settings), argued that the change was more significant. They argued that the change was partly driven by the need to reconcile the FASB conceptual framework with the growing use of fair-value accounting. This practice involves recording assets and liabilities on corporate books at estimates of their current value, and it represents one of the biggest shifts in the nature of accounting over the past thirty years.
Because fair values could not always be objectively measured, the notions of reliability and verifiability in the FASB’s constitution posed an impediment to the growing use of fair-value accounting in GAAP. Moreover, the rise of fair-value accounting can be tied to the contemporaneous financialization of the US economy, and the private benefits of players in the finance industry. Effectively, the growth of fair-value accounting gives rise to suspicions that the FASB is captured by certain finance-industry interests.
“Conceptual veiling is costly to regulators not only because producing conceptual narratives is time-consuming but also because embracing a given conceptual justification usually involves, as James Kwak notes, taking sides in an ideological debate.”
In a forthcoming publication, I principally examine the two competing explanations for the changes to the FASB’s constitution: clarifying its original intent; and justifying the rise of fair-value accounting after-the-fact. I draw on primary archival evidence from FASB and IASB board meeting minutes (the two boards had been working closely together on these changes), internal and external staff documents, and communication by key FASB constituents. I also rely on original field interviews with thirteen board members, seven senior staffers, and seven active constituents of the FASB and IASB at the time. Finally, I supplement these sources with secondary data from academic and media articles on the changes.
The evidence does not rule out either explanation. A small core group of senior staff members at the FASB had long held the view that the term reliability was misinterpreted in practice to mean objectivity. To these FASB insiders, the revisions to the conceptual framework did in fact represent a clarification of original intent.
But to several board members and constituents, the revisions reflected a need to update the framework to be consistent with changes in the nature of GAAP, especially fair-value accounting. As one individual who served as a board member during the deliberations noted, “The major thing hanging over our head then was fair-value measurement… This issue of reliability versus faithful representation was very core to the decisions in fair-value measurement… No one came out and said that, but it was pretty clear that this was one of the big things… Fair value was used in thirty-plus places in the accounting literature… I might not have known it in the beginning [when I joined the board], but in the end it was pretty clear.”
The evidence consistent with this latter explanation is noteworthy because it illustrates the importance to regulators of having a conceptual narrative for their actions, even if such a narrative is constructed ex post facto. After all, the changes to the conceptual framework were effected in 2010, nearly twenty years after the FASB first initiated a major thrust towards fair-value accounting.
It is possible that regulators construct such conceptual narratives for their actions because they crave an internal intellectual consistency. But, as I explain in my paper, manufacturing and adopting a new conceptual narrative is costly, in terms of both direct and opportunity costs. Moreover, the conceptual framework was created to guide standard setting, but the evidence herein suggests it was being modified to reflect changes in standard setting, a circularity that is both publicly observable and embarrassing. This observation suggests that there is likely a stronger reason for the conceptual-framework revisions than seeking internal consistency.
A more plausible explanation is that conceptual narratives provide regulators cover against criticism. To this end, the timing of the purging of reliability and verifiability can be informative. While the project was first seriously conceived in 2004, the FASB and IASB boards cast their final effective votes on the changes in January 2009, at the very height of the global financial crisis, when stock markets had sunk to dangerous lows and their regular working was disrupted. As the world was reeling from a financial crisis, the boards that oversaw accounting rulemaking for much of the global economy voted to eliminate “reliability” and “verifiability” as necessary properties in corporate financial reporting. This, I argue, they did in part to deflect criticisms about the dangers of fair-value accounting, criticisms that had started to become more audible to the general public due to the global financial crisis.
These revisions are an illustration of a phenomenon I describe as conceptual veiling, wherein regulators fabricate or embrace conceptual justifications for their actions in an attempt to diffuse criticisms. Conceptual veiling is costly to regulators not only because producing conceptual narratives is time-consuming but also because embracing a given conceptual justification usually involves, as James Kwak notes, taking sides in an ideological debate. This approach can lower public perception of regulatory neutrality.
Conceptual veiling is related to the phenomenon of regulator covering-up (labelled CYA or “cover your a**”), which, while, widely acknowledged by journalists covering regulatory behavior, has not been well-developed as an idea in the academic literature on regulation. William Safire described Regulator CYA as a cultural tendency amongst bureaucrats to diffuse criticism and deflect accountability. Conceptual veiling is similar to regulator CYA in that both involve manufacturing cover against criticism. But whereas regulator CYA is attributed to regulator risk-aversion, conceptual veiling is associated with a regulator seeking protection against scrutiny of risky (and potentially captured) regulation.
I expect we can find conceptual veiling in situations where regulators are liable to being second-guessed, perhaps because of suspicions of capture. Conceptual veiling may well occur in contexts beyond accounting, as diverse as regulation of labelling genetically modified foods and regulatory forbearance in bank supervision.
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