professional judgment and accounting standards

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Accounting, Organizalions andSociety, Vol. 00, No. 0/0, pp. ()()()-{)00, 1992. Printed In Great Britain

0361-3682192 15.00+.00 Pergamon Press Ltd

PROFESSIONAL JUDGMENT AND ACCOUNTING STANDARDS• GRANT A. BROWN University of Lethbridge ROGER COLUNS Concordia University and DANIEL B. TiiORNTON University of Calgary

Abstract This essay explores relationships between accounting standards and people's Inferences and judgments.

Acknowledging that Demski's impossibility theorem impUes that the standards will be "social·preCcrence Incomplete", the paper shows that they are also "decision-procedure Incomplete" on three levels. These levels correspond to three kinds of professional judgment: semantic, pragmatic and Institutional. 1be Investigation filcilitates understanding of ( 1) how accountants excrclse judgment and deduction In applying Incomplete standards; {2) how financial statement readers use the Incomplete standards to draw deductive Inferences from financial reports which are based on accountants' judgments; ( 3) the special kinds of judgments required of standard setters; and ( 4) the meaning and extent of professional Uabillty, given the relationships Identified between accounting standards, inferences and judgments.

Accounting standards give practising accountants only incomplete direction, necessitating the application of professional judgment. Whereas some accounting pronouncements say this explicitly, we will show that all pronouncements imply it by dint of their logical structure. But even pronouncements that explicitly mention judgment stop short of explaining ''what is meant by good judgment or what the characteristics of good judgment are" (Mason & Gibbins, 1991, p. 21 ). One reason for this is that the basis of the relationship between professional judgment and accounting standards is not well understood. This lacuna is far from being filled

in the academic literature. Sterling, at one extreme, pleads for nothing less than a transformation of accounting "from an elusive art into a science", thus eliminating "judgments and decisions made by people" (1979, p. 3). At the other extreme Stamp (1981) recognizes that judgment is ineliminable but, in admitting that judgment does not lend itself to verification by measurement, "runs the risk of committing himself to the view that his own subject is irremediably subjective" (Lyas, 1984, p. 104). In the tradition of analytic philosophy, we examine the relationship between professional judgment and accounting standards, our purpose

• Thanks for comments on previous drafts of the paper go to Charles Christenson, David Cooper, Robert Crandall, Michael Gibbins, Murray Undsay, Alister Mason, Richard Mattcssich, Norman Macintosh, George Murphy, Rebeca Reuber, Cynthia Simmons, Farhad Simyar, Ross Skinner, Uoyd Smith, David Solomons, Michael Wright and the reviewers. The paper has also benefitted from exposure at workshop presentations at Queen's University, Concordia University and The University of Lethbridge.

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being to elucidate what is Involved in good professional judgment. 1 We show that account· lng standards are inherently incomplete on several levels. In the process of explicating the incompleteness of the standards, we explain how preparers and users of accounting reports can nonetheless utilize accounting's incomplete standards to make decisions and inferences. We then discuss the implications of our analysis for professional accountants, financial statement users and accounting standards setters.

COMPLETENESS

The "completeness" of accounting standards can be understood in two quite different ·ways. First, accounting standards are complete in one way if and only if they supply decision procedures telling accountants how to report upon all possible situations. We call this decisionprocedure completeness. By analogy, a mathematical system is said to be complete when all "true" statements that can be expressed by the system are theorems, i.e. are derivable from its axioms (Hofstadter, 1979). In alluding to the need for professional judgment, U.K and Canadian pronouncements refer to decision-procedure incompleteness. 2 The second conception of completeness comes from information economics. A seminal

et at.

insight by Demski ( 1973) was that choices among competing accounting standards can be seen as choices among information systems choices that involve expected-utility calculations by individuals contemplating specific decisions. Completeness is achieved if and only if, for all pairs of alternative accounting standards, either people agree that one is preferred to the other or they are indifferent between them. We call this social-preference completeness. Demski's impossibility theorem Implies that if people differ in their tastes and in the decisions they need to make, social-preference completeness is unattainable. 3 Decision-procedure completeness and social· preference completeness are distinct concepts. On the one hand, accounting standards which fail to cover certain situations could still be agreed upon by all users. In principle, standards could be arbitrarily modified to accommodate disagreements; in the limit, social-preference completeness of a trivial kind could be secured by forgoing standards and letting people use whatever accounting methods they liked 4 On the other hand, standards that are Incomplete in the sense that they are not agreed on could still provide decision procedures for accountants to follow in all situations. Analogously, speed limits are not unanimously agreed on, yet there is a means of determining what they are on any stretch of road.

1 The exposition of professional judgment by Gibbins & Mason ( 1988) differs from ours. They acknowledge that standards give accountants Incomplete guidance. Uke us, they stress the need to recognize, in educational programs and In professional handbooks, an explicit role for professional judgment; but they do not Investigate the philosophical basis of how standards and judgments are related. 2 Paragraph 5 of the U.K. profession's Explanatory Foreword states that " ... accounting standards ... are not Intended to be a comprehensive code of rigid rules. They do not supersede the exercise of an Informed judgment". The Canadian Introduction to Accounting Recommendations states, ". . . no rule of general application can be phrased to suit all circumstances ... nor Is there any substitute for the exercise of professional judgment ... of what constitutes fair presentation or good practice In a particular area".

3 Though Demski's paper purports to show "the general impossibility of normative accounting standards", Mattesslch ( 1991) argues that It Is more accurate to say that the paper demonstrates "the Impossibility of general normative accounting standards".

~ Bryant & Thornton ( 1984) advance a similar argumenL

PROFESSIONAL JUDGMENT

Benefits and costs of completeness Whereas Demski sees social-preference completeness as impossible under plausible assumptions, Dopuch & Sunder (1980) imply that standards setters have missed opportunities to garner the benefits of decision-procedure completeness. For instance, the FASB specified only necessary conditions for resources to qualify as assets or for obligations to qualify as liabilities. "(l]n the absence of sufficient conditions", say Dopuch and Sunder, "these definitions will be of little use to accountants" (p. 4). In support of this, they show that the FASB's definitions could not resolve the question of whether deferred taxes are liabilities. The FASB ( 1976, pp. 5-6) suggested that an agreed upon conceptual framework for accounting would produce the following benefits: It would ( 1) guide standard setting bodies; (2) provide a frame of reference for resolving accounting questions in the absence of specific promulgated standards;5 ( 3) determine bounds for judgment in preparing financial statements; ( 4) facilitate readers' understanding of financial statements; and ( 5) enhance the comparability of financial information produced by different accounting entities. These putative benefits depend on whether accounting standards are complete or not, and on whether completeness is conceived as being procedural or social. The first three benefits could not exist if standards were decisionprocedure complete: if standards instructed accountants how to handle every situation, all 5

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accounting questions would be resolved by existing standards. There would be no room for professional judgment and no further need for standard setting. The last two benefits could exist, however: if, because judgment was eliminated, everyone knew exactly how accounting information was generated, readers would more easily comprehend financial statements; and comparability would surely be enhanced if all accounting information were generated in exactly the same way. Whether decision-procedure complete accounting standards would be useful is a separate question, to be addressed nexL Costs ofcompleteness. The costs of completeness have yet to be fully debited to its account in the literature. These costs, paradoxically, may be either oversimplification or excessive complexity. An analogy reveals the essence of our argument. In mathematics, it is a simple exercise to create a system that is complete in the sense that all "true" statements expressible by the system are theorems of the system {Hofstadter, 1979). GOdel (1931/1962] proved, however, that no "sufficiently powerful" mathematical system can be complete, where "sufficiently powerful" is understood to mean "capable of representing all primitive recursive truths", i.e. being capable of self-reference.6 Likewise, a primitive and limited set of accounting standards could be complete, but they would be too crude to be useful to financial statement readers. Why would complete standards be burdened with this crudeness? There are two reasons. First, as Demski ( 1973) points out, socialpreference completeness is attainable only if standards can be ranked on the basis of the fineness 7 of the information that they cause to

DePree (1989) explores this point.

6 Formally undecidable propositions in sufficiently powerful mathematical systems are of the form, "This well-formed formula of X cannot be proved within X". An example In the econometrics literature Is "the identification problem": an exogenous variable must be used In order to Identify the equation that Is being estimated. Another example Is a computer program that Is locked In an endless "do·loop": only an Instruction Invoked from outside the program (often from a human programmer) can achieve a solution to the problem being analysed. Hofstadter (1979) provides allegories to IUustrate this need to "pop out" of a system In order to Improve it.

7 One Information system Is said to be less fine than another when the signals that can result from applying It are a subset of the signals that can result from applying the other one.

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be produced. In practice, however, different standards generally produce different information, not more or less information, and so only oversimplified standards can be ranked according to fineness. Second, in order to be decisionprocedure complete, standards would have to specify how to report on every conceivable situation; but in practice, all circumstances are conceivable in advance only if either ( 1) the conception of unanticipated situations is crude enough to permit allocating the situations ad hoc to pre-specified categories when they arise(Williamson, 1989, refers to this as "presentiation" of all possible future states of the world}; or (2} the standards are just as complicated as the phenomena that the standards were deSigned to make understandable to readers. The first alternative makes decision-procedure complete standards unresponsive (by construction) to users' changing needs, whereas the second robs them of their power. In sum, the costs of complete standards are oversimplification or excessive complexity. In accounting, as in mathematics, completeness has its costs." But if useful accounting standards are necessarily incomplete, how can people logically use them?

The logic of accounting standards To aid the exposition, we focus on the example alluded to by Dopuch & Sunder (1980}. The FASB (1977, para. 47) stated that, to qualify as an asset, a resource must satisfy

three conditions (and so the conditions are correctly termed "necessary but not sufficient" by Dopuch and Sunder): NC, (Necessary condillon I). An asset must result from a past transaction, I.e. a transaction by an accounllng entity that has already occurred. NCa (Necessary condition 2). An asset must Involve a claim on cash by the entity. NC~ (Necessary condition 3). An asset must be under the entity's controJ.9

Each of the three conditions can be stated equivalently in three other ways; e.g. NC 1 can be expressed as (i) "All assets result from past transactions" - the so-called universal-conditional format (Christenson, 1980, p. 11 }, which was later adopted by FASB (1985) and other stan~d setting bodies; 10 ( ii) "If an item is an asset, then it has resulted from a past transaction"; or (iii) "If an item did not result from a past transaction, then it is not an asset". The differences among the four ways of stating NC, are merely syntactic. In other words, only the surface structures of the four sentences differ; they are identical in meaning (Thornton, 1988). We refer to the properties satisfying the conditions as: T: the past transaction property, M: the cash or money property, C: the control property.

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We should note that this analogy Is suggestive only; the reasons for the Incompleteness of sufficiently powerful mathematical systems and of sufficiently powerful sets of accounting standards are different Macintosh & Scapcn's ( 1990, pp. 471-2) use of GOdel's Theorem to help explain the Incompleteness of structuratlon theory Is similar In spirit to our exposition. 9 Similarly, for an obligation to qualify as a liability NC 1 : it must have resulted from a past transaction; NC 2 : it must Involve a future sacrifice of resources; NC~: It must be an obligation of the entity (FASB, 1977, para. 47). "Sacrifice" and "claim", arc obverse to "obligation" and "control", respectively, in the standards relating to liabilities and assets. 10 In a later publication, FASB ( 1985, p. 10) stated: "An asset has three essential characteristics: (a) It embodies a probable future benefit that Involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others' access to it, and (c) the transaction or other event giving rise to the entity's right to or control of the benefit has already occurred". In 1988, The Canadian Institute of Chartered Accountants adopted the three criteria, verbatim, in Section 1000 of the aCA Handbook (para. 26).

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Fig. 1. Pictorial representation of necessary conditions (NC) in accounting standards. (a) NC 1 : assets must possess the past transaction property, T; (b) NC 2 : assets must possess the claim on money property, M; (c) NC,: assets must possess the control property, C.

The FASB's statement (in any ofits four forms) is represented in Fig. 1. On the o~ hand, we can imagine a set of items called assets, A, and a complementary set of items that are called not

assets, A. On the other hand, we can envisage a set of items that result from past transactions, T, and a complementary set of items that do not result from past transactions, t. Choosing "assets" and "items that result from past transactions" as topics for analysis (or elements of discourse) can be said to determine part of a conceptual.framework (or an event structure) for accounting (Christenson, 1983, p. 13), although this usage of the term "conceptual framework", taken from the philosophy of science literature, differs from accountants' normal usage. As Fig. 1(a)shows, FASB's statement prohibits the joint occurrence of A and t. This prohibition is denoted by "no no" in the figure. In science, such prohibitions are called "laws"; in accounting, they are "standards". Dopuch & Sunder (1980), as well as the FASB (1985), refer to them as "definitions". This is incorrect because definitions must give both necessary and sufficient conditions. Figures 1(b) and (c) illustrate the standards prohibiting the joint occurrence of A and M, and of A and C, respectively. Figure 1 implies that standards can be used in just two ways. First, suppose that a balance sheet asserts that an item is an asset. By looking down the column headed "A" and relying on the standard that prohibits the joint occurrence of A and t, we can deduce that the item resulted from a past transaction. Second, suppose that an item does not entail a past transaction. By looking across the row labelled "T'' and relying on the same prohibition, we can deduce that the item is not an asset. The standard has its limitations, however. The inference, "if an item resulted from a past transaction, then it is an asset" is invalid, 11 there being no proscription in row T against either A or A. Similarly, it is invalid to peer down column A and to deduce, "if the item is not an asset, then it did not result from a past transaction". In both cases, the item in question could be a liability, which has resulted from a past transaction but is not an as:set

11 The fallacy here is sometimes referred to as "the fallacy of affirming the consequent" (Leblanc & Wisdom, 1974; see also Simon, 1965), e.g. "All dogs are mammals; Grover is a mammal; hence Grover is a dog."

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This logic of accounting standards seems to suggest a natural difference in how financial statement readers and accountants utilize the standards depicted in Fig. 1. It is as if readers, seeing only the caption "assets" on a balance sheet and being unable to observe the items assigned that sobriquet, look down the left-hand column of Fig. 1 and deduce that such resources possess the properties, T, M and C. It is as if accountants look across the rows in Fig. 1. In principle they observe whether T, M and C exist, each of which is a necessary condition for the resource to be classified as an asset. This means that, if any of T, M or c@Jo( es) not exist, the standard prohibits accountants from disclosing the item as an asset; and if all of T, M and C exist, the standard allows, but does not require such disclosure. H accounting standards were scientific laws, observing that one or more of the properties were absent would refute the hypothesis that the resource was an asset; but the presence of all three properties would not "prove" that the resource was an asset.

Philosophical issues Though the logic of applying accounting standards in their necessary-but-not-sufficient form seems clear enough, philosophical difficulties persist when one tries to apply words like "transaction", "control", "claim on cash" and "asset" in practice. The classic quest of philosophers in the analytic tradition has been to determine, often with the aid of thought experiments, the "essences" of things. 12 They thought that if only they knew what is essential to something being what it is, as opposed to being just accidentally associated with it, then they would be able to specify both necessary and sufficient conditions for applying words like "person", "good", "right" (in its several senses),

and so on (Rorty, 1979). Aristotle, for example, defined "man" as "the rational animal", believing that the unique, identifying characteristic of humankind was rationality. He also conceived his "unmoved mover" (the god of his universe) as a rational being but not as an animal, and so "rational animal" was both necessary and sufficient to define "man". In contrast, he argued that being bipedal was merely an accidental attribute of humans. Attempts at rigorously applying this approach spawned difficulties when it was proposed that things do not have essences after all (Wittgenstein, 1958; Rorty, 1979). We can always find, at least in our thought experiments, things that fall between whatever categories we choose to create. One thing trails off imperceptibly into another, so that any dividing lines our concepts impose are arbitrary, from a disinterested point of view. A paradigm illustration of this is the color categories (red, orange, yellow... ): there are not sharp lines between them on the spectrum. Thus, Wittgenstein (1958) argued that all rule-following, and indeed the learning of language itself, involves an ineliminable element of judgment. People need to judge the intent of rules, whether one case is similar enough in the intended ways to other cases, and so on. The upshot of this line of inquiry is that the categories we choose to create are necessarily influenced by our reasons for creating them, by our interests (Lyas, 1984, p. 102). These, in tum, are influenced by cultural or individual variables. 13 It is therefore important to understand those interests, in accounting as well as in other endeavors. Doing so will help us to create more suitable categories and will give us guidance in deciding upon hard cases. (Some theorists would see cultural and individual variables as being more important or fundamental

12 We use the word "things" with no ontological commitments. It could equally well refer to objects like apples or to properties of objects like redness. It could even refer to Imaginary creations like unicorns or abstract (functional or attributive) categories like working capital or value. 1 ~ For Instance, people's understanding of materiality Is related to such things as the size of the finn they work In, the organizational culture of the firm, and so on (Robinson, 1985 ).

PROF~IONALJUDGMENT

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than we do here; Burchell et a£, 1980; Hines, 1991. For our purposes, the question as to the roles of these variables can be bracketed).

to order a firm's products be disclosed as an asset on the firm's balance sheet? A semantic question bearing on the decision is, "does the order entail a past transaction?" Because the answer is generally thought to be straightforwardly "no" in this case, Fig. l(a) implies that JUDGMENT the order should not be disclosed as an asset, Our anatomy of a conceptual framework for despite its anticipated value to the enterprise. It is not always easy to determine whether "assets", together with the philosophical issues just discussed, reveal that accountants need to a transaction has occurred for accounting exercise at least three kinds of judgment in purposes, however. Arguably, internally generated goodwill results partially (though some· applying incomplete accounting standards: ( 1) Semantic judgment. Because accounting times indirectly) from past transactions involving concepts like "transaction" and "control" are expenditures on advertising and employee inherently vague, applying them to things and training. Because specific exchanges of cash for events requires accountants to question semantic goodwill have not taken place, however, specific identification of the expenditures with the relationships (Sterling, 1970, p. 446). (2) Pragmatic judgment. The necessary resulting goodwill is moot. 14 Moreover, ( econconditions NC~o NC 2 and NC 3 do not define omic) goodwill can result from fortuitous events assets, e.g. a "research and development expend- that do not involve transactions at all. Professional semantic judgment also arises iture" can succeed in meeting all three conditions but be not an asset. This is the kind of with regard to "control". There is not an incompleteness Dopuch & Sunder ( 1980) allude articulated set of necessary and sufficient to, and it necessitates the application of pragmatic conditions an entity must satisfy, vis-a-vis an object or process (or whatever), in order to be judgment. (3) Institutional judgment. Occasionally, said to have control over it. Control is always a something that fails to meet one of the so-called matter of degree, ranging from none to absolute. "necessary" conditions for being an asset (or It would be absurd to say that resources could liability) may nonetheless be best regarded as no~ be candidates for asset-status unless they such by standard-setters, on the basis of what were under entities' absolute control, for then we term "institutional judgment". controversy virtually none would qualify. Accounts receivover whether deferred taxes are liabilities, even able would not be assets since their collection, though they are not obligations of accounting though probable, is never absolutely guaranteed. Even cash in the bank could fail to qualify if the entities, attests to this. funds could be withdrawn only after a 30-day waiting period which was customarily waived. Professional semantic judgment As already indicated, accountants first need to The semantic question of where we draw the · exercise judgment in applying concepts like line naturally arises in each case. Recalling "transaction", "control" and "claim on cash" to Demski (1973), it might even be appropriate to the phenomena upon which they are asked to specify different levels or thresholds of control, report. Should a customer's declared intention depending upon the kind of asset in question,

11 Note that empirical research may be incapable of resolving the issue of whether transactions caused goodwill. In a cross-sectional sample of firms, those that spent more on advertising and employee training may exhibit less (economic) goodwill than the others, owing to the familiar statistical problem of "self-selection" (Campbell & Stanley, 1963). This pattern would be observed If the firms undertook the advertising and training to compensate for unfavorable market conditions, but were only partially successful In doing so.

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or depending upon the uses that accounting information is intended to serve. Divergent semantic interpretations by different accountants would make readers' inferences awkward and costly, and so standard setters are sometimes concerned with semantic judgment. For instance, accountants may agree that all assets result from past transactions, but differ on whether internally generated goodwill results from past transactions. Thus an interpretation, or "special standard" relating specifically to goodwill, may be desirable. To recapitulate, we model accountants' semantic judgment with reference to Fig. 1, as follows. For each economic resource, accountants judge (semantically) which rows in the figure are applicable. That is, they judge whether the resource has properties T or t, M or M, and C or C. If they judge, for instance, that the negative row t applies, then NC 1 makes their choice clear: the item is not an asset. This choice requires only elementary logic, not further judgment. On the other hand, suppose that a second resource is judged to meet all of the positive row conditions (T + M + C). Then accountants cannot rely solely on the set of necessary conditions {NCa. NCz, NC~} to deduce whether the item is an asset or not. The FASB standards allow this second item to be an asset but they do not require it to be. As already noted, expenditures on research and develop· ment sometimes have the properties T, M and C but are not considered to be assets. At this juncture, the second level of professional judgment - pragmatic judgment - arises.

Pragmatic judgment Perhaps the most difficult and interesting kind of judgment in practice is left open once the semantic questions are settled. Suppose that accountants judge that a resource satisfies all three conditions in Fig. 1. Should it be disclosed as an asset? Answering this question requires pragmatic judgment, i.e. judgment concerning how people will react to the disclosure (Sterling, 1970). To begin our exposition of pragmatic judgment, we pose the naive questions: why did the

fASB specify only three conditions to be used in judging whether an item is an asset or notwhy not five, ten, or twenty? Can standard setters eventually arrive at a "complete" set of conditions which will be sufficient as well as necessary for resources to qualify as assets, thus rendering pragmatic judgment unnecessary? Imagine a "complete" set S

= {Pa. P2 , •••, P,.}

of properties, such that each ofP1 is individually necessary, and all are jointly sufficient, for resources to qualify as assets. Then accountants could merely list the attributes of each resource, calling it an asset (A) if it had all of the properties inS, and not an asset (A) if it failed to possess any single property in S.

A

A

Sufficient--->

Fig. 2 Pictorial representation of necessary and sufficient conditions in accounting standards. S Is a set of properties that satisfy both necessary and sufficient conditions for a resource to qualify as an asset, I.e. If the resource Is an asset, then it possesses all of the properties In S; and If a resource possesses all of the properties in S, then it Is an asseL

This example of decision-procedure completeness is depicted in Fig. 2. There are two prohibitions in the figure. One, like the necessary conditions in Fig. 1, proscribes the joint occurrence of A and S: if the item does not possess property S, then it is not an asset. The other one, the sufficiency condition, bans the joint occurrence of A and S: if the item possesses property S, then it is an asset. Completeness in this sense would render pragmatic judgment unnecessary. If all conditions were met accountants would know for certain that the item was an asset If at least one condition were not met, they could say for certain that the item was not an asset. In other words, we would have a


definition of"asset". The naivete of this proposal becomes apparent, however, when we consider --!fe barriers to this sort of completeness. Barriers to completeness. The difficulty with the proposal is similar to the semantic problem we noted with regard to applying accounting concepts like "control", only at a different level. It may be impossible to specify clearly bounded necessary and sufficient conditions for applying concepts like "assets" in abstraction from the purposes they are intended to serve. Moreover, the possibility sketched in Fig. 2 is only one of an infinite number of possible definition-schema which "assets" might take. Let {Ph P2...Pm} be the properties of resources that meet the additional conditions, {AC~> AC2.. .AC~}. which would make a resource possessing (T + M + C) an asset. The definition-schema for assets is then: A=

dc!n

{T + M + C + P1 + P2 + ... +Pm}·

That is, an "asset" is a resource which possesses T, M, C and any k ofP 1...Pm (k = 1,2.. .m). Now, three pragmatic considerations argue for standard-setters specifying only a few necessary conditions, allowing accountants' pragmatic judgment to determine whether resources satisfying those conditions should be disclosed as assets. First, if the number of necessary conditions exceeded three, fewer items would survive the screen and be classed as assets. Using the procedure outlined in Fig. 1, but with more than three diagrams at their disposal, financial statement readers could then make more than three inferences about resources called "assets"; however, their inferences would apply only to a smaller set of resources that had survived the finer screen. It is not clear whether more or less information would be channelled to readers by the larger number of conditions. Whether it is better to know a lot about a little, or a little about a lot, is a philosophical question, and its answer is subject to the problems raised by Demski's impossibility theorem (1973). Second, if k were equal to m, any "asset" would possess all of the properties in the definition schema H k were less than m, however, one or more of the additional conditions

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would not be necessary. In this case, users would not know which additional properties, P1, the assets possessed, and so the standard might convey little or no additional information to them. Suppose, for example, that either of two additional properties, P 1 and P2, in conjunction with T + M + C, were sufficient for a resource to qualify as an asset ( m = 2; k = 1 ). Accountants, seeing properties {T + M + C + P 1} in a resource, know that the item should be disclosed as an asset. Users, however, seeing only the word "asset" on the firm's balance sheet, and not being able to observe the properties of the resource directly, know that the resource has T + M + C but cannot tell whether it possesses property P 1 or property P2 (or both). Thus, though accountants' judgments would be facilitated by specifying variables like "P/', users would not necessarily benefit from this, and so the social desirability of the proposal is open to question. A third reason why standard-setters might specify only a short list of necessary conditions is that sufficiency conditions might be essentially elusive. Recall the example of cash in a bank, which is available only on 30 days' notice. Is it sufficient to know that the bank has never enforced the waiting period? What if the funds are in a demand account and said to be available immediately, but the bank is rumored to be in financial difficulty? It seems that no matter how air-tight a condition may seem to be at first blush, we can always imagine exceptions to the rule that the condition is sufficient. Since the classification of resources as assets is just an example of the general problem of setting standards, the forgoing analysis implies that professional standards cannot provide complete guidance to accountants or to users. Even incomplete standards are valuable, however, because they provide useful constraints for accountants' judgments and allow readers to make some valid inferences, given those judgments. Our analysis implies that the very question of completeness is ill-posed. The more pertinent question is how incomplete standards ought rationally to be used. The fact that the standards are incomplete, in not providing

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sufficiency conditions for items to be classed as assets, does not impair the information that readers can garner from the three necessary conditions. Users have semantic interpretations to make, of course. They need to understand what accountants mean by "transactions", "control", "claims on cash", and so on. Therefore, users need to understand how accountants apply the framework before they can effectively apply it themselves. This argues for commonality in the educational backgrounds of accountants and the consumers of their services, and for special training on the part of standard setters.

Professional institutional judgment and standard setting Accounting is constantly undergoing diange as new developments transpire or new proposals are made. Recent examples are innovations in financial instruments (Chant, 1989), frequentflyer plans in the airline industry ( Gujarathi, 1991) and triple-entry accounting (Ijiri, 1989). The possibility of unanticipated challenges, which require advances in accounting, brings us to the final level at which accountants must exercise professional judgment - institutional judgment. To exercise this kind of judgment, accountants must be able to "jump out of the system" of which they are a part and analyse its strengths and weaknesses (Hofstadter, 1979). 15 In this section we explore the reasons why an 15 lf they

external point of view is necessary for standard setters, and what considerations contribute to this point of view. Our position is similar to that of Lyas ( 1984), who discusses Sterling's ( 1970, 1979) attempt to eliminate judgment in accounting by modelling accounting on science. 16 Since there is no logical limit to the number of conditions that standards may incorporate, standard setters must declare, for example, that NCa, NC2, and NC3 are the only necessary conditions relating to assets; and that beyond this, decisions on whether resources are assets are to be left to professional pragmatic judgment. A difficulty with obtaining closure by fiat in this way is that it begs the question: "How do standard setters decide how long the list should be?" In principle, standard setters trade off the costs of formulating, promulgating and applying more conditions on the one hand v.t the costs of allowing more leeway for professional judgment on the other. In practice, though, how do standard setters know what these costs and benefits are? It seems inevitable that accountants and users need to voluntarily accept a set of incomplete institutional rules or standards, but accept them provisionally, knowing that they may change in the future as improvements become available (Thornton, 1979 ). The utility of the standards is then tested by accountants who need to make judgments, and by users who wish to draw inferences, given

are unable to do so, they will be confronted with formally undecidable propositions. See footnote 6.

16 "Science Is Invoked as a model for accounting because, Sterling believes, only so will accountants have a decision procedure that will allow them to settle matters objectively" (Lyas, 1984, p. 103). As Lyas points out, Sterling's proposal Is flawed by the fact that the scientific method Is not a settled and complete decision procedure for generatlng and choosing among theories; rather, science itself Is "an elusive art" which Is riddled with subjectivity and judgment (Feyerabend, 1978, 1975), for three reasons. First, even at the lowest level, observation Is theory-laden. What we see (fee~ hear, smell, taste) depends partly on what we have been trained or conditioned to see, what we already believe to be true, what we expecL Second, logic and observatlon alone are not sufficient for constructing worthwhile scientific hypotheses, since almost any hypothesis can be made consistent with the finite number of observations made by scientists, given appropriate and ad hoc ancillary hypotheses. Thus judgment must enter, In the form of considerations of relevance, which guide our Inferences to the best explanation. Finally, and perhaps most striklngly, subjectivity enters into science when, through an Imaginative leap, a new paradigm of scientific explanation is discovered. The Idea of inertia, the shape of the benzene molecule, and the constant speed of light were all "discovered" through the exercise of imagination rather than simple observation and logic, as In the positivist model of science. Stretching the analogy somewhat, these three levels of judgment In science could be compared to our three levels of professional judgment in accounting. semantic, pragmatic and Institutional; however, in spite of the rough fit between judgment In science and judgment in accounting. we agree with Lyas that the latter Is even better modelled on judgment in law, since law, like accounting. Is a social practice.


those judgments. If the standards are unsatisfactory for either purpose, another set of standards is tried. 1bis incremental experimentation is repeated until a satisfactory set is established for the time-being. In attempting to understand what goes on during this incremental experimentation, we suggest that at least two parallels can be drawn between the development of accounting and that of science and law. First, it may tum out that what was thought to be an essential characteristic of "assets" is merely an accidental (though common) one, as the bipedal characteristic is to being human. Such realizations have been fairly frequent in the history of science. Before egg-laying platypi were discovered, all mammals were thought to bear live offspring. Second, the meanings of words like "transaction" and "control" c~ change with time. Kuhn ( 1962) showed how the meanings of scientific vocabularies change- though the words persist -through "scientific revolutions". At one time, "atoms" referred to simple, indivisible, and indestructible particles, which were supposed to compose everything that exists. Later it was discovered that "atoms" are composite, divisible, and convertible into energy. In social sciences and in law, meanings also change. "Marriage" at one time referred to a very specific and formal domestic arrangement. More recently, the word has come to denote any "common law" relationship which survives beyond some specified time period, whether or not the relationship originated in a formal ceremony or legal pronouncement. Two related factors motivate these changes: ( 1) advances in understanding the underlying realities of the field in question (physical, biological, social, economic, and so on); and ( 2) a desire for parsimony and theoretical economy where possible. Thus, taxonomists decided to classify platypi as mammals partly because they recognized underlying biological similarities between platypi and paradigmatic cases of mammals, but also

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because they did not want to create a completely new class of animals with only a few members. 1' Again, by a series of small steps, the word "atom" has come to mean, in most respects, the contrary of what it originally denoted, because at each step it seemed more reasonable to retain the word "atom" and modify its meaning ~an to invent a new word. Deferred taxes and platypl. The relevance of these analogies to the development of accounting standards can be shown more clearly by considering an historical example. In criticizing the FASB's conceptual framework for not unequivocally defining liabilities, Dopuch ·and Sunder state that " ... the FASB's definition of liabilities is so general that ... we cannot predict the Board's position on deferred taxes" ( 1980, p. 6). They recount the statement of the FASB's predecessor, the Accounting Principles Board, that •... liabilities also include certain deferred credits that are not obligations of the entity but that are recognized and measured in conformity with generally accepted accounting principles" (AICPA, 1970, para. 132). Thus deferred taxes - the platypi of the accounting kingdom provide an illustration of liabilities which, for a time, failed to satisfy one of the so-called "necessary" conditions - in this case, the "control" condition- for being liabilities. Later, the FASB proposed abolishing the term, "deferred taxes" and instead recognizing "future tax liabilities", which could be interpreted as obligations. 1bis can be construed partly as a proposal to move toward theoretical economy. The question is far from resolved, however (Rayburn, 1987). The point can be generalized. Dogmatically stipulating, once and for all, that all assets must have (T + M + C) could potentially stultify further devlopments in accounting, to the detriment of the profession. We cannot rule out the possibility, a priori, that a "revolution" in accounting might overturn our ideas of what assets, liabilities, and so on, really are. Naturally, examples of how accounting might

Our colleague, C.S., tells us that echidnas, like platypl, are now also classed with mammals even though they lay eggs.

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be revolutionized in the future are highly speculative, but such speculation can be fruitful if it prepares the mind of a critical practitioner. In this spirit, we offer the following speculations on goodwill and human capital. Evidently, these items have many of the same economically important characteristics as paradigm kinds of assets, though they may lack one or more of (T + M + C). Now, suppose that someone were to discover an ingenius way of measuring the value to an entity of human capital and internally generated goodwill - a way which was inexpensive, reliable, and comparability-enhancing. It seems to us that this would be a compelling reason to modify our understanding of "assets" (and the standards which elucidate it) so as to include goodwill and human capital under that head. Other discoveries in economics or finance might warrant re-interpreting the categories "assets", "liabilities", and so on, in other ways. Semantic and pragmatic judgment are import· ant to all practitioners; but institutional judgment, at the level of revolutionizing the accounting framework itself, is relevant mainly to standard setters. It would be inappropriate for individual practitioners to "bend" existing standards in the ways suggested above, even if underlying economic realities justified doing so. Users could be misled by such maverick practices, drawing false inferences from the resulting disclosures. Until the standards themselves are changed, and the changes are duly announced to the public, our analysis implies that the practitioners should use standards as readers expect the practitioners to use them. On the other hand, to be effective in their roles, practitioners- especially those holding tenure in the standard-setting institutions or advising their staffs - must be alert to the possibility of "revolutionary" changes in accounting and welcome them when underlying realities or opportunities for achieving theoretical economy warrant doing so. This is the essence of professional institutional judgment

PROFESSIONAL LIABIU1Y The preceding analysis can be used to elucidate several contemporary accounting issues, such as that of accountants' liability to users of financial statements. By bounding accountants' judgments, even incomplete standards ensure that readers do not infer too much from financial statements, and thus the standards place limits on the accountants' liability to users. Suppose that "loans receivable" are disclosed as a $1 million asset on a bank's balance sheet. Readers have only the three necessary conditions in Fig. 1 to guide their inferences about the loans, i.e. (1) there is a claim on cash; (2) collection is sufficiently under the control of the bank to warrant recording the amount receivable at the value reported; and (3) they resulted from past transactions. Readers familiar with Fig. 1 should not infer more than this, and so it is inappropriate to hold accountants legally liable to readers if they do. 18 On the other hand, bad judgment on the part of accountants can cause readers of financial statements to draw mistaken inferences when the readers apply the logic of Fig. 1, and for this accountants can be culpable. Note, however, that accountants' judgments could be "bad" for two reasons. ( 1) Incompetence. Wright's ( 1989) investigation of a notorious Canadian bank failure indicates that the bank's auditors, though they canvassed a representative sample of debtors, failed to ascertain whether full collection of the reported balances was under the bank's control. In the parlance of Fig. 1, the auditors erred in judging that row C ("control'') in the conceptual framework applied. This error in judgment allowed the loans to be shown as assets. Using Fig. l(c), readers inferred that the loans were fully collectible. Some depositors, assuming that the bank was solvent on the basis of these disclosures, would have lost much of their lifesavings when the error was discovered, had the

18 Whether readers unfamiliar with the conceptual framework should be of concern to standard setters and practising accountants Is a philosophical question not considered In this essay.

.,,, ~ '

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i PROFESSIONAL JUDGMENT

government not reimbursed them. Thus the auditors were cited for incompetence and negligence. (2) Uncertainty. A firm's performance is stochastic after accountants have made their judgments. Thus there is always a chance that the temporal resolution of uncertainty will tum out to be unlucky for the firm. That is, the accountants' judgments may have been reasonable and competent in the circumstances that existed at the time when the financial statements were issued, but subsequent events may tum out to be unfavorable by chance (Thornton, 1983, chapter 3). For example, an unexpected war might cause a recession, driving debtors of the bank into receivership. Professional organizations, such as the institutes of CAs and CPAs, try to ensure that professionals are trained to make competent judgments. Both professional organizations and the courts try to distinguish among the reasons for erroneous inferences. Our analysis makes clear that censure is appropriate for incompetence, but not for resolutions of uncertainty that are merely unpalatable to readers, and certainly not for readers' inferring more than is warranted from Fig. 1.

CONCLUSION We have shown the ways in which accounting standards give incomplete guidance to professionals and to the consumers of their services. Incompleteness is caused not just by the technical difficulties encountered in comparing intetpersonal utilities; nor by the inability of standard setters to see how to set complete standards. Rather, standards are inherently incomplete because they can supply only necessary but not sufficient conditions for

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making professional (pragmatic) decisions, and because even the necessary conditions are fraught with (semantic) vagueness. The complex issues raised by the inescapable vagueness of accounting concepts cannot be resolved a priori; we must use judgment, guided by the interests being served by the social practice of accounting. The analysis reinforces and clarifies several ideas that have perhaps been taken for granted. ( 1) Users need to understand the logic of accounting standards and the meanings ofwords like "transaction" and "control" in order to make valid inferences from financial disclosures. ( 2) The logic of accounting standards depicted in Fig. 1 is a conduit linking accountants' judgments to readers' inferences. This logic amplifies the information contained in professional judgments, but it also places limits on the inferences and expectations of financial statement users. Both professional organizations and the courts of law need to understand these limitatlons in setting bounds on professional liability. (3) Standard setters need to understand both of the preceding ideas in exercising professional institutional judgment - especially in deciding whether to keep intetpreting new situations in terms of existing standards or to modify the standards in a more revolutionary way. The analysis underscores the importance of accountants understanding how users make inferences from financial statements, and of users understanding how accountants exercise judgment, for only then will the conduit hold. This argues for considerable overlap in the educational programs of accountants and those of the consumers of their services. It also supports Mutphy's ( 1992) recent call for liberal accounting education, which helps accountants to understand the underlying phenomena they are supposed to report on.

BffiUOGRAPHY AICPA, Baste Concepts of Accounting Principles Underlying Financial Statements of Business Enterprises, Statement No. 4 of the Accounting Principles Board ( 1970).

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Bryant, M. & Thornton, D., Public Choice of Corporate Accounting Standards, In Mattessich, R. (cd.) Modern Accounting Research: lllstory, Survey and Guide, pp. 151-163 (Vancouver: Canadian CGA Research Foun