On the Conceptual Foundations of Financial Reporting
27 Pages Posted: 16 Oct 2015
Date Written: October 14, 2015
Standard setters advocate a balance sheet approach to financial reporting, which views assets and liabilities as primary, and income as just the change in net assets. This paper argues that income is conceptually and practically better described as “adjusted net cash flows,” where the adjustments are the accounting accruals. One proof of that is seen in the existence of whole accounting systems like tax accounting and NIPA accounting, which emphasize the determination of income but have no balance sheets. Another comes from the observation that income drives changes in net assets, and not the other way around. The paper also argues that an income-based approach to financial reporting is better suited to reflect the success of advancing cash to earn more cash, which defines what for-profit entities do. There are two main features of the income-based approach. One is attention on the cash flows as the natural foundation for financial reporting because they are precisely determined, and provide a clear link to firm valuation. The other is attention on the accounting accruals, which serve to adjust the raw cash flows to better show the current success of investing cash to ultimately earn more cash. Specifically, it argues for revenue recognition which is close to current practice, and for expense recognition which is aligned with the matching principle.
Keywords: standard setting, assets, income
JEL Classification: M41
Suggested Citation: Suggested Citation