J. Account. Public Policy

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Two conﬂicting deﬁnitions of relevance in the FASB Conceptual Framework

Myojung Cho

^a

, Oliver Kim

^b,^⇑

, Steve C. Lim

^c

aFordham University, United States

bUniversity of Maryland, Accounting and Information Assurance, 4333J Van Munching Hall, College Park, MD 20742-1815, United States

cTexas Christian University, United States

a r t i c l e i n f o

Article history:

Available online xxxx

a b s t r a c t

In this paper we show that the FASB Conceptual Framework stipu- lates two mutually conflicting definitions of relevance. Both the original FASB Concepts Statement No. 2 of May 1980 and the IASB/FASBExposure Draft of May 2008 define relevance as the pertinence of the selected economic phenomenon to the decisions of accounting users. However, both pronouncements also define relevance as the pertinence of accounting information to decisions.

While many textbooks and conceptual frameworks of other countries use the second definition, we provide evidence that the first definition is more consistent with a model in which relevance and faithful representation are the two essential qualities required for the provision of useful accounting information. To improve internal consistency, the second definition should be removed from the Concepts Statement.

1. Introduction

The FASB Concepts Statement, especially Statement No. 2 (May 1980, hereafter CS2), are intended to serve as an authoritative directive for standard setting. CS2 is also a guideline for applying standards when either preparing or interpreting accounting information.¹ At the core of CS2, relevance

doi:10.1016/j.jaccpubpol.2010.09.005

⇑Corresponding author. Tel.: +1 301 405 2243; fax: +1 301 314 9414.

E-mail addresses:mycho@fordham.edu(M. Cho),okim@rhsmith.umd.edu(O. Kim),s.lim@tcu.edu(S.C. Lim).

1 These roles of CS2 are speciﬁed in the ﬁrst paragraph of CS2.

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and faithful representation (formerly, reliability) are deemed the two fundamental characteristics of useful accounting information.²In this paper we describe two mutually conflicting definitions of relevance in both CS2 and the recently issued Exposure Draft, Conceptual Framework for Financial Report- ing: Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information (May, 2008, hereafter ED).³We analyze the nature of the two definitions and suggest that only one should be retained, based on how the concept of relevance can be used in a manner that is logically consistent with other parts of CS2 and with the notion of trade-offs between relevance and faithful representation (reliability).

The first definition describes relevance as the pertinence of the chosen economic phenomenon to the decisions of accounting users. This definition is found in several paragraphs of CS2 and ED and is sup- ported bySterling (1985)andSloan (1999). An economic phenomenon is often referred to as ‘‘what it purports to represent.” It is what standard setters choose as the target for accounting information to represent, i.e., the representation target.

The second definition, also found in several paragraphs of CS2 and ED, describes relevance as the pertinence of accounting information to decisions. It typically appears in a phrase such as ‘‘accounting information is relevant if it is capable of making a difference in the decisions made by users.” Account- ing information is an estimate, or representation, of the selected economic phenomenon, and such an estimate generally fails to perfectly represent the economic phenomenon. Thus, the second definition is fundamentally different from the first definition, which describes relevance as the pertinence of economic phenomenon to decisions. Interestingly, the second definition is often the only definition given by the conceptual frameworks of other countries.⁴In addition, most popular US financial accounting textbooks introduce only the second definition of relevance.

The presence of two conflicting definitions of relevance creates confusion among accounting practitioners and researchers in applying the concept to accounting choices. We propose that the FASB should adopt the first definition of relevance based on the following reasons. First, the first definition is consistent with the notion that decision-usefulness requires both relevance and faithful representation (as stated in the Conceptual Framework), while the second definition of relevance is indistinguishable from the definition of decision-usefulness. We provide statements in the FASB Conceptual Framework and in the literature that clearly support the first definition of relevance.

Second, trade-offs between relevance and representational faithfulness make sense only under the first definition. Trade-offs between relevance and representational faithfulness are often at the center of debates on various accounting choices such as fair value versus historical cost and recognition versus disclosure. The Conceptual Framework clearly states that for information to be useful, it must be both relevant and representationally faithful. Under the first definition of relevance, a trade-off exists between relevance and representational faithfulness, depending on the choice of economic phenomena. For example, regarding the choice between fair value and historical cost, relevance is sacrificed when historical cost is chosen as the economic phenomenon if historical cost is not as relevant to decision makers as fair value. Representational faithfulness is sacrificed when fair value is chosen as the economic phenomenon if estimates of fair value are less precise than historical cost. However, under the second definition of relevance, no clear trade-off exists between relevance and representational faithfulness, because in this case relevance is indistinguishable from decision-usefulness and thus requires faithful representation.

Our analysis of the relationships among relevance, representational faithfulness, and decision- usefulness leads to another closely related and important inconsistency. The Conceptual Framework describes relevance and representational faithfulness as two fundamental characteristics of useful accounting information. However, relevance and representational faithfulness are not properties of accounting information alone because, without ﬁrst selecting an economic phenomenon, they cannot

2 In theExposure Draft of May, 2008, the term ‘‘faithful representation” replaces ‘‘reliability.” Many non-US countries still use the term ‘‘reliability.”

3 Relevance and reliability are regarded as fundamental characteristics of useful accounting information in many other countries, including UK.

4 Many of the ﬁnancial accounting conceptual frameworks (or their drafts) of non-US countries (Australia, Britain, Canada, France, Germany, Hong Kong, and Japan) contain only the second deﬁnition of relevance. SeePierrot (2007)for a related article.

M. Cho et al. / J. Account. Public Policy 29 (2010) 604–611

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be deﬁned. Thus, relevance and representational faithfulness are properties of accounting information only in the context of a selected economic phenomenon.

The paper proceeds as follows. In Section2, we analyze the two deﬁnitions of relevance. In Section 3, we examine the compatibility of the two deﬁnitions with the concepts of faithful representation and decision-usefulness and with the notion of a trade-off between relevance and faithful representation.

In Section4, we discuss a related inconsistency in describing relevance and faithful representation as characteristics of accounting information. In Section5, we consider possible reasons why the two definitions have persisted and discuss whether they can be allowed to continue. Finally, we conclude in Section6.

2. The two deﬁnitions of relevance in the FASB concepts statement No. 2

The two definitions of relevance are found in the 1980 FASB Concepts Statement No. 2, and they remain largely unchanged in the IASB/FASB ED of May 2008.⁵The first definition appears or is implied in several places in CS2 and ED. For example, paragraph QC12 of ED clearly states the first definition:

The qualitative characteristic of relevance is concerned with the connection of economic phenomena to the decisions of capital providers and other users of ﬁnancial reporting information—the pertinence of the phenomena to those decisions. Application of the qualitative characteristic of relevance will identify which economic phenomena should be depicted in ﬁnancial reports, with the intent of providing decision-useful information about those phenomena. Relevance refers to the economic phenomena, not to their depictions, and therefore will be considered before the other qualitative characteristics.

Paragraph QC13 of ED states:

Once relevance is applied to determine which economic phenomena are pertinent to the decisions to be made, faithful representation is applied to determine which depictions of those phenomena best correspond to the relevant phenomena. Application of the faithful representation characteristic determines whether a proposed depiction in words and numbers is faithful (or unfaithful) to the economic phenomena being depicted.

Paragraphs QC 12 and QC 13 present deﬁnitions of relevance and faithful representation and ex- plain the standard setting process. Paragraph QC12 discusses the selection of relevant economic phenomena and paragraph QC13 discusses the choice of rules that generate reliable depictions of the chosen economic phenomena. The two paragraphs together indicate that standard setting is essen- tially a dual selection process. That is, standard setting must include the selection of economic phenomena (based on relevance) and representation rules (based on faithful representation) that together generate decision-useful accounting information.

Once selected, an economic phenomenon is what accounting preparers are asked to depict. Para- graph QC2 of ED describes economic phenomena:

Economic phenomena are economic resources, claims to those resources, and the transactions and other events and circumstances that change them. Financial reporting information depicts economic phenomena (that exist or have already occurred) in words and numbers in ﬁnancial reports.

Paragraph QC2 implies that a wide variety of objects can serve as an economic phenomenon. An economic phenomenon is what standard setters choose from the real world as a target of representation for generating accounting information, i.e., a representation target. In other words, it is what standard setters want accounting preparers to depict in ﬁnancial terms.

A representation rule is a rule by which a given economic phenomenon should be depicted. For example, suppose standard setters want to set a standard for valuing investment securities on the

5 According toKitchen (1954), there are two kinds of definitions of terms. Lexical definitions record usage and usage is a matter of history – that is, how people have used the terms. Stipulative (nominal) definitions are chosen names by which objects are called. The issue in this paper is the stipulative definition of relevance.

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balance sheet and that they think fair value, if closely estimated, is the value that is most useful. In this case, standard setters have selected the fair value of the security as the economic phenomenon to be represented by accounting information. Suppose further that standard setters determine that fair value should be estimated as the market price if a market exists or as the market price of a similar security if a market does not exist. This is referred to as a representation rule.

The second deﬁnition of relevance also appears in various places including CS2, Concepts State- ment No. 5 and other FASB documents. For instance, ED paragraph QC3 states:

Information is relevant if it is capable of making a difference in the decisions made by users in their capacity as capital providers. Information about an economic phenomenon is capable of making a difference when it has predictive value, conﬁrmatory value, or both.

This definition of relevance refers to the association between accounting information, a specific depiction of the economic phenomenon, and users’ decisions rather than the association between the economic phenomenon and the decisions. This definition is included in many textbooks and is often used by accounting researchers. For example,Kieso, Weygandt, and Warfield (2010, p. 36)state:

‘‘To be relevant, accounting information must be capable of making a difference in a decision.”Barth (2007, p. 9)states: ‘‘Relevant information is capable of making a difference to a ﬁnancial statement user’s decisions.”

Accounting information and the selected economic phenomenon are two distinct objects. There- fore, the pertinence of the economic phenomenon to decisions – as in the first definition – and the pertinence of the representation of the phenomenon (i.e., accounting information) to decisions – as in the second definition – are two distinct, mutually contradicting definitions.Sloan (1999)tries to reconcile the two definitions by describing relevance as the pertinence of the accounting information to the decision, on the condition that the accounting information perfectly represents the economic phenomenon. However, it is generally impossible to perfectly represent an economic phenomenon as in the example of fair value. Thus, the two definitions of relevance cannot be established simultaneously and cannot be used interchangeably.

3. Which deﬁnition of relevance should be adopted?

In this section we examine the question of which definition of relevance should be adopted from two perspectives. First, we examine which of the two definitions renders logically consistent relationships with faithful representation and decision-usefulness. Second, we assess which definition is com- patible with the notion of trade-offs between relevance and faithful representation.

We begin with logical consistency. Paragraph QC14 of ED clearly describes the relationships among relevance, faithful representation, and decision-usefulness as follows:

As fundamental qualitative characteristics, relevance and faithful representation work together to contribute to the decision-usefulness of information in different ways. A depiction that is a faithful representation of an irrelevant phenomenon is not decision useful, just as a depiction that is an unfaithful representation of a relevant phenomenon results in information that is not decision useful. Thus, either irrelevance (the economic phenomenon is not connected to the decision to be made) or unfaithful representation (the depiction is not connected to the phenomenon) results in information that is not decision useful. Together, relevance and faithful representation make ﬁnancial reporting information decision useful.

Paragraph QC14 supports the first definition of relevance and clearly depicts the relationships among accounting information, economic phenomenon, and decisions with respect to relevance and faithful representation. Similarly,Sterling (1985, p. 30)uses the first definition of relevance:

Decision-usefulness requires both relevance and reliability. Neither can be traded for the other because they perform different roles in the decision process. Relevance refers to the connection of the phenomena to the decision. Reliability refers to the connection of phenomena to the representation. They refer to different connections and therefore it is difﬁcult to understand the allegation that more of one can be traded for less of the other.

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Fig. 1depicts the relationships among accounting information, economic phenomenon, and decisions with respect to relevance, faithful representation and decision-usefulness in this context. In Fig. 1, ‘‘decisions” represent the decisions of all accounting users in a given standard setting situation.

Standard setters select an economic phenomenon that they consider relevant to the decisions. Stan- dard setters also choose a representation rule that dictates how accounting information should depict the chosen economic phenomenon. For the accounting information to be decision-useful, the selected economic phenomenon must be relevant and the accounting information must faithfully represent the phenomenon.Fig. 1shows that, under the ﬁrst deﬁnition of relevance, useful accounting information is linked to the economic phenomenon through faithful representation and impacts users’ decisions through relevance.

In the second deﬁnition, relevance is the pertinence of accounting information to decisions.

This second definition of relevance is, however, indistinguishable from the definition of decision- usefulness. In other words, accounting information that is capable of making a difference in a decision (i.e., relevant information by the second definition) is indistinguishable from accounting information that is decision-useful. This is inconsistent with the familiar notion that both relevance and faithful representation are required to achieve decision-usefulness.

Next we consider compatibility with the notion of trade-offs between relevance and faithful representation. Trade-offs between relevance and faithful representation are often at the center of debates on accounting choices such as disclosure versus recognition and fair value versus historical cost. In order to understand the trade-off, consider the choice between fair value and historical cost accounting as an economic phenomenon. Under the premise that fair value is more difficult to estimate than historical cost, a trade-off between relevance and faithful representation exists under the first definition of relevance. Fair value is often believed to be more pertinent to the decision than historical cost. However, historical cost estimates often depict historical cost more closely than fair value estimates depict fair value.Barth (2007, p. 12)makes a similar argument:

* In the current conceptual framework, accounting standard setting includes the selection of a phenomenon and a representation rule. The preparers of accounting information take the economic phenomenon and the representation rule as given and prepare accounting information. Relevance represents the association between the underlying economic phenomenon and the decision of accounting users. Faithful representation is the closeness between the selected economic phenomenon and the accounting information. Decision-usefulness represents the association between the accounting information and the decision.

Decisions

Economic Phenomenon

Representation Rule

Accounting Information

Faithful representation of the chosen economic phenomenon by accounting information Decision-usefulness

of accounting information

Relevance of the chosen economic phenomenon to the decision

Fig. 1. Relationships among decision, economic phenomenon, representation rule, and accounting information based on the ﬁrst deﬁnition of relevance.*

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For example, although historical cost is a real-world economic phenomenon and, thus, a historical cost measure can be a faithful representation, historical cost may not be a relevant economic phenomenon for users making economic decisions.

Thus, a choice between fair value and historical cost as the economic phenomenon involves a trade-off between relevance and faithful representation.

The notion of a trade-off, however, is not clear-cut under the second deﬁnition. If relevance is the pertinence of accounting information to the decision, then representations of fair value, e.g., market value, are not necessarily more pertinent to the decisions than representations of historical cost, because fair value tends to be harder to estimate than historical cost. In other words, a crude estimate of fair value is not necessarily more useful than a faithful estimate of historical cost. Thus, the notion of a trade-off between relevance and faithful representation becomes blurred under the second deﬁnition of relevance.

Overall, our discussion suggests that adopting the first definition of relevance would enhance the internal consistency of the Conceptual Framework. Therefore, we recommend that the first definition of relevance be adopted, and that the second definition be eliminated from the Conceptual Framework.

4. Are relevance and faithful representation properties of accounting information alone?

We now turn to another problematic description in the FASB Conceptual Framework which is closely related to the two deﬁnitions of relevance. Relevance and faithful representation are described as two fundamental qualitative characteristics of useful ﬁnancial information, as stated in paragraph QC2 of ED:

For ﬁnancial information to be useful, it must possess two fundamental qualitative characteristics—

relevance and faithful representation.

Similarly, the title of CS2 is ‘‘Qualitative Characteristics of Accounting Information” and ED adopts a similar title, ‘‘Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information.”

We challenge the notion that relevance and faithful representation are qualities of accounting information alone because, for given information, these two concepts cannot even be defined without first choosing the economic phenomenon. Relevance is defined only for a given economic phenomenon, and representational faithfulness is defined by how faithfully (closely) the generated accounting information represents the given economic phenomenon.

In contrast, the decision-usefulness of speciﬁc accounting information can be determined independently of the chosen economic phenomenon. Decision-usefulness is determined by users who actually see how the information makes a difference in their decisions. As an example, suppose that an investment security is reported on the balance sheet at its acquisition cost. The users of the balance sheet, who know what they observe is the acquisition cost, can evaluate and use the balance sheet information in their decision-making process even without the knowledge of what the acquisition cost is sup- posed to represent. Therefore, the decision-usefulness of given accounting information can be examined without knowing the chosen economic phenomenon and, thus, without referring to either relevance or faithful representation.

Note that accounting information that is generated as a faithful representation of a relevant economic phenomenon is decision-useful. It is, therefore, natural to understand relevance and faithful representation as criteria for selecting an economic phenomenon rather than as properties of accounting information.

5. Can the two deﬁnitions of relevance be tolerated?

If the presence of the second definition of relevance results in a contradiction, why does it continue to exist in the FASB Conceptual Framework and why is it more popular than the internally consistent first definition? It could be simply a drafting error, and standard setters may not believe it is necessary

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to eliminate the second definition even if they are aware of the conflicting nature of the two definitions. Or it may be due to the belief that an accounting conceptual framework has little actual impact on financial accounting standard setting or financial reporting. Much skepticism was voiced about the conceptual framework prior to and subsequent to the issuance of the FASB Concepts Statement No. 1 in 1978. For example,Dopuch and Sunder (1980)questioned whether the Concepts Statement No. 1 would influence the development of future financial standards, arguing that standard setting is mainly a process of negotiation among various interest groups.Peasnell (1982)andChambers (1996)raise similar concerns and question whether any worthwhile new ground is broken by the Conceptual Framework. Despite the possibility that these concerns are valid, we believe that achieving internal consistency is essential for the existing conceptual framework to effectively play the positive roles envisioned by standard setters. Possible positive roles include economizing of effort, gain in consistency, and improved communication as pointed out bySolomons (1986). According to Solomons, economizing effort comes from the fact that ‘‘many accounting problems have common elements, and they should not have to be thought through afresh each time the board encounters them.”Solo- mons (1986)states about gain in consistency: ‘‘Accounting standards promulgated against the back- ground of an agreed conceptual framework may be expected to be more consistent with one another than standards developed independently of such a framework.” Improved communication can occur among standard setters and accounting users, practitioners, and researchers.Peasnell (1982)identifies the role of increasing the moral tone of the accounting profession. Given that the FASB is currently reevaluating the Conceptual Framework to make it more internally consistent, we believe it is unlikely that the Board will choose to be silent with regard to the internal inconsistency we identify and discuss in this paper.

The use of two definitions of relevance causes confusion among accounting practitioners and researchers. An example of such confusion is evident inBarth, Beaver, and Landsman (2001). After quoting the second definition of relevance,Barth, Beaver, and Landsman (2001, pp. 80, 81)indicate that the value-relevance of an accounting variable is evidence that the variable is relevant (because relevance in this context means decision-usefulness, which, we assume, is implied by value-relevance) and not totally unreliable (because if it were totally unreliable, it would not be useful). Under the first definition of relevance, however, value-relevance of an accounting variable is only evidence that the variable is not totally irrelevant and not totally representationally unfaithful. Thus, value-relevance, which is often measured by the association of accounting information with security prices or returns, merely rules out a complete lack of relevance or faithful representation. Yet, evidence of relevance or representational faithfulness cannot be claimed without explicitly considering the association between the economic phenomenon and decisions, or between the economic phenomenon and the accounting information, respectively.⁶

6. Conclusion

We believe that eliminating internal inconsistency in the Conceptual Framework enhances its positive roles. In particular, the second definition of relevance may have caused unintended misunder- standings of the concept of relevance and of the standard setting process. We believe that the first definition of relevance should be adopted, and the parts of the Conceptual Framework that indicate the second definition should be removed or revised. In addition, we suggest that relevance and faithful representation be depicted as properties of accounting information with respect to the chosen economic phenomenon, or as criteria for selecting economic phenomena in standard setting.

Acknowledgements

We thank Mary Stanford, Bill Wempe, and workshop participants at the City University of Hong Kong, Fordham University, Wilfrid Laurier University, and the 2008 Annual Meetings of the American

6 The chosen economic phenomenon is often unobservable. In such a case, neither relevance nor faithful representation is easily measurable.

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Accounting Association for their helpful comments and suggestions. Steve Lim also thanks the Charles Tandy American Enterprise Center at Texas Christian University for ﬁnancial support.

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