Economic, Legal and Social Dimensions of Regulatory Arbitrage

1. Introduction – The Economic, Legal and Social Dimension of Regulatory Arbitrage, by Jan Friedrich and Matthias Thiemann, https://doi.org/10.1515/ael-2020-0150.

2. Regulatory Arbitrage – What’s Law Got To Do With It?, by Katja Langenbucher, https://doi.org/10.1515/ael-2019-0054.

3. Regulatory Arbitrage and Non-Judicial Debt Collection in Central and Eastern Europe – Tax Sheltering and Potential Money Laundering, by Cătălin-Gabriel Stănescu and Camelia Bogdan, https://doi.org/10.1515/ael-2019-0055.

4. Ambiguities in Accounting and their Impact on Regulatory Arbitrage: A Study on the Anchoring of the Rights and Obligations Approach in the IASB’s Conceptual Framework, by Tessa Kunkel, https://doi.org/10.1515/ael-2019-0049.

5. Regulatory Arbitrage in the Intersection of Accounting Standards and Tax Laws: The Case of Synthetic Leases, by Jan Friedrich, https://doi.org/10.1515/ael-2020-0098.

6. Detecting Tail Risks to Preclude Regulatory Arbitrage – The Case for a Normatively Charged Approach to Regulating Shadow Banking, by Matthias Thiemann and Tobias Tröger, https://doi.org/10.1515/ael-2019-0059.

1 Introduction

In March 2018, the International Accounting Standards Board (IASB) published the revised version of its Conceptual Framework (CF), which constitutes the principles-based guideline for the development and revision of International Financial Reporting Standards (IFRS).^[1] For a long time, preparers, users and other stakeholders widely considered the conceptual framework project “as something not deserving of much attention because of its high-level nature and the fact that it is unlikely to have any impact on requirements in accounting standards for some time to come” (ICAS/IFAC, 2014, p. 5). However, the CF is at the heart of the IASB’s “revolution in financial reporting” (IASB, 2012, p. 4), which has striven for a more faithful representation of the “economic substance of the underlying economic phenomenon” (IASB, 2018b, para. 2.32) since 2001. As a cornerstone of this movement, the IASB refined two key elements of financial statements – assets and liabilities – in terms of rights and obligations. In doing so, the board removed ambiguities in the definitions of balance sheet items. While the previous CF, issued by the International Accounting Standards Committee (IASC) in 1989, ambiguously defined assets in such a way that allowed multiple interpretations (Abela, Barker, Sommer, Teixeira, & André, 2014; Booth, 2003), the revised definition of assets limits its scope to a single accounting model, thereby “altering the concepts to advance a particular model of financial reporting” (O’Brien, 2009, p. 273). Despite this significant conceptual shift, accounting research has left the IASB’s decisions leading up to removing ambiguities in the asset and liability definitions as well as the implications of this important refinement largely unexplored.

By abstaining from a notion of assets as indivisible items^[2], the board has attempted to remove the conceptual grounding for issuing accounting standards that follow an “all-or-nothing” (Dworkin, 1967, p. 25) approach. Particularly, previous lease accounting standards (IAS 17 and the US counterpart Statement of Financial Accounting Standards (SFAS) 13) followed a notion of assets linked to the tangible reality, which either recognized the entire physical asset (leased property) and the corresponding lease liability or nothing at all (e.g., Donegan & Sunder, 1989, p. 211). Along these lines, the resulting sharp demarcation for the classification in finance (‘all’) or operating (‘nothing’) leases forms part of what W. McGregor (former IASB board member) calls “‘cliff-edge’ accounting [that] has no conceptual rationale” (AASB, 2013, p. 36). As accounting practice applied IAS 17 with the bright line tests of SFAS 13 in mind^[3], the lease accounting standard allowed economically similar business transactions to be treated differently and, thus, facilitated “accounting-motivated financial engineering” (Dye, Glover, & Sunder, 2015, p. 266).

Against the backdrop that the previous lease accounting standards were “[c]onceptually and operationally an accounting nightmare” (Reither, 1998, p. 288), the reviewed definitions of assets and liabilities in terms of atomized rights and obligations lay the conceptual foundation for bundling and unbundling of items. This componentization option is a necessary precondition for tackling arbitrary bright lines at the standards level, for example, those included in the flawed lease accounting standards, as it allows a more fine-grained depiction of an entity’s wealth. Along these lines, the IASB’s CF project and the conceptual alterations on the asset and liability definitions in particular, are crucial for revising various accounting standards (IASB, 2012, p. 8; see also ICAS/IFAC, 2014, p. 12), as the framework “sets the direction of travel and it is at the heart of debates about what gets recognised (and what does not)” (ICAS/IFAC, 2014, p. 5; see also McCahey & McGregor, 2013, p. 10).^[4] Even though the rights and obligations approach enables componentization of balance sheet items and aims to move “[a]ssets and liabilities that companies have moved ‘off balance sheet’ […] back ‘on balance sheet’” (Tweedie, 2002, p. 13), this paper shows that the CF spawns new complexities and ambiguities, creating, in turn, new opportunities for regulatory arbitrage.

By drawing upon 18 expert interviews and a document analysis, this study traces the process of removing ambiguities from the asset and liability definitions, covering the period from 2001 to 2018 and sheds light on shifts in ambiguities to other arenas. As theoretical basis for the analysis, this paper draws on works on the role of ambiguities in accounting (Hopwood, 1990; McSweeney, 1997) to examine the ambiguity-reducing and ambiguity-creating functions of accounting as a self-perpetuating cycle (Davie, 2000). While “accounting is supposed to reduce ambiguity through its conceptual and technical specificity and precision” (Davie, 2000, p. 316) at one level, the paper illustrates that the anchoring of the rights and obligations model entails new ambiguities at another level, particularly in the conceptually interlinked building blocks of the unit of account and recognition criteria. The paper goes on to show how this conceptual juxtaposition of ambiguity reduction and ambiguity creation is anchored in accounting standards, using the example of IFRS 16: Leases. While removing ambiguities in the asset and liability definitions provides the conceptual rationale for fundamental changes at the standards level, the paper demonstrates that ambiguities, inherent to the rights and obligations approach, were translated into the new accounting standard for leases. By examining this translation process, the study argues that the perpetual cycle of ambiguity reduction and creation (Davie, 2000) also includes ambiguity shifting between the conceptual basis of financial reporting and accounting standards.

This paper contributes to the debate on the conceptual underpinnings in financial reporting by analyzing the reconceptualization of elements of financial statements and by examining how this refinement shifts ambiguities to the issue of the unit of account and recognition criteria. Research on CF projects (Booth & Cocks, 1990; Bullen & Crook, 2005; Hines 1989, 1991; Peasnell, 1982; Robson, 1999; Whittington, 2008) examined the social construction of users in financial reporting (Young, 2006) while more recent studies provide interview-based evidence on the decision-making process in revising the objective of financial reporting (Pelger, 2016) and the qualitative characteristics (Erb & Pelger, 2015). This paper adds to this literature as it traces the path towards the anchoring of the rights and obligations approach since 2001 and reveals how changes in the conceptual framework served as a political tool to legitimate accounting change at the standards level.

In this vein, the paper brings together literature on conceptual frameworks with research that focuses on the political dimension of accounting standard setting processes (Baudot, 2014, 2018; Morley, 2011; Thiemann, 2018; Young, 1994, 2014). While research on the conceptual underpinnings of financial reporting investigated conceptual changes that are “too lofty criteria” (Ohlson et al., 2010, p. 475) to have direct implications for the (re)designing of accounting standards (comp. Erb & Pelger, 2015; Pelger, 2016), it widely neglects the crucial role of further conceptual building blocks and their (direct) impact on accounting standard setting (but see Monson, 2001 on the Financial Accounting Standards Board’s (FASB) CF and SFAS 13). By examining the implications of the transition from IAS 17 to IFRS 16 from a lessee’s perspective^[5], this paper shows how removing ambiguities from the definitions of assets and liabilities feeds into accounting standards and affects the playing field of regulatory arbitrage. As such, this paper also adds to the literature on financial engineering in accounting (Biondi et al., 2011; Donegan & Sunder, 1989; Dye et al., 2015; Thiemann, 2014; Thiemann & Lepoutre, 2017), as it demonstrates how issues of regulatory arbitrage are linked to ambiguities in the conceptual underpinnings of financial reporting.

This paper is structured as follows: Section 2 first outlines the role of ambiguities in accounting and discusses the literature on conceptual frameworks of financial reporting in the context of regulatory arbitrage, before explaining the methods used in the empirical analysis in Section 3. Section 4 examines conceptual adjustments in three cornerstones of financial reporting – definitions of elements, unit of account and recognition. In Section 5, the paper traces the process of anchoring the rights and obligations approach in the IASB’s CF, before turning to the creation of ambiguities through the revised definitions of assets and liabilities. By focusing on issues of regulatory arbitrage, this creation of conceptual ambiguities and their translation into accounting standards is then examined through a comparison of the previous IAS 17 with the new lease accounting standard IFRS 16. The final section discusses the findings and closes with an outlook as well as possible opportunities for future research.

2 Literature Review Focusing on the Significance of Ambiguities in Accounting

Hopwood (1990, p. 79) describes accounting as a “paradoxical phenomenon” and emphasizes the tense juxtaposition of technical specificity and conceptual vagueness, which “enables a degree of ambiguity to enter the accounting realm” (ibid.). Despite accounting regulations being full of technical details and precisely defined procedures, “[t]erminology is subject to poor usage and a lack of clarity” (ibid.).

On the one hand, ambiguities allow accounting terminology to be interpreted in a variety of ways. This allows “a certain fluidity to enter into the corporate accounting domain” (Hopwood, 1990, p. 80) and leaves “room for alternative reactions and classifications” (Davie, 2000, p. 315). The ambiguity inherent to accounting expressions is associated with discretion for preparers and auditors. In practice, accounting expressions are interpreted divergently and can be manipulated (Hopwood, 1987, 1990; McSweeney, 1997) to obtain a certain accounting outcome. The combination of multiple interpretations, omissions in accounting regulations and susceptibility for structuring activities “makes the practice of accounting a fertile source of ambiguity” (Davie, 2000, p. 316).

On the other hand, accounting can also be seen as a performance aimed at reducing these ambiguities through conceptual and technical explicitness (Davie, 2000, p. 316). Boundaries and task performance tend to be precisely defined to deal with the inherent vagueness of accounting terminology and ensure a certain degree of order and control over accountants’ behavior. However, removing ambiguities is also a classificatory process, which involves a managerial issue of proper application of technical procedures and practices to delineate between categories. As drawing boundaries is a highly political act in accounting (Thiemann & Friedrich, 2016), Davie (2000, p. 315) emphasizes that ambiguities are part of a dynamic process as “there would be no need for clarity if there were no ambiguities, and there would be no ambiguities if not for the pursuance of specific and conflicting interests”. Davie (2000, p. 316) further argues that drawing boundaries also “produces the ultimate source of indecision and uncertainty”, creating new ambiguities that call for further precision and clarification. In this way, accounting is characterized by a perpetual cycle of ambiguity reduction and ambiguity creation and “conceptual and technical ambiguities merely create and enhance the need for more and more accounting” (ibid., p. 330). The reciprocity between specifications and ambiguities in accounting practice and regulation manifests in the debate of precise accounting rules and vaguely formulated principles (Maines et al., 2003a; Nobes, 2005; Schipper, 2003; Wuestemann & Wuestemann, 2010).

Nelson (2003, p. 91) understands rules “to include specific criteria, ‘bright line’ thresholds, examples, scope restrictions, exceptions, subsequent precedents, implementation guidance, etc.”. Rules-based accounting standards contribute to certainty, order, comparability, and enforceability (cf. Wuestemann & Wuestemann, 2010), thereby reducing vagueness, uncertainties and judgment. Notwithstanding their ambiguity-reducing function (Davie, 2000), rules are particularly prone to regulatory arbitrage. Financial engineers purposively exploit “the gap between the economic substance of a transaction and its legal or regulatory treatment” (Fleischer, 2010, p. 3) and creatively redesign transactions, instruments and even organizations (Bens & Monahan, 2008; Robé, 2011; Sunder, 2011) “to make accounting choices that cast their actions in the best possible light” (Donegan & Sunder, 1989, p. 206). In this vein, “accounting resembles a game” (Gerboth, 1987a, p. 97) and rules “facilitate strategic evasion, allowing artful dodging of a rule’s spirit by literal compliance with its technical letter” (Cunningham, 2007, p. 1423). Research studies indicate that “identifying stylized arrangements that fall between the cracks” (Maines et al., 2003b, p. 167) are more likely if standards include quantitative thresholds rather than qualitative principles (Agoglia, Doupnik, & Tsakumis, 2011). Here, national and international regulations for lease transactions are a textbook example of evading precise accounting rules (Biondi et al., 2011; Donegan & Sunder, 1989; Friedrich, 2020 in this issue; Imhoff & Thomas, 1988), as they “inadvertently provide preparers with a roadmap for evading regulatory intent” (Dye et al., 2015, p. 270). Several studies provide evidence that precisely formulated accounting standards encourage managers to engage in earnings management by artificially structuring transactions to manage the current-year income of their firms and that auditors are less likely to adjust such attempts (see on SFAS 13 Krische, Sanders, & Smith, 2012; Nelson, Elliott, & Tarpley, 2002, 2003).

As rules are often incomplete and susceptible to actions of regulatory arbitrage, principles-based accounting systems have been hailed for placing the standard’s intent center stage (Maines et al., 2003a; Schipper, 2003; SEC, 2003), as they allow for a dynamic interpretation that adapts to the circumstances of each case. Instead of numerical guidance, principles-based accounting systems focus on the regulation’s spirit. Such accounting systems are predominantly viewed as mitigating structuring activities (cf. Dye et al., 2015) as they underscore the economic substance of the underlying business transaction rather than its form. As such, they ensure a ‘fair’ representation of financial statements (Sunder, 2009).

Nevertheless, principles-based accounting systems also have significant shortcomings, as they too spawn new complexities and ambiguities. The abstractness and inherent openness of principles induce uncertainties (see Braithwaite, 2002 for a critical stance to this prevailing view) and shift discretionary power about acceptable accounting practices to preparers and auditors. Nelson (2003) cites a large strand of empirical literature arguing that imprecise accounting standards allow multiple interpretations and offer room for negotiation, which equips managers with new tools to conduct ulterior and aggressive reporting (see also Donegan & Sunder, 1989; Maines et al., 2003a; Sunder, 2009). Pointing to the weaknesses of ambiguous accounting principles subject to individual interpretation (partly used to achieve desired accounting outcomes), other constituents emphasize the need for preparers’ and auditors’ willingness for unbiased reporting (Maines et al., 2003a; SEC, 1999; Sunder, 2010). For example, Hackenbrack and Nelson (1996) provide evidence that vaguely formulated accounting standards allow auditors to justify either aggressive or conservative reporting decisions, depending on their incentives. Despite these deficiencies, standard setters have increasingly established a more principles-based accounting system over the last 20 years (Camfferman & Zeff, 2015).

In accounting systems predominantly based on principles, conceptual frameworks are central devices that provide “a basic structure for organising one’s thinking about what one is trying to do and how to go about it” (Macve, 2016, p. 45). Conceptual frameworks do more than pursue the goal of conceptually defining the boundaries within which standard setters should operate (Ohlson et al., 2010); they also demarcate – from a technical and functional perspective – the boundary between what is true and false, acceptable and unacceptable, good and bad accounting treatment (Peasnell, 1982; Solomons, 1997; Young, 1994, 2006). Although conceptual frameworks naturally involve a certain degree of ambiguity, accounting research strongly criticized the initial series of Statements of Financial Accounting Concepts (SFAC 1-6) issued by the FASB during the late 1970s and 1980s as well as the IASC’s conceptual framework for their abstractness and technical and conceptual imperfection (Agrawal, Jensen, Meador, & Sellers, 1989; Gerboth, 1987b; Hines, 1989, 1991). Bryer (2004, p. 1) even argues that “the Enron experience reveals a problem at the heart of US accounting – with the FASB’s conceptual framework that encourages and legitimates creative accounting”. Specifically, this critique referred to the core of the conceptual frameworks, namely their definitions of assets and liabilities, which have been blamed for their all-inclusiveness and openness to a wide range of interpretations (Booth, 2003; Bullen & Crook, 2005; Dopuch & Sunder, 1980; Gore & Zimmerman, 2007; Samuelson, 1996; Solomons, 1986; Williams, 2003).

Besides the functional aspect of conceptual frameworks, a growing strand of accounting literature points to the central role of ambiguities in conceptual framework projects (Erb & Pelger, 2015; Pelger, 2016). While Young (2006) investigates the social construction of users and its connection to the objective of financial reporting, Zeff (2013, p. 265) states that the objective – decision usefulness – is “[y]et another term with diverse meanings, or at least diverse interpretations”. Pelger (2016, p. 66) demonstrates that the ambiguous wording of decision usefulness in the IASB’s Exposure Draft (ED) on the CF from 2008 allowed for multiple interpretations and “contributed to the lack of challenge […] by either side at this stage”. Hence, ambiguities are crucial for finding consensus among competing actors in accounting standard setting (Erb & Pelger, 2015).

Along these lines, Erb and Pelger (2015) have traced the process of replacing the qualitative characteristic of reliability with the more ambiguous principle of faithful representation in the IASB’s partial revision of the CF in 2010. While elevating faithful representation facilitates the use of fair value accounting, Erb and Pelger (2015, p. 34) emphasize that “[t]he material effect of the replacement, however, remains unclear, given diverse views on the meaning and relevance of qualitative characteristics even among board members”. Elaborating on ambiguities surrounding the principle of faithful representation and its pursuit to reflect economic reality, accounting research has stressed that neither current nor reformed accounting regulation is capable of producing unambiguous representations (Hines, 1991; McSweeney, 1997). As there is no escape from judgment on the abstract principle of faithful representation, McSweeney (1997, p. 706) argues that “the pursuit of the unattainable is nonetheless real and productive”. Besides these ambiguous, but fundamental principles of financial reporting, Sunder (2011, p. 126) points to the “precision-breadth dilemma”^[6] in the context of the definition of words, and stresses that some degree of ambiguity of meaning and words is useful for ensuring that most of the elements are captured by the definition. In the same vein, Schipper (2003, p. 65) emphasizes the necessity of broad asset and liability definitions to avoid any type of threshold issues. Research leaves the conceptual changes to the elements of financial statements and related concepts, such as the unit of account issue and recognition criteria, widely unexplored, however. Analyzing conceptual changes to assets and liabilities and interrelated building blocks as set out in the revised IASB’s CF from 2018 is essential as those building blocks directly impact accounting standard setting, whereas the objective of financial reporting as well as qualitative characteristics are both rather overarching building blocks from which to guide and revise standards.

Furthermore, although conceptual frameworks are of central importance in accounting, literature on the political economy of accounting standard setting (Baudot, 2014, 2018; Fogarty, Hussein, & Ketz, 1994; Morley, 2011; Thiemann & Lepoutre, 2017; Young, 1994, 2014) largely neglects the crucial role of conceptual framework projects for any fundamental and incremental (Djelic & Quack, 2003) accounting change. Hines (1989) has pointed to the political and strategic dimension and Horngren (1994, p. 106) argued that a “conceptual framework can help policymakers” “if it provides a common language, methods of analysis and constraints” (ibid., p. 107). In a similar vein, Miller (1990, p. 23) stresses that the unanimous vote of the FASB to adopt the asset/liability view “contains much that would lead to substantial reform in accounting practice” as the question on the elements of financial statements represents a “pivotal issue” (ibid., p. 26), enabling “significant change in the status quo” (ibid., p. 23, italics in the original). Chakravarthy (2014) provides empirical evidence that, in the period after the FASB’s issuance of the initial series of SFACs in 1985, the Financial Accounting Foundation preferably selected FASB members, advocating the asset and liability approach in the development of accounting standards. The study shows that this change to the institutional composition fostered the FASB’s transition to the asset and liability language in accounting standard setting, as it reduced the level of disagreement among board members on this issue. While Morley (2011, p. 179) points out that conceptual frameworks may become an obstacle for accounting change and stresses that “[w]hat might have been considered a force for change at one point in time, now acts as a reminder of the radical thinking of a long gone era”, Friedrich et al. (2020) show that accounting professionals may also exploit the subordinate role of conceptual framework projects to gradually implement substantial accounting reform.

Relying on literature on ambiguities in accounting, this paper aims to reveal linkages between conceptual frameworks and the political economy of accounting standard setting. Specifically, it traces the process leading to the rights and obligations approach in the IASB’s CF and seeks to understand how ambiguities are translated from the conceptual to the standards level and how this process affects regulatory arbitrage.

3 Methods

To accomplish this task, this paper combines a document analysis and interview data. The paper starts by comparing the definitions of assets and liabilities in the IASC’s CF from 1989 with the refined notions in the IASB’s CF from 2018 to demonstrate conceptual adjustments. This comparison is combined with a hand-selected document analysis of what constitutes assets and liabilities. Here, relevant materials released from accounting standard setters and its technical staff who were either directly involved in the drafting of the relevant passages or indirectly dealt with the elements of financial statements through their work in related projects (e.g., leases or provisions) are of particular interest. Sources for this review include publicly available documents from the IASC/IASB/FASB and market regulators (e.g., the Securities and Exchange Commission (SEC)) that focus on developing and revising the conceptual basis for accounting standard setting. The analysis also includes speeches as well as agenda papers, discussion papers, exposure drafts, final accounting standards (especially leases) or frameworks and the corresponding Basis for Conclusions.

In addition, 18 semi-structured expert interviews (Glaeser & Laudel, 2010) were conducted. The interviews serve as a (case-centric) tracing of the process which eventually led to the redefinition of assets and liabilities in the IASB’s CF. While case-centric process-tracing approaches acknowledge that “the social world is very complex, multifactored, and extremely context-specific” (Beach & Pedersen, 2013, p. 13), the interviews provide background information to give “the best possible explanation of a given phenomenon” (ibid.). In the context of applying process-tracing methods, I used elite interviewing (cf. Tansey, 2007) to validate the accuracy of information that has previously been collected from the document analysis and to gain “new information that will advance the research process” (ibid., p. 766). Elite interviewing provided insight into the activities surrounding the conceptual framework project in general and the redefinition of assets and liabilities in particular. In such a vein, the change in the notions of financial elements can be contextualized as part of a larger process. The document analysis led to the first set of interviewees and “one person leads to another which in turn leads to another” (Myers & Newman, 2007, p. 14). This snowballing technique helped to identify the elite group of experts that were involved in this process.

The interviews were conducted from December 2018 to September 2019 predominantly with standard setters at the IASC/IASB, its technical staff and representatives of the European Financial Reporting Advisory Group (EFRAG) who were either directly or indirectly involved in the framework revision or related projects (particularly leases). In addition, a member of the Australian Accounting Research Foundation (AARF), an auditor from a Big Four accounting firm and a member of the Institute of Public Auditors in Germany (IDW) with specialization in the framework project and related matters were also interviewed. A generic description of the interviewees’ professional affiliation is given in Table 1.

Guidelines were prepared for each interview and adapted to the interviewee’s specific expertise. Although semi-structured interviews start with a set of prepared questions, the conversation develops into a lively dialog and allows interviewees elaborate at will and mind additional aspects. This openness helps to “gather rich detail about key elites’ thoughts and attitudes on central issues” (Tansey, 2007, p. 766). Each interview included questions on the political economy of the IASB’s conceptual framework project, ambiguities in accounting as well as the impact of the rights and obligations approach on future standard setting. In total, 16 phone interviews and two face-to-face interviews were conducted.^[7] Notetaking was permitted during the two off-the-record interviews, while the other 16 interviewees agreed to having the interview recorded, which was transcribed afterwards. The duration of the interviews ranged between 40 and 116 min. Anonymity was guaranteed as this allows interviewees to express their personal views and to speak openly and unconstrained while avoiding any potential downsides in their professional lives.^[8]

4 The Elements of Financial Statements in the IASB’s Conceptual Framework

Macve (1981, p. 9) has stressed that “[t]he role of a ‘conceptual framework’ is to provide a structure for thinking about what is ‘better’ accounting and financial reporting”. Hence, when standard setters strive for a major reform of financial reporting, they must reconsider the “coherent system of interrelated objectives and fundamentals that prescribes the nature, function, and limitations of financial reporting” (Johnson, 2004, p. 4) by addressing the fundamental but demanding conceptual questions of accounting: What is the asset or the liability? How big is the asset and how broad is the liability? What belongs on balance sheet and what should be left off? (comp. Gerboth, 1987b; Johnson, 2003). A conceptual framework should answer those crucial questions up front and provide direction and structure for standard setters in reforming accounting in such a way that it more faithfully reflects the economic reality.

The IASC’s CF from 1989 defined an asset as “a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise” (IASC, 1989, para. 49a). A liability, on the other hand, was defined as “a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits” (ibid., para. 49b). The vagueness of the IASC’s terminology allowed multiple interpretations of the term ‘asset’, such as indivisible (physical) items, future economic benefits (i.e., the ultimate inflow or outflow per se), and even componentized rights (Booth, 2003; G4+1, 1996, pp. 4–7; IASB, 2014a, p. 3; Teixeira in Abela et al., 2014, p. 260). The similarly vague definition of the term ‘liability’ provided corresponding room for interpretation. This resulted in both the capitalization of liabilities that did not meet the definition or non-capitalization of liabilities even though they met the extant definition, such as liabilities arising from operating leases (Hoogervorst, 2016, p. 2) or certain contingent liabilities (see AASB, 2013 for a critical discussion). Against this backdrop, the IASB’s CF from 2018 includes changes in three elemental and interwoven building blocks, namely in the (1) definitions of elements, (2) unit of account and (3) recognition.

1. Definitions of elements (What is the asset or the liability?): In the revised asset and liability definitions, the IASB primarily focuses on the existence of potential balance sheet items. The board clarifies that an asset (i.e., the economic resource) neither represents (physical) objects nor the resulting future economic benefits. In essence, an asset is defined as a single right that has the potential to generate economic benefits (IASB, 2018a, para. 4.2) and is linked to the underlying (physical) resource. More precisely, “each of an entity’s rights is a separate asset” (IASB, 2018a, para. 4.11), including, for example, the right to use the underlying object, the right to sell rights or the right to pledge rights over the object (ibid.). A liability is defined as a present obligation to transfer an economic resource and is further specified as a present “duty or responsibility that an entity has no practical ability to avoid” (IASB, 2018a, para. 4.29). Although the modified definitions of assets and liabilities combine accounting jargon with legal terms, namely ‘rights’ and ‘obligations’^[9], the board explicitly notes that the scope of assets and liabilities is not limited to enforceable (legal) rights and obligations. Rather, the IASB stresses the broad and economic notions of both terms (IASB, 2018a, para. 4.7; IASB, 2018b, para. 4.30). Hence, the revised definitions extend the scope of items that qualify as balance sheet positions. In addition, lease arrangements now clearly meet the new definitions of an asset and a liability as a result (see Section 5.3).

2. Unit of account (How big is the asset and how broad is the liability?): The IASC’s CF failed to address the issue of the unit of account, even though it “is a fundamental, pervasive, and yet unresolved, issue in financial accounting and reporting” (Johnson, 2003, p. 1). The revised CF from 2018 finally introduces this issue on the conceptual level. The IASB defines the economic resource as a set of rights over the object, abstaining from physicalizing the assets. Although each single right and obligation qualifies as a balance sheet item, the IASB de facto requires the aggregation of similar items or combination of dissimilar items to a unit of account if that bundle provides more relevant information than the separate disclosure of single assets or single liabilities (IASB, 2018a, para. 4.51a). In other words, an entity would view the entire bundle of rights as the single asset, which consequently represents the unit to be accounted for (IASB, 2014a, p. 3). Furthermore, the IASB states that “describing the set of rights as the physical object will often provide a faithful representation of those rights in the most concise and understandable way” (IASB, 2018a, para. 4.12). In this regard, it may be more appropriate to refer to the underlying item (e.g., car) itself as the asset, rather than to the bundle of rights and obligations related to it. On the other hand, the IASB requires ‘unbundling’, i.e., disaggregating a bundled item, if this provides a more relevant and faithful representation. Componentization is always required if the real economic substance of transactions would be otherwise obscured.

3. Recognition (What belongs on balance sheet and what should be left off?): The unit of account (either as the single right or obligation or the group of rights or the group of obligations) is the object of recognition and is required to meet additional criteria. The IASC’s CF included an ambiguous minimum probability threshold (“sufficiently certain” (IASC, 1989, para. 50, 83))^[10] as well as the loose requirement of reliable measurement (exercised at the “reasonable estimate” (IASC, 1989, para. 86)), enabling preparers to arbitrarily interpret the vague recognition criteria in their favor. The revised CF eliminates any type of probability thresholds in the conceptual underpinning and focuses on the principles of relevance and faithful representation (IASB, 2018a, para. 5.7). Here, the board designates the same principles – relevance and faithful representation – as the criteria of recognition, which operationalize the overall objective of financial reporting – decision usefulness.

Figure 1 depicts the hierarchy of conceptual frameworks as well as the interconnectedness of building blocks and highlights the relevant conceptual changes in the IASB’s CF.

Figure 1:

Conceptual Framework for Financial Reporting IASC, 1989 and IASB, 2018.

Source: Author’s illustration, based on Johnson (2004, p. 6). Changes highlighted.

While the pyramid on the left-hand side reflects the IASC’s concepts, the figure on the right-hand side highlights the conceptual changes made by the IASB’s revised CF. On the level ‘fundamental’, the elements of financial reporting – assets and liabilities – have been redefined in terms of rights and obligations and, in this way, reduced ambiguities that surrounded the previous 0-1 dichotomy. In addition, the IASB replaced the qualitative characteristic of reliability with the principle of faithful representation. Both qualitative characteristics (relevance and faithful representation) operationalize the objective of financial reporting (decision usefulness). In the IASB’s revised CF, the same principles – relevance and faithful representation – now guide the recognition of elements on the level ‘operational’. The new building block ‘unit of account’ constitutes an interlocking component that provides a bridge between the fundamental and operational level.

All in all, the definitions of assets and liabilities, unit of account and recognition represent three indiscerptible components of financial reporting. While the definitions of balance sheet items constitute the logical starting point, the unit of account bridges the conceptual gap between definition and recognition, thereby linking the fundamental level with the operational level. More specifically, “the unit of account refers to the words that are used to describe the item” (Johnson, 2003, p. 4), and thus relates to the specific assets (rights) and liabilities (obligations) according to the definitions. In this way, the unit of account is equivalent to the object of recognition.

The hierarchy in the conceptual framework provides a serial order for standard setters who seek to foster fundamental changes in accounting. Given that the top of the pyramid (decision usefulness) already complies with the conceptual thinking of reform-oriented standard setters at the IASB, any major accounting change would inevitably require approaching the fundamental level (and subsequently the operational level) of financial reporting. Section 5 examines why the IASB revised central building blocks in the CF project and traces the process towards the implementation of the rights and obligations approach from 2001 onwards. It further shows that the revision of central building blocks does not fully remove but rather shift ambiguities to other arenas and, finally, discusses the implications of these changes at the standards level.

5 The Removal and Creation of Ambiguities in the IASB’s Conceptual Framework and in Accounting Standard Setting

Conceptual frameworks constitute “aspirational documents, setting the direction for reform of financial reporting” (McCahey & McGregor, 2013, p. 10). As a fundamental accounting change requires a shift that “not only modifies models and ideas as in the process of editing and translation but also involves significant co-construction of ‘new,’ common models and ideas” (Baudot, 2014, p. 981), standard setters were urged to accurately review, reorganize and even remove existent concepts. In drafting conceptual frameworks, standard setters strive for an up-front definition of key terms, such as assets and liabilities, to mitigate “inefficient wrangling over their meanings each time a new matter came before the Board” (Gerboth, 1987b, p. 2). Hence, framework revisions should “make a constructive impact on financial reporting practice” (Ohlson et al., 2010, p. 473) as accounting principles and accounting concepts “rule in, and rule out, potential accounting standards that deal with the myriad measurement, recognition, and classification issues” (ibid., p. 475). As a conceptual framework attempts to describe an ideal accounting model, it “provides standard setters with consequential starting points when they attempt to resolve accounting issues” (Ohlson et al., 2010, p. 474), such as flawed accounting standards, prone to regulatory arbitrage. The following subsections outline adjustments to central building blocks in the revised CF, shed light on possible implications of these changes and demonstrate how they eventually translate in the accounting for leases.

5.2 Creating and Shifting Ambiguities in the Revised IASB’s Conceptual Framework from 2018

While Section 5.1 demonstrated that the IASB’s CF reduced ambiguities by explicitly adopting the rights and obligations approach, the revised accounting model creates new ambiguities in a self-perpetuating process. Even the term ‘right’ itself is open to interpretation. Given an international application of IFRS with heterogenous domestic accounting traditions, the IASB’s intended interpretation of an economic resource in terms of an (economic) right may not be self-explanatory. For example, in countries with a strong link between civil law and accounting (e.g., Germany), the term right might be interpreted through the lens of civil law, limiting the scope to enforceable (legal) rights. Aside from this unintentional narrowing of the scope of rights, the ambiguity also allows for an overly broad interpretation, which would include, for example, rights of access to public goods. Even though the IASB excludes as assets these rights available to entities without significant cost (IASB, 2018a, para. 4.9), their recognition would be de facto covered by the IASB’s ambiguous conception of rights in the CF.^[17] This all-inclusiveness inherent to the rights approach complicates which rights in fact belong to the select group of those recognized, as a member of the IASB’s technical staff emphasizes:

“When I try to define economic rights, I enter a space in which I can recognize everything or nothing. The term ‘economic rights’ is so broad … that it is hard to tell where to draw the line.” (Interview #8)

As a consequence of this inherent openness of the term ‘right’ in the revised CF, the same interviewee adds:

“The IASB failed to address this in the new CF. This new definition creates more questions than it does answer.” (Interview #8)

As these statements illustrate, the focus on rights fuels the everlasting inclusion-exclusion dilemma “because the ‘boundaries’ of assets are not well defined, that is, the points at which an asset’s existence begins and ends are sometimes rather ambiguous” (G4+1, 1994, p. 54). Even though the IASB further specifies the pool of recognizable rights in accounting standards, as is the case with the ‘right to use’ in IFRS 16: Leases (see Section 5.3), determining the unit of account is the main issue here.

While the IASB now addresses the unit of account issue in its conceptual underpinning, the framework lacks detailed guidance for determining the level of aggregation and decisions about when and to what extent the bundled rights and obligations shall be unbundled. This even holds true on the accounting standards level, which creates discretionary leeway for preparers and their auditors, because determining the object of recognition involves various steps of judgment (ICAS/IFAC, 2014, p. 13). These difficulties regarding the unit of account issue and the aggregation and disaggregation process is further outlined by a member of EFRAG, with long-term expertise in this area:

“Some people think that the unit of account should only have one right attached to it. Other people see units of account as bundles of rights and obligations … Different people think of it differently. Nobody has ever … been able to come up with a clear and agreed approach to what unit of account means. It’s one of the most difficult questions.” (Interview #14)

This quote highlights the lack of a conceptually pure solution to the unit of account issue as well as proper guidance for bundling and unbundling at the application level, creating ambiguities. In addition to the abstract nature of determining the object of recognition, the new recognition criteria (i.e., relevance and faithful representation) are themselves rather ambiguous concepts from which to guide and revise accounting practices and leave significant room for discretion. Along these lines, Barker and Teixeira (2018, p. 154) stress that if the IASB takes the revised CF for standard development “it is difficult to see what accounting would result” and highlight that notwithstanding the IASB’s conceptual refinements “it appears that something conceptual is missing” (ibid.). This “open-ended nature of the Framework” (ibid.) increases the level of subjectivity and uncertainty in financial reporting. An IASB board member underscores this:

“One of the things that is a consequence of the approach that we developed, the conceptual approach, is that it does introduce a degree of subjectivity and it introduces uncertainty. But … isn’t that what business is like? The world is uncertain. Very few decisions can be made as black or white. A large majority of them are in the grey area, because of the uncertainty around the existence of events, the implications of events and the implications of transactions. So, having an accounting model that affirms that you … have knowledge of the future is certainly unrealistic and of very little benefit to those trying to make decisions on a timely basis … It is both sides of the equation; to benefit from a more robust accounting model that provides a better reflection of the economic reality.” (Interview #2, emphasis added)

While the conceptual adjustments allow a more meaningful representation of the economic substance, the quote illustrates that the rights and obligations approach increases subjectivity in financial reporting and that the IASB accepts this increasing level of uncertainty as a given feature of the business world.

Although the conceptual refinements clarify the definitions of balance sheet items, the explicit focus on the rights approach creates new ambiguities, demonstrating the self-perpetuation of ambiguities in accounting. Figure 2 displays a timeline of events in the IASB’s framework project and illustrates the gradual honing of the definitions of assets and liabilities, which again induces new ambiguities inherent to the rights and obligations approach.

Figure 2:

The juxtaposition of ambiguity creation and ambiguity reduction in the IASB’s CF project.

Source: Author’s illustration.

The creation of ambiguities is particularly evident with the issue of the unit of account, which requires interpretation by preparers and auditors. These conceptual ambiguities are further translated into accounting standards albeit somewhat weakened. Given this translation of ambiguities into a standards level combined with increasing discretionary leeway, the conceptual adjustments may shift the potential risk of regulatory arbitrage from rule evasion to bending interpretations. The following Section 5.3 illustrates this juxtaposition of ambiguity reduction and ambiguity creation by analyzing the implications of the rights and obligations approach in the accounting for leases in the context of accounting motivated financial engineering.

6 Discussion and Conclusion

This paper has analyzed the ambiguity-reducing and ambiguity-creating functions of accounting (Davie, 2000) by examining the redefinition of assets and liabilities in terms of rights and obligations in the IASB’s CF from 2018. It has shown that the CF project was central to fostering changes in accounting by limiting the scope of possible interpretations of financial elements, thereby anchoring the rights and obligations approach as the guiding accounting model. As ambiguities are inherent in the revised accounting model (e.g., the issue of the unit of account), this article demonstrated how ambiguities were translated from the conceptual to the standards level. Furthermore, the paper shed light on how this process of ambiguity shifting affects the playing field of regulatory arbitrage.

As the IASB strove for a more faithful and fine-grained depiction of an entity’s wealth, the anchoring of the rights and obligations approach paves the way for “tough decisions and unpopular standards” (Tweedie, 2002, p. 13). The definitions of assets and liabilities is one of the “crosscutting issues” (Johnson, 2004, p. 6), as it lays the fundamental basis for the operational level and thus directly feeds into accounting standards. As conceptual frameworks “presume, legitimize and reproduce the assumption of an objective world” (Hines, 1991, p. 327) from which to guide and revise accounting practices, conceptual adjustments are a central device to legitimate and justify accounting change. Removing ambiguities from the definitions of assets and liabilities shows that conceptual frameworks serve as a political tool (Hines, 1989; Horngren, 1994; Miller, 1990). This equips standard setters with an ‘objective’ rationale in political discussions at a standards level. By clarifying what assets and liabilities should mean, the IASB establishes a sound conceptual rationale that legitimizes fundamental changes in standard-setting projects, such as leases, thereby mitigating opposition from constituents.

As such, this article contributes to the literature on the political economy of accounting standard setting (Baudot, 2014, 2018; Fogarty et al., 1994; Morley, 2011; Thiemann & Lepoutre, 2017; Young, 1994, 2014) as it shows how standard setters define terms within conceptual frameworks to induce major changes in accounting standards. Clarifying financial elements “contributes to greater efficiency in the standard-setting process by avoiding the necessity of having to redebate fundamental issues such as ‘what is an asset?’ time and time again” (Foster & Johnson, 2001, p. 2) and getting troublesome conceptual questions “out of the way once and for all” (Gerboth, 1987b, p. 2). As “[c]hange is often introduced in new and powerful vocabularies” (Hopwood, 1990, p. 82), the revision process of the IASB’s CF is a “significant event” (McCahey & McGregor, 2013, p. 2). It provides standard setters the “opportunity to put in place something that will have lasting benefit for those involved in and impacted by financial reporting” (ibid., pp. 2–3).

Previous research on the IASB’s conceptual framework project primarily focused on the revision of the objective of financial reporting (Pelger, 2016; Young, 2006) and the qualitative characteristics (Erb & Pelger, 2015) that “are too lofty criteria for the making of accounting standards” (Ohlson et al., 2010, p. 475). While alterations in those areas may primarily represent a shift in wording rather than in substance and are intended to clarify the boards’ understanding (IASB, 2018b, para. 2.26), adjustments to the elements of financial statements are a shift in substance rather than in wording. Although the IASB staff describes the focus on rights as “a slightly simpler definition” (Teixeira in Abela et al., 2014, p. 263) and “a tweak not a major rewrite” (ibid.), this research indicates that anchoring the rights and obligations approach is key to the IASB’s efforts to more truthfully depict the economic substance of business transactions. While this paper only outlines changes to parts of the conceptual pyramid (see Figure 1), exploring linkages to further building blocks (e.g., measurement) or translations of conceptual changes in accounting standards (e.g., IAS 37: Provisions, Contingent Liabilities and Contingent Assets; IAS 38: Intangible Assets) would be interesting areas of future research.

This paper indicates that the explicit focus on the rights and obligations model forms part of a political agenda to further substance over form in financial reporting. The new accounting model facilitates the elimination of arbitrary bright lines, as it provides the precondition for a continuous balance sheet approach (Donegan & Sunder, 1989; Dye et al., 2015). While the new definitions resolve ambiguities in what an asset and a liability are, the rights and obligations approach creates new ambiguities in turn. As such, the study illustrates that the new accounting model is an expression of the “in-built tendency to self-perpetuation” (Davie, 2000, p. 316) of ambiguities in accounting. The analysis of the anchoring of the rights and obligations approach in the accounting for leases shows that ambiguities, inherent in the revised accounting model, become translated into accounting standards, shifting the playing field of regulatory arbitrage from evading rules to bending interpretations. Due to the increasing significance of the abstract concept of the unit of account, the boundaries of ‘what belongs to the asset’ have become more fluid and auditors and preparers have received additional discretion. Hence, demarcating the asset to be recognized (unit of account) has increasingly become a “zone of strategic choice for corporate management and a basis for a negotiated rather than purely procedural audit function” (Hopwood, 1990, p. 80, emphasis added). Along these lines, the paper adds to the literature on structuring activities in accounting (Donegan & Sunder, 1989; Friedrich, 2020 in this issue; Imhoff & Thomas, 1988; Thiemann, 2018), as it shows the link between the conceptualization of financial elements and how regulatory arbitrage happens.

Given that “conceptual and technical ambiguities merely create and enhance the need for more and more accounting” (Davie, 2000, p. 330), this paper predicts that the unit of account is one of the key issues that will “keep pushing themselves into the standard setting arena” (Abela in Abela et al., 2014, p. 267). Due to the increasing significance of the unit of account at the conceptual and standards level, accountants have called for more precision “rather than leaving it to chance” (ibid.). Notwithstanding its crucial role, the concept of the unit of account is too abstract to be universally defined ex ante, as its meaning is inextricably linked to the respective transaction. Along these lines, Barker and Teixeira (2018, p. 154) assume that the unit of account is one of “that conceptual issues […] worked through at this (lower) [standard’s] level, rather than being guided by, and being consistent with, an overarching conceptual framework”. The unit of account issue fuels the self-perpetuating cycle of ambiguity reduction and ambiguity creation, as newly created ambiguities inevitably require ambiguity-reducing activities in turn through ‘re-refinements’ in accounting standards.

Against the backdrop of the IASB’s increasingly abstract conceptual framework and its broad impact on the formulation of accounting standards, future research could investigate the role of actors and institutions in reducing ambiguity through subsequent interpretation and continual refinement of accounting terminology, concepts and principles. While prior research examined the handling of ambiguities by private standard setting bodies, interpretative committees as well as accounting expert professionals (c.f. Brown, Collins, & Thornton, 1993; Hines, 1989), more research is needed on the role of regulators as interpretative communities (Black, 2002; Ford, 2010; Thiemann & Troeger, 2020 in this issue) in the accounting realm. Given the special court-based system in the European Union and the EU’s aspiration for consistent interpretation and application of IFRS to ensure comparability of financial statements, the judicial branch may also gain importance in interpreting ambiguous accounting terminology. Understanding the role of actors in fields adjacent to accounting (e.g., lawyers and regulatory bodies) is crucial as they could decisively influence the process of accounting self-perpetuation.