Inconsistencies in Acocunting For Liabilities

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Why is there inconsistency in

accounting for liabilities in IFRS? An
analysis of recognition, measurement,
estimation and conservatism
a b
Richard Barker & Anne McGeachin
a
Saïd Business School, Oxford University, Oxford, UK
b
Business School, University of Aberdeen, Aberdeen, UK
Published online: 21 Oct 2013.
To cite this article: Richard Barker & Anne McGeachin (2013) Why is there inconsistency
in accounting for liabilities in IFRS? An analysis of recognition, measurement,
estimation and conservatism, Accounting and Business Research, 43:6, 579-604, DOI:
10.1080/00014788.2013.834811
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Accounting and Business Research, 2013
Vol. 43, No. 6, 579 –604, http://dx.doi.org/10.1080/00014788.2013.834811
Why is there inconsistency in accounting for

liabilities in IFRS? An analysis of
recognition, measurement, estimation and
conservatism
RICHARD BARKERa∗ and ANNE MCGEACHINb∗

a
Saı̈d Business School, Oxford University, Oxford, UK; bBusiness School, University of Aberdeen,
Aberdeen, UK
We report that International Financial Reporting Standards (IFRS) are inconsistent with respect
to the recognition and measurement of liabilities, both in the conceptual framework for
financial reporting and in accounting standards themselves. We demonstrate that this arises
in part because the International Accounting Standards Board (IASB) does not make a
conceptual distinction between the process of measurement, which requires a currently
observable measurement attribute, and the process of estimation, which is inherently
subjective. The IASB employs only the logic and language of measurement, while actually
requiring entities to report both measurements and estimates in financial statements. Our
contribution is to identify and interpret this conceptual conflict, to demonstrate that this has
particular relevance to accounting for liabilities, and to draw implications for accounting
research and policy with respect to recognition, measurement and conservatism.
Keywords: conceptual framework; conservatism; IFRS; liabilities; measurement; recognition
1. Introduction
We demonstrate in this paper that International Financial Reporting Standards (IFRS) are incon-
sistent in the recognition and measurement of liabilities. Accounting standards and proposals
contain multiple, conceptually conflicting requirements, no two standards or proposals adopt
the same method and there is no formal explanation or justification for how these inconsistencies
have come about.1 Our aim in this paper is to understand why this inconsistency exists.
We note that the problem here is not one of neglect: the International Accounting Standards
Board (IASB)’s efforts to account for liabilities have been considerable and longstanding, with
∗
Corresponding authors. Emails: anne.mcgeachin@abdn.ac.uk, richard.barker@sbs.ox.ac.uk
This article was originally published with errors. This version has been corrected. Please see Erratum (http://
dx.doi.org/10.1080/00014788.2013.862372).
# 2013 Taylor & Francis

580 R. Barker and A. McGeachin
major projects concerning leases, revenue recognition, pension obligations, provisions and insur-
ance contracts having had a sustained and prominent, indeed arguably dominant, presence on the
IASB’s agenda (see, for example, Napier 2009). In spite of these efforts, a robust and consistently
applied theory of how to account for liabilities is conspicuous by its absence. Turning to the litera-
ture, we identify (and draw upon) a number of contributions that relate in various ways to the rec-
ognition and measurement of liabilities, although we do not find research that is directly concerned
with the question addressed in this paper. We therefore seek to contribute to the literature, in the
form of enhancing accounting theory with respect to the recognition and measurement of liabilities.
We draw from the literature a distinction between carrying amounts in financial statements
that are measured and those that are estimated, and we find that this distinction offers considerable
insight into our research question. Measurement is in principle possible only when there exist cur-
rently observable measurement attributes, while estimation is required in cases where measure-
ment is not possible (Chambers 1998, Vehmanen 2007). By attribute, we mean a defining
characteristic of the liability, such as fair value or amortised cost. Some attributes have a currently
observable measure, others do not. For example, if an entity receives a cash inflow (proceeds or
cost) in return for assuming an obligation that will result in future cash outflows, the amount of the
proceeds is a currently observable measurement attribute of the liability. In contrast, the value of
future cash flows can be estimated at the reporting date but it cannot in principle be measured,
because the future does not currently exist.2 We show that IFRS require the recognition of liabil-
ities that have no currently observable measurement attributes. This poses the question of what
amount should be recognised for such liabilities, a question that the IASB incorrectly addresses
as a measurement issue rather than, as will be explored below, an issue of the recognition of an
estimated amount. It is this misunderstanding of the nature of the problem that leads to the lack of
progress towards a consistent approach to accounting for liabilities.
The paper is structured as follows. In the next section, we set out our research method. The
paper is predominantly theoretical, in that we seek to analyse the concept of measurability and to
identify normative implications. Yet there is also a specific sense in which it is helpful to interpret
our method as empirical (King et al. 1994). While not a conventional empirical test of theory
against (quantitative) data, our method can be viewed analogously in the following way. Employ-
ing data in the form of the qualitative, textual content of accounting standards, we seek to reject
the hypothesis, which we argue to be implicitly adopted in IFRS, that measurability is possible for
all recognised liabilities.
In Section 3, we evaluate the conceptual boundaries of measurability, drawing the distinction
between measurement and estimation that is central to the paper. We apply this distinction in Sec-
tions 4 and 5, where we first evaluate the IASB’s conceptual framework (IASB 2010, hereafter
‘Framework’) and then international accounting standards themselves (including proposed revi-
sions to standards). We note that there are categories of liabilities which are recognised in IFRS,
yet for which observable measurement is not possible. In this context, the IASB requires estimation,
yet describes this requirement using the logic and language of measurement. We interpret this as
inconsistency between theory and practice, and in Section 6 we therefore argue the need to
extend the conceptual foundations of IFRS. We first argue that there are challenges of recognition
and measurement that are more apparent from the study of liabilities than of assets. We associate this
observation with the demand for conservative accounting, and we identify a need for a normative
theory of conservatism in IFRS, to be applied under conditions of uncertainty where recognised
liabilities are estimates and not observable measures. We conclude the paper in Section 7, identify-
ing potential avenues for further research, as well as policy implications for IFRS.
Overall the contributions of our paper can be summarised as follows. We argue that the IASB
fails to make a clear distinction between observable measurement and estimation, and that con-
ceptual inconsistencies result with respect to recognition criteria, the definition of measurement
Accounting and Business Research 581
and the application of measurement attributes.3 We identify the need for an expanded conceptual
framework in IFRS, to allow for cases where observable measurability is not achievable. In par-
ticular, we argue that the limitations of measurability are manifest in IFRS for liabilities to a
greater degree than for assets, that conservatism in accounting is the primary reason for this
and that the IASB’s presumption of universal measurability has misled it into rejecting conserva-
tism, which it interprets as biased measurement rather than as a cautious method of accounting
that arises in response to the absence of measurability. Moreover, we identify that this need to
develop conservatism in IFRS is different from that identified in the literature (Watts 2003a,
2006). Watts argues that conservatism implies a need for verifiability: if the amount recognised
for an asset cannot be verified, it should not be recognised. However, for liabilities conservatism
requires recognition of amounts that cannot be measured and instead must be estimated. Hence,
rather than conservatism being consistent with the demand for verifiability, it is instead in conflict.
We therefore identify, as avenues for further research, the need for a normative theory of conser-
vatism as well as for normative and empirical research, addressing the presentation of financial
statement data in the light of the distinction between the measurable and the immeasurable,
and the associated effects of conservatism and of forecasting error.
2. Research method: analysis, application and development of theory

In our research method, we have followed the approach to theory-building of Van de Ven (2007),
who defines theory as ‘a pattern of conceptual organisation that explains phenomena by rendering
them intelligible’. The phenomena that we seek to explain are the conceptual inconsistencies in
IFRS with respect to the recognition and measurement of liabilities.4 Our meaning of ‘IFRS’ in
this context is all accounting standards, exposure drafts (EDs) and discussion papers (DPs) issued
by the IASB concerning the recognition and measurement of liabilities. These data, which are
summarised in Table 1, contain not only the formal requirements of IFRS, but also the IASB’s
formal explanations for these requirements.5 Through the issues raised by each document, and
the changes made from one document to the next, these documents also help to reveal areas of
tension and challenge, together with the reasons why these challenging situations are perceived
to exist, and the extent to which they are either similar or different in nature across accounting
standards. The focus of the paper is on liabilities; hence our detailed analysis covers documents
relating to liabilities, not documents relating to assets. Nonetheless, in our analysis we also make
certain comparisons with the treatment and discussion of assets in IFRS and IASB proposals;
references to IFRS in these cases are made within the main body of the paper.
In seeking to develop a conceptual understanding of inconsistencies in IFRS, we compared
our IFRS data and various strands of accounting theory in the literature. One focus was on
alternative measurement attributes in different areas of IFRS and on seeking to understand
these alternatives in the light of the (partially) corresponding literature. For example, we
drew from Edwards and Bell (1961), Macve (2010), Whittington (2010), Horton et al.
(2011) and Nobes (2011) in providing a theoretical structure for thinking about different
measurement attributes, which we explore in Section 6. Particularly helpful in this regard
was the limited literature addressing the distinctive recognition and measurement aspects of
liabilities in comparison with assets, including Baxter (1975), Lennard (2002) and Nobes
(2003). These papers helped us to identify what it is that causes so many different (and incon-
sistent) requirements and proposals on liabilities: namely the extent to which estimation is
required for recognised liabilities. Another focus was conservatism (or prudence), which was
rejected by the IASB in its 2010 revisions to the Framework. Conservatism features strongly
in stakeholders’ responses to these revisions as well as (mostly implicitly) in accounting stan-
dards themselves, and again in partially corresponding analysis and evidence in the literature,
Table 1. IFRS sources on liability recognition and measurement.a

Comment End of comment
Publication title Date letters period
Conceptual framework for 1989 (original) N/A N/A
financial reporting 2010 (partially revised)
IAS 12 income taxes 1996b N/A N/A
IAS 17 leases 1997 N/A N/A
Leases ED August 2010 760 Dec 2010
Leases DP March 2009 302 July 2009
IAS 19 employee benefits 1998 N/A N/A
Pensions DP (for contribution- March 2009 150 Sept 2009
based promises)
IAS 37 provisions, contingent 1998 N/A N/A
liabilities and contingent assets
IAS 37 ED June 2005 123 Oct 2005
IAS 37 ED/working draft of January 2010 211 May 2010
revised standard
IAS 39 financial instruments: December 2003 N/A N/A
recognition and measurement
IFRS 9 financial instruments October 2010 (liabilities) N/A N/A
IFRS 4 insurance contracts 2004 N/A N/A

Insurance contracts DP May 2007 162 Nov 2007
Insurance contracts ED July 2010 248 Nov 2010
Revenue recognition DP December 2008 211 June 2009
Revenue recognition ED June 2010 973 Oct 2010
Credit risk DP June 2009 123 Sept 2009
Notes: DP ¼ discussion paper, ED ¼ exposure draft.
a
We have excluded IAS 18 (Revenue) and IAS 20 (Government Grants) because the issues we discuss in the paper do not
concern deferred income. In contrast, proposals to revise revenue recognition are included because of the aim therein to
adopt a balance sheet approach, including the recognition of liabilities for performance obligations.
b
An ED of amendments to IAS 12 was issued in 2009, but the IASB suspended the project in 2010.
such as Basu (1997) and Watts (2003a, 2006). We noted from this literature that conservatism
has different implications for the recognition and measurement of liabilities in comparison with
assets, and we return to this later in the paper. A further focus was on the underlying definition
of liabilities, contrasting the Framework with, for example, the discussion in Beaver (1991),
Botosan et al. (2005), Murray (2010) and Nobes (2012). These papers illustrate a range of
issues that arise in determining what expected future events should be recognised as an existing
liability, making them only indirectly relevant to our concern about how the IASB accounts for
liabilities once it has determined that they do exist.
This process of comparing IFRS and the literature eventually led us to narrow our atten-
tion to the distinction between observable measurement and estimation, which appeared to
offer the greatest insight into our research question, while also being relatively under-devel-
oped in the literature. Accordingly, we review and interpret the relevant literature in this area
in Section 3, setting out an analysis of measurability that serves as the theoretical foundation
for our paper.
We then argue, in Sections 4 – 6, that an implicit assumption in IFRS is that of universal mea-
surability for liabilities, meaning that if the definition of a liability is met, the liability is accounted
for as if its measurement attributes were observable. We identify flaws in this implicit assumption,
and from this we identify implications for accounting theory with respect to recognition, measure-
ment and conservatism.
3. The boundaries of measurability

There is no universally accepted definition of measurement. A standard reference is Stevens
(1946), who defines measurement as any process of ‘the assignment of numerals to objects or
events according to rules’. This definition has been criticised for being too loose, because it
allows more or less any assignment of numbers to categories to be defined as measurement,
even if the underlying method of assignment is inherently arbitrary (Lord 1953). On this basis,
any number reported in a financial statement is by definition a measure, based as it is upon the
application of a rule, in the form of an accounting standard. If the concept of measurement is
to help with any analysis or standard-setting decision-making, something narrower is required.
Deeper insight comes from considering the process of measurement, which can be broken down
into three stages: definition of the attribute to be measured, determination of the quantum (or
measurement scale) and application of a measurement instrument to the item in question (Chambers
1998, Vehmanen 2007). It is only the third of these stages that is empirical. While the measurement
attribute and the measurement scale can be determined in principle, the application of a measure-
ment instrument can only be done in practice, and it requires the existence of a currently observable
measurement attribute. This is an essential point. Measurement is straightforward in certain cases,
such as cash, or assets and liabilities with observable market values in active markets. Such items are
in principle measurable, and they are also verifiable and objective, in the sense that independent
observers could each be expected to take the same measurement (Morgenstern 1950, McKernan
2007). Consider, however, a case where the desired measurement attribute for a liability is the
cost of performance, which can be defined as the (entity-specific) present value of economic benefits
expected to be consumed in settlement of the liability. In this case, the attribute to be measured is the
cost of performance, and the quantum is money, yet a fundamental problem arises, which is that a
measurement instrument cannot be applied. This is because future cash flows are not currently
observable. The cost of performance therefore cannot, in the sense described here, be measured:
it can only be estimated. This is because the future does not currently exist, and so future cash
flows are immeasurable (Rosenfield 2003).
The future cash flows in a forecast cannot therefore be verified objectively, because they are a
matter of individual opinion about something that is unobservable, as opposed to existing inde-
pendently of subjective opinion.6 The difference in this case between an estimated value and a
future realisation that does not yet exist is a forecast error, which is a concept that does not
apply to the process of measurement. And while measurement can be viewed, in the simplest
case, as relating to a single, currently observable measurement attribute, a forecast can be concep-
tualised as a probability distribution, making the estimated economic value of the asset or liability
an expected value and not a measurement.
It is essential here not to confuse the data in a forecasting model, with which a cost of perform-
ance can be estimated, and future data themselves, which do not currently exist (Winston 1988). A
model can be used to estimate the value of future cash flows and so to determine a (currently held)
expectation. While the future cash flows themselves do not exist, the current expectation of those
cash flows does exist and is in principle measurable. Sterling (1970) cautions that these expected
values, based upon forecasts, are ‘not a measurement of wealth unless one defines wealth as a
state of mind’, and an important question is therefore whether (and if so in what way) it is appro-
priate to base the balance sheet valuation of liabilities upon these subjective estimates.
It is in this context that the market mechanism comes into play as a measurement instrument,
because market prices provide observable and verifiable evidence of currently held expectations.
In effect, the market transforms subjective expectations about the future into currently observable
amounts. In contrast, certain other types of expectation, such as those underpinning management’s
forecast of the cost of performance, are not directly observable in practice, meaning that they cannot
be measured, and that they are subjective and non-verifiable (Nagel 1986).
A further consideration is that measurement can be of different types. Stevens (1946) noted the
existence of ‘different kinds of scales and different kinds of measurement, not all of equal power and
usefulness’. He proposed a classification of these scales into four types: nominal, ordinal, interval
and ratio. Chambers (1964, 1965) noted that the secondary metrics common in accounting, such as
net assets, leverage and return on equity, are conceptually valid only if there is ratio measurement,
which is the most demanding category in Stevens’ typology. For this purpose, there must be only a
single measurement attribute used for all assets and liabilities, because core properties of additivity
and ratio measurement would otherwise not hold (Chambers 1998, Barth 2006).
This measurement perspective can be contrasted with an information perspective (Hitz 2007,
Christensen 2010a). While not tightly defined, an information perspective views accounting infor-
mation as part of a broader information set, providing one source of input to users’ economic
decision-making. Grounded in an acknowledgement of the inherent practical difficulties of a
measurement perspective under conditions of imperfect and incomplete markets (Beaver and
Demski 1974), an information perspective permits a mixture of measurement and estimation in
the financial statements, so long as the reported amounts meet the criterion of providing
‘useful information on the assessment of future cash flows’ (Beaver 1989, p. 4). Assets or liabil-
ities can exist even if their values are not observably measurable, and information pertaining to
them may be useful even though it is inevitably subjective (Landsman 2007).
The next sections of the paper explore the distinction between observable measurement and esti-
mation in IFRS. Specifically, we seek to reject the hypothesis, which we argue to be implicitly adopted
in IFRS, that all recognised liabilities can be treated as if they have observable measurement attributes.
We argue that the IASB employs only the logic and language of a measurement perspective, while
actually requiring entities to report both measurements and estimates in financial statements.
We present our analysis in two parts, which are the theoretical foundations of liability recog-
nition and measurement in the Framework (Section 4) and theory and practice in accounting stan-
dards themselves (Section 5).
4. Recognition and measurement in the conceptual framework

The IASB’s Framework provides little guidance on recognition and measurement, even though it
is clear on the importance of both factors for effective financial reporting. To the extent that the
Framework does reveal the IASB’s position, the communication is often implicit. This may
change as a result of the current project to revise the Framework, which has not yet addressed
the chapter on measurement, although change is not yet evident in the revisions already made,
which cover ground that relates directly to the nature and purpose of measurement (IASB
2010, Chapter 1: Objectives and Chapter 3: Qualitative Characteristics).
A liability is defined in the Framework as ‘a present obligation of the entity arising from past
events, the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits’ (para 4.4). Yet the Framework also has two recognition thresholds
that serve to constrain the practical applicability of this definition:
A liability is recognised in the balance sheet when it is probable that an outflow of resources embody-
ing economic benefits will result from the settlement of a present obligation and the amount at which
settlement will take place can be measured reliably. (para 4.46, italics added)7
Viewed through the lens of the distinction between measurement and estimation, these recog-
nition thresholds are problematic in several ways. Consider, for example, the case of a liability
that is a derivative financial instrument, with a currently observable market price, yet where it is
probable that there will not be an outflow of resources. In this case, the existence of an observable
measure makes it difficult to argue that the liability should not be on the balance sheet, and indeed
it would in practice be recognised. Yet the probable outflow recognition threshold is not crossed,
and so a strict application of the Framework would lead to non-recognition.
Next, consider the case of a liability for which there do not exist observable measurement
attributes, yet where there is a high degree of confidence in estimating the value of the liability.
An example might be a finance lease, where there does not exist an observable market price for
the leased asset. In this case, the value of the liability must be estimated and is somewhat subjec-
tive, yet nevertheless may be known within a relatively narrow range if there is sufficient evidence
from other sources of an appropriate cost of finance. In this case, the reliable measurement
threshold is somewhat ambiguous. If measurement is taken to imply the existence of an observa-
ble measurement attribute, then the threshold is not crossed. If, however, the notion of reliable
measurement is intended to embrace both observable measurement and reliable estimation,
then the lease obligation would be recognised. The point here is that the recognition threshold
is only meaningful and necessary if it concerns estimation and not measurement, because it is
only in the former case where a judgement on reliability needs to be made. Note that this is
the case even where there are a number of possible attributes that could be recognised: if the attri-
butes have an observable measure, they meet the criterion of reliability. It is only if they need to be
estimated that the question arises of the reliability of that estimation.
Finally, consider the case where reliable estimation is considered to be possible, but where it is
considered that there is not a probable outflow of resources. An example here might be where an
entity offers a guarantee, which is highly unlikely to be exercised by the counterparty, but where
reliable estimation of the value of the guarantee is deemed possible by means of a specified
present-value calculation. In this case, one argument would be that a liability should be recognised
and that there is no need for a probable outflow recognition threshold. This approach would treat a
liability that can be reliably estimated in the same way as one that can be observably measured.
An alternative argument would be that users of accounts are not best served by reporting amounts
derived from subjective estimates of hypothetical outcomes that are unlikely ever to take place.
On this view, a probable outflow recognition threshold is needed because it makes a useful dis-
tinction, albeit subjective, between liabilities that the entity is likely to have to settle, as opposed
to those that are unlikely to result in cash outflows, with little practical relevance and with the
potential to obfuscate the balance sheet. Whichever view is taken, the point here is that the
issue arises only within the realm of estimation, where observable measurement is not possible.8
This is because the concept of ‘probable’ is explicitly concerned with unobservable future cash
flows, making it a necessarily vague concept that requires subjective judgement in application
(Williamson 1994). Consistent with this view, the term ‘probable’ is used in the Framework
yet it is not tightly defined (Ma and Lambert 1998).9 This is unavoidable: if a tighter definition
could be achieved, it would be redundant, because it would imply the absence of subjectivity.
In summary, the implication of this analysis is that the recognition thresholds in the Frame-
work are incorrectly formulated. Reliable measurement and probable outflow are not conditions
that must jointly be satisfied for recognition. Instead, observable measurement is enough on its
own to justify recognition, and its existence makes the probable outflow criterion redundant. If
observable measurement is not present, reliable estimation is a necessary condition, and probable
outflow can be viewed as either a necessary condition or as a redundant concept, depending upon
which view is taken (as discussed above) over the decision-usefulness of estimates of outcomes
that are unlikely to occur.
This summary is presented algorithmically in Figure 1, which is proposed as an alternative to
the current recognition thresholds in the Framework.
Figure 1. Recognition algorithm for liabilities.

Note: As discussed in Section 4, recognition would also be possible in this case, depending on whichever
view is taken on the decision-usefulness of estimates of outcomes that are unlikely to occur.
Consistent with the Framework, a prerequisite for recognition in Figure 1 is meeting the defi-
nition of a liability. The first filter thereafter is the possibility of observable measurement, with the
effect that all measurable liabilities are recognised. For example, if the market mechanism trans-
forms uncertain future cash flows into quantified obligations, and thereby creates an observable
measure, no further recognition threshold is needed. If not, a second filter is needed, whereby
liabilities that cannot be reliably estimated are not recognised. Finally, and if the argument
above is accepted that estimates of less-than-probable outflows should not be recognised, then
a third filter is also needed; this is the probable outflow threshold that exists currently in the Fra-
mework. If Figure 1 is applied, recognised liabilities would be of two types. The first would be
observably measurable, while the second would lack measurability but would instead be subjec-
tively determined to be reliable estimates of probable outflows.
In contrast with this discussion, the 2010 revision to the Framework does not make an effec-
tive distinction between observable measurement and estimation. As discussed in O’Brien (2009),
the IASB replaced ‘reliability’ with ‘faithful representation’, the components of which are com-
pleteness (representation is not partial), neutrality (there is no intended bias) and freedom from
error (the item portrayed is the economic phenomenon in question); para QC12. In the DP that
preceded the revised Framework, verifiability had also been included as a component of faithful
representation, in the same way that it had previously been a component of the concept of
reliability. In the 2010 Framework, however, verifiability was repositioned into a role of explicitly
lower importance, as explained in BC3.36:
Some respondents [to the DP] pointed out that including verifiability as an aspect of faithful represen-
tation could result in excluding information that is not readily verifiable . . . (which) would make the
financial reports much less useful. The Board agreed and repositioned verifiability as an enhancing
qualitative characteristic, very desirable but not necessarily required.
The implication is that faithful representation is considered to be applicable even when observable
measurement is not possible. This is explained as follows in para QC15:
Faithful representation does not mean accurate in all respects . . . For example, an estimate of an unob-
servable price or value cannot be determined to be accurate or inaccurate. However, a representation
of that estimate can be faithful if the amount is described clearly and accurately as being an estimate,
the nature and limitations of the estimating process are explained, and no errors have been made in
selecting and applying an appropriate process for developing the estimate. (para QC15)
Forming part of a conceptual shift that Power (2010) characterises as a ‘transformation of

reliability’, this is faithful representation of the process of determining an estimate, rather than faith-
ful representation of the balance sheet item itself.10 The problem here is that an ‘unobservable price
or value’ cannot in principle be measured, no matter what process is applied in its determination.
Along similar lines, the Framework adopts a notion of verifiability that is broad enough to encom-
pass both amounts that are observable and amounts that are not. On the one hand, the concept of
‘direct verification’ corresponds to that of observable measurement; it is described as ‘verifying
an amount or other representation through direct observation, for example, by counting cash’
(para QC27). On the other hand, ‘indirect verification’ corresponds to estimation; it is described
as ‘checking the inputs to a model, formula or other technique and recalculating the outputs
using the same methodology’. As with the concept of faithful representation, the IASB’s descrip-
tion of indirect verification concerns verifying a process, not an output. The measurement of an
attribute cannot be verified unless it can be observed, in other words unless independent observers
can objectively reach the same outcome (Sterling 1970, Nagel 1986). This confusion of concepts is
evident in para QC26, where it is stated that ‘Verifiability means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete agreement, that a
particular depiction is a faithful representation.’ The references here to the possibility of consensus
and the absence of complete agreement are applicable to estimation, but not to observable measure-
ment.11 In other words, the notion of inter-observer agreement is being invoked in two conceptually
distinct ways, one objective and the other subjective.
In relegating the requirement for verifiability, and also in defining verifiability loosely, the
applicability of the IASB’s concept of faithful representation is broadened, while its meaning
is weakened (Power 2010). The approach fails to make the distinction between items that are mea-
surable and those that are not, but instead creates a concept that embraces both categories.12 If the
concept of faithful representation is, in this way, allowed to embrace both observable measure-
ment and subjective estimation, then it cannot in principle be tightly defined.13 Yet, and as will
now be argued in Section 5, the IASB has not in practice interpreted it as such. In developing
accounting standards, the IASB has used the logic and language of measurability, allowing its
own definition of faithful representation to be interpreted and applied incorrectly as a definition of

measurement.
5. Recognition and measurement in accounting standards

In this section, we explore the application of recognition and measurement criteria in accounting
standards themselves (including proposals for new standards). Table 2 summarises the require-
ments of all of the IASB pronouncements that comprise the source data for our paper. The existing
standards are covered first, followed by proposals (both DPs and EDs). It can be seen that these
pronouncements contain multiple methods of determining the carrying amounts of liabilities (the
various aspects of the methods being compared in columns 1 – 7), with inconsistencies among
these methods and with no two standards or proposals adopting the same method. In this
section, we analyse this remarkable inconsistency. Our discussion follows the structure of
Table 2, first addressing recognition (the probable outflow and reliable measurement thresholds),
followed by measurement and estimation.
The first issue we consider is that of a probable outflow recognition threshold (column 1 in
Table 2). While included in the Framework, such a threshold is present in only one other
IASB pronouncement, in IAS 37.14 Moreover, the EDs of amendments to IAS 37 (2005 and
2010) proposed removing the threshold. If enacted, this would result in the Framework being
the sole outlier.15
It could be argued that in other standards and proposals, the IASB concluded that it is obvious
that for the liabilities in question outflows are always probable, and hence there is no need in the
standard or proposal for the threshold. However, that does not seem always to be the case, as, for
example, with derivative liabilities under IAS 39/IFRS 9 or insurance contracts under the insur-
ance contract ED, where individual liabilities could well have outflows that are less likely than
not. In general, the absence of a probable outflow recognition threshold is consistent with the
IASB adopting the hypothesis that all liabilities can be measured, and hence should be recognised.
Under this view, a probability recognition threshold is just an arbitrary and conceptually indefen-
sible barrier. This is illustrated in the IASB’s explanation that applying such a threshold would
result in ‘the flawed conclusion that a performance obligation arising from a guarantee, a warranty
or an insurance contract should not be recognised until it is probable that a claim will arise’ (IASB
2006). In these cases, there is an observable entry value (e.g. an insurance premium) and so it
could be argued that a probability threshold is not needed because there is an observable measure-
ment. However, the IASB is also claiming that a probability threshold is redundant even when
estimating an amount based on the probability-weighted average of expected cash flows (IASB
2006). Yet this claim fails to recognise that, in the sense described in Section 3, there is no cur-
rently observable measurement attribute and instead only estimates of expected future cash flows,
and that (as set out in Figure 1) it is precisely in such cases that a probability threshold potentially
has a role to play.
As with the probability threshold, a reliable measurement threshold (column 2 in Table 2) is
rare in standards on liabilities, in spite of its presence in the Framework. In the same way as for the
probability criterion, its general absence in standards could be because the IASB regards it as
unnecessary, because reliable measurement can be assumed to exist for the liabilities in question.
However, as discussed below, such an assumption would be flawed.
The criterion that a liability must be capable of reliable measurement is explicit only in IAS 37
and in specific parts of IAS 19.16 IAS 37 notes that ‘the use of estimates is an essential part of the
preparation of financial statements’, yet it then claims that this ‘does not undermine their
reliability’ notwithstanding that provisions are ‘by nature . . . more uncertain than most other
items in the statement of financial position’. This is again consistent with the Framework, yet
Table 2. Requirements in IFRS for determining the carrying amounts of liabilities.
Recognition Measurement/ Estimation

Publication title estimation Measurement
(1) Probable
outflow (2) Reliable (4) Observable (5) Expected value
recognition measurement (3) Specified measurement of cash flows or
Date threshold threshold measurement attribute attribute most likely outcome (6) Discount rate (7) Risk-adjustment
a
Conceptual 1989 Yes Yes Various For one Silent Unspecified Silent

framework for measurement
financial objective
reporting
IAS 12 income 1996b No No No No Silent Not discounted None
taxes
IAS 17 leases 1997 No No None No Neither: minimum Rate implicit in lease or Yes, initially in discount
lease payments incremental borrowing rate. Not reassessed after
rate. Not reassessed initial measurement
after initial recognition
Leases DP 2009 No No None No Cash flows based on Incremental borrowing To the extent that it is
most likely lease rate included in the discount
term and expected rate
value of contingent
rentals
Leases ED 2010 No No None No Cash flows based on Rate implicit in lease or Yes, initially in discount
longest lease term incremental borrowing rate. Not reassessed after
that is more likely rate. Not reassessed initial measurement
than not to occur and after initial recognition
expected value of
contingent rentals
(Continued )
589
Table 2. Continued.
590
(1) Probable
IAS 19 1998 No For profit-share and None No Most likely outcome Current market No
employee bonus payments, and (A best estimate is assessment of a high-
benefits for multi-employer required, which is quality corporate bond
defined benefit interpreted in rate or government
plans. Explicitly practice as being bond rate if no deep
assumed to be met most likely) market in high-quality
for other defined corporate bonds

benefit plans
R. Barker and A. McGeachin

Pensions DP 2009 No No Fair value assuming No Expected value, Current market Yes, specifically
(for the terms of the benefit excluding possibility discount rates that including credit risk but
contribution- promise do not change that the entity may adjust the estimated excluding the possibility
based promises) change the terms of future cash flows for that the entity may
the benefit promise the time value of change the terms of the
money benefit promise. Notes
that the effect of
diversifiable risk has not
yet been considered
IAS 37 1998 Yes Yes Best estimate of No Expected value, but Current market Yes, silent on the effect
provisions expenditure required in practice most assessments of the time of diversifiable risks and
to settle the present likely outcome often value for money and credit risk
obligation at the end of used the risks specific to the
the reporting period liability
IAS 37 ED 2005 No Yes The amount the entity No Expected value Current market Yes, silent on the effect
would rationally pay at assessments of the time of diversifiable risks and
the end of the reporting value for money and credit risk
period to be relieved of the risks specific to the
the present obligation liability
IAS 37 ED/ 2010 No Yes The amount the entity No Expected value Current market Yes, silent on the effect
working draft of would rationally pay at assessments of the time of diversifiable risks and
revised standard the end of the reporting value for money and credit risk
period to be relieved of the risks specific to the
the present obligation liability
IAS 39 financial 2003 No No Amortised cost and Yes [AG76] Expected value Current market rate Yes (implicit in fv
instruments: fair value (implicit in fv (implicit in fv measurement). Only
recognition and measurement). Only measurement). Only reassessed for those
measurement reassessed for those reassessed for those liabilities measured at
liabilities measured liabilities measured at fair value
at fair value fair value
IFRS 9 financial 2010, but liability No No Fair value or amortised Yes [AG76] Expected value Current market rate Yes (implicit in fv
instruments recognition and cost (implicit in fv (implicit in fv measurement). Only
measurement measurement). Only measurement). Only reassessed for those
unchanged from reassessed for those reassessed for those liabilities measured at
IAS 39 issued in liabilities measured liabilities measured at fair value
1999, with fair at fair value fair value
value option added
in 2005

IFRS 2 Share- 2004 No No Fair value No Expected value Current market rate Yes (implicit in fv
based Payment (implicit in fv (implicit in fv measurement)
measurement) measurement)
IFRS 4 2004 No No None No Silent, either would Unspecified Unspecified
insurance be allowed
contracts
Insurance 2007 No No Current exit value No Expected value Consistent with Yes, specifically
contract DP observable current including credit risk and
market prices for cash diversifiable risk
flows whose
characteristics match
those of the insurance
liability, for example, in
timing, currency and
liquidity
Insurance 2010 No No Amount the entity Yes Expected value Current market risk- Yes
contracts ED would rationally pay at free rate
the end of the reporting
period to be relieved of
the present obligation
plus a residual margin
to eliminate any gain
on contract inception
(Continued )
591
592
Table 2. Continued.
(1) Probable

R. Barker and A. McGeachin

Revenue 2008 No No Customer Yes Not discussed Not discussed Not discussed
recognition DP consideration
(discusses
performance
obligations
which are
liabilities)
Revenue 2010 No No Transaction price Yes Expected value of Time value of money No
recognition ED customer and credit risk
consideration
a
Some chapters were revised in 2010, but they did not cover the definition, recognition or measurement of liabilities.
b
An ED of amendments to IAS 12 was issued in 2009, but the IASB suspended the project in 2010.
it fails to recognise that a process of estimation differs from a process of measurement. IAS 37
concludes that, ‘except in extremely rare cases, an entity will be able to determine a range of poss-
ible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to
use in recognising a provision’. IAS 37 therefore comes close to acknowledging the problem of
the immeasurable, but in the end asserts a conclusion that is actually based upon the notion of
reliable estimation.
Elsewhere in IFRS, the criterion of reliable measurement is simply assumed to be met, and so
measurability is assumed to be universal. This assumption does not, however, stand up to scrutiny.
This can be seen by first considering whether each DP, ED or IFRS specifies clearly its desired
measurement attribute (column 3 of Table 2). As was discussed in Section 3, the identification
of the measurement attribute is fundamental to the concept of measurement, and necessary for
any given measurement requirement specified in IFRS. Yet there is not always a specified
measurement attribute in IFRS. Moreover, whenever an attribute is stated, it is in each case differ-
ent from any attribute stated elsewhere. Further, none of these attributes is described in the same
terms as any of those described in the Framework, albeit in the extant 1989 text.17 All of this
suggests an absence of conceptual clarity.
Although the stated attributes in the IFRSs, EDs and DPs are all different in some way, they
can be categorised broadly into three groups: fair value, cost (subsequently amortised cost) and
the amount the entity would rationally pay at the end of the reporting period to be relieved of
the present obligation (or similar wording). The first category, fair value, is an observable
measure if there are active markets. However, the IASB also requires fair value in situations
where there are no active markets, at which point it ceases to be an observable measurement attri-
bute (IASB 2011).18 The second category, cost, is an observable measure on initial recognition,
but amortised cost in subsequent periods in general cannot be (Thomas 1974). The third category,
the amount the entity would rationally pay at the end of the reporting period to be relieved of the
present obligation, is the definition that the IASB has developed for liabilities for which it wishes
to recognise a cost of performance. The measurement attribute in IAS 37, for example, is the best
estimate of expenditure that an entity would rationally pay to settle an obligation. In the 2005 ED
of amendments to IAS 37, and repeated and reinforced in the 2010 ED, this measurement attribute
was clarified as being the amount the entity would rationally pay at the end of the reporting period
to be relieved of the present obligation (Rees 2006). This can be interpreted as an attempt to trans-
form the cost of performance from an estimate of future cash flows (which as discussed earlier is
not a current attribute because the cash flows are in the future) into an attribute that does currently
exist (because it is an amount that the entity would pay now), and it can therefore be seen as going
some way towards the appearance of an observable measure. Yet what we have here is a hypothe-
tical market attribute. Conceptually, it exists in the balance sheet, but while in principle it is obser-
vable, in practice it is not. Indeed, if it were, then there would have been no need for the 2005 and
2010 EDs, because there would have been no need to (in effect) assert the potential for observable
measurement.
One aspect of liability measurement that is not discussed in the Framework, but that has a
strong influence on the IASB’s standards and proposals, is whether the amount initially recog-
nised should be linked to an amount observed (or observable) in a transaction (column 4 in
Table 2). There is a fundamental difference between those liabilities where initial recognition
is at an amount identified in an exchange transaction (which is measurable), as opposed to
cases where determination of an amount to be recognised relies on an estimate of future cash
flows.
Liabilities for which an initial measure can be identified in an exchange transaction arise in
three contexts: financial instruments (IAS 39 and IFRS 9); insurance contracts (ED) and
revenue recognition (ED and DP). In all these cases, the initial measurement of the liability is
linked to the amount identified in the exchange transaction. It is therefore possible to characterise
these proposals as stating a preference for an observable measure over an estimate of future cash
flows. Using an observable transaction price, when one exists, does not, however, solve the
problem of what to do when one does not exist, nor if it is thought desirable to re-measure
the liability subsequent to initial recognition. In these cases, there is no observable measure in
the absence of active markets, yet the evidence in IFRS is that the IASB continues to presume
measurability. This leads to conceptual confusion, as the IASB employs the language of measure-
ment in specifying how the amount it wishes to be recognised should be determined.
To illustrate, if the cost of performance could be observed, there would be no need to consider
what expected cash flows should be included in its estimation. Because it cannot be observed, the
IASB has specified (for example, in the 2005 and 2010 EDs of amendments to IAS 37) that the
probability-weighted average of all possible cash flows (expected value) should be used (column
5 of Table 2), arguing that this is necessary to meet the measurement objective of an amount that
the entity would pay to transfer or settle the liability at the reporting date. The IASB is seeking to
position expected value as a method for determining a meaningful measure, yet this aspiration is
invalid, because an observable measurement attribute does not exist.
As with cash flows, if cost of performance could be observed, there would be no need to con-
sider what discount rate to use (column 6 of Table 2). In current practice, IFRSs, EDs and DPs are
uniform in their requirements and proposals that all carrying amounts that are based on estimates
of future cash flows should be discounted, whenever the impact of discounting is material (except
for IAS 12).19 There are differences, however, on which discount rate to use to reflect the time
value of money. There is one (almost) universal feature, which is that all the discount rates
being considered by the IASB are current rates. The only exception to this is the rate proposed
in the leases ED.20 However, even having established an almost common approach to including
the time value of money, further questions arise as to how this should be done. For example, the
insurance contracts DP and ED raise the issue of the liquidity characteristics of the liability and
propose that the discount rate should reflect the liquidity characteristics of the item being
measured. All other IFRS, EDs and DPs are silent on this issue.
A related challenge concerns adjustments for risk (column 7 of Table 2). There are differences
in IFRS on whether to include a risk-adjustment for the uncertainties surrounding the cash flows
and, if a risk-adjustment is included, what the objective of the risk-adjustment is, how to treat
diversifiable risk and how to treat credit risk. These challenges have proved intractable for the
IASB. As with the cash flows and discount rate, however, the question of the effect of risk
would not need to be considered if cost of performance were an observable measure. It is the
absence of measurability that, ironically, has led the IASB to consider the effect of risk in
trying to ‘measure’ the cost of performance. For example, the IAS 37 and insurance contracts pro-
jects both use the language of measurement to require/propose an adjustment for risk. The pro-
blems of using a measurement perspective can be seen from the significant debate and
disagreement within the IASB over the objective and the impact of diversifiable risk (IAS 37
2010 ED, Insurance Contracts ED). The inclusion of own credit risk in the carrying amount of
a liability has also proved irresolvable. IAS 37 is silent on the matter, while the insurance con-
tracts ED includes own credit risk only in the residual margin that calibrates the liability measure-
ment to the transaction price.21 In 2010, the IASB decided to abandon its standalone project on
own credit risk.
The general point being illustrated here is that the practical challenges faced by the IASB in
determining expected cash flows, discount rates and risk-adjustments are not issues of measure-
ment, even though the IASB characterises them as such. Instead, they must be conceptualised in a
different way. Those aspects of financial reporting practice that are inadequately theorised from a
measurement perspective require adoption of an alternative theory, which is at present absent in
IFRS. In the next section, we therefore turn to this issue. We first make the observation that the
need is greater for liabilities than for assets, and that this asymmetry has been overlooked in the
literature. As will be seen, this conclusion follows directly from a consideration of the practice of
conservatism in accounting, which leads to the recognition of liabilities that, on initial recog-
nition, can only be estimated, while typically requiring observable measurement for the initial rec-
ognition of assets. The effect is to create challenges of recognition and measurement that are
distinctive to liabilities.
6. Conservatism and the distinctive nature of liabilities

The literature contains many theoretical papers and other contributions relating primarily to the
measurement of assets, published over several decades (for example, Edwards and Bell 1961,
Sterling 1970), yet relatively little has been published specifically addressing liabilities.22
There are perhaps two reasons for this. First, when addressing value attributes, it is common,
in the literature and in practice, for attention to turn first to assets, or else to subsume liabilities
within net assets. Second, if a liability is conceptualised as the opposite of an asset, then an analy-
sis of assets can simply be viewed in the mirror for the purpose of analysing liabilities. On this
second point, a simple illustration is a fixed-rate bank loan, where the asset (liability) in a
bank’s (borrower’s) accounts is a right to receive (obligation to transfer) economic benefits: the
liability mirrors the asset, and the accounting for each counterparty is in principle identical.23
In general, and as set out in Table 3, for any measurement attribute of an asset, there is an analogue
for a liability (see also Baxter 1975, Lennard 2002, Nobes 2003, Macve 2010, Horton et al. 2011).
For the bank loan held as a liability, for example, the measurement attribute might be an exit
value, given by the present value of contractual payments (cost of performance), the amount
for which the loan could be exchanged in the capital market (fair value), or the amount that
the borrower is contractually entitled to pay, at the balance sheet date, in full settlement of the
outstanding balance (cost of release).24 Alternatively, it could be either an entry value, being
the historical or current equivalent proceeds that the entity receives on, respectively, the initiation
or replacement of a loan. And finally, the measurement attribute might be a hybrid of the above
(settlement amount or relief value).
While this mirror-like theoretical relationship between liabilities and assets holds in principle,
its relevance to practice is constrained by real-world data limitations, resulting in asymmetry
between accounting for liabilities and for assets. This is illustrated in Table 4, which summarises
the four possible types of data combination concerning the availability of observable entry and/or
exit measurement attributes on initial recognition.
It is common in practice that observable exit values are unavailable for both liabilities and
assets. For many liabilities, for example, a cost of transfer may not exist. This might arise
where inflows occur in advance of performance, for example, arising from revenue contracts
with customers (Samuelson 1993). The difference here from the earlier case of a bank loan is
that, while there is an inflow of economic benefits, the liability is in the form of a performance
obligation (an expected outflow of goods or services), rather than a contractual future cash
outflow.25 Such obligations typically have unique, entity-specific attributes, and there may be
no readily available way of transferring the liability and hence no cost of transfer.26 For other
liabilities, there is no cost of release. This is often the case with provisions, which typically
have either no underlying contract (e.g. lawsuits) or else a contract with effectively no current
exit option (e.g. pension obligations in most jurisdictions).27
In general, for both liabilities and assets, if an exit value measurement attribute is desired yet
not observable, a typical, implicit assumption is that of an exchange of equal value. This assump-
tion allows that an observable entry value can be used as a proxy for an exit value: the (unknown)
Table 3. Assets vs. liabilities – measurement attribute analogues.a

Measurement
Attribute Assets Liabilities
(1) Current holding Value-in-use Cost of performance
value (Entity-specific present value of (Entity-specific present value of
expected economic benefits) economic benefits expected to be
consumed in settlement of the
liability)
(2) Current market Fair value Cost of transfer (fair value)
exit value (The price that would be received to (The price that would be paid to
sell an asset in an orderly transaction transfer a liability in an orderly
between market participants at the transaction between market
measurement date) participants at the measurement date)
(3) Current Cost of liquidation Cost of release
contractual exit (The amount that the entity would (The amount that the entity would
value currently accept from the currently pay to the counterparty in
counterparty to liquidate the asset) full settlement of the liability)
(4) Current entry Replacement cost Current equivalent proceeds
value (The outflow of economic benefits (The inflow of economic benefits
that would be required to replace the corresponding to the current
service potential of the existing replacement of the liability)

asset)
(5) Historical entry Historical cost Historical proceeds
value (The outflow of economic benefits to (The inflow of economic benefits
acquire the asset) corresponding to the incurrence of
the liability)
(6) Mixed Recoverable amount Settlement amount
measurement: exit (Higher of value-in-use and value- (Lower of cost of performance or
value in-exchange) cost of release)
(7) Mixed Deprival value Relief value
measurement: (Lower of replacement cost or (Lower of current equivalent
entry and exit recoverable amount) proceeds or settlement amount)
value
a
See also Nobes (2011).
exit value of the asset or liability is set equal to the (known) entry value of the corresponding side
of the double entry.28 This assumption can be applied more generally to assets than to liabilities.
Table 4. Measurement attributes on initial recognition.a

Is an exit value observable?
Yes No
Is an entry value Yes Asset: Asset:
observable? Bank loan Some intangible assets and
specialised PPE
Liability: Liability:
Bank loan Performance Obligation
No Asset: Asset:
Some donated assets Some intangible assets
Liability: Liability:
Some shared-based payments Provisions
a
The examples given in the table are illustrative, not exhaustive.
This is because the acquisition of assets is usually associated with the sacrifice of monetary
resource. In contrast, the initial recognition of liabilities such as provisions need not correspond
to the recognition of an asset with an observable entry measurement attribute. Indeed, in a case
such as a lawsuit, there is arguably no entry value at all. Yet cases where neither entry nor exit
value is observable also exist for certain intangible assets, such as internally generated brands,
and so there is no difference in principle here between the nature of assets and liabilities. What
is different is that the practice of conservatism allows for the non-recognition of assets for
which there is no observable measure but calls for the recognition of such liabilities. This asym-
metry necessitates the use of an estimated amount for liabilities.
This effect of conservatism can be illustrated by contrasting IAS 37 with IAS 38. In the latter,
it is acknowledged that for internally generated goodwill and some internally generated intangible
assets, it is not possible to determine reliably either their exit value (IAS 38.51) or their entry value
(IAS 38.49, goodwill; IAS 38.51(b), other internally generated intangibles; IAS 38.57(f), devel-
opment costs). Such assets are thereby not recognised. Yet, without explanation, the exact oppo-
site conclusion is reached in IAS 37, where measurability is presumed for provisions: ‘except in
extremely rare cases, an entity will be able to determine a range of possible outcomes and can
therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a
provision’ (para 25). The difference here is not in measurability but in desired recognition
outcome. The practical effect is that the application of conservatism causes the carrying
amounts of many liabilities to differ in nature from the carrying amounts of most assets,
because there is required recognition of estimates as opposed to only observable measurements.29
Conservatism can be defined as the differential verifiability required for the recognition of
gains and losses, whereby expected losses are recognised with less verification than expected
gains (Basu 1997, Watts 2003a). To some extent, conservatism has been viewed in the academic
literature as evidence of tradition and convention, rather than as a practice that can be justified
conceptually (Sterling 1970). In contrast, a more recent strand in the literature has provided theor-
etical support for conservatism. In particular, a contracting explanation (Watts 2003a) identifies a
need for conservatism as a means of addressing the problem of moral hazard that arises among
stakeholders of the reporting entity, a view supported by considerable empirical evidence (e.g.
Basu 1997, Watts 2003b, Ryan 2006, LaFond and Roychowdhury 2008, LaFond and Watts
2008, Giner et al. 2011). According to this view, conservatism results from a demand for verifia-
bility – for ‘hard’ data – to mitigate the effects of asymmetric information and payoffs (Mack-
intosh 2006, Gassen and Schwedler 2010). Hence, in commenting on a Preliminary Views
document for a revised Framework, the Financial Accounting Standards Committee of the Amer-
ican Accounting Association proposed a ‘conservative bias, wherein revenue is not reported as
such unless it is clear (certain or very highly probable) that has been earned. However, expenses
are reported currently (not deferred in the form of assets)’ (Benston et al. 2007). At first sight, this
demand for conservatism is consistent with a requirement for observable measurement attributes,
because it is based upon the conclusion that if the measurement of an asset cannot be verified, it
should not be recognised. Watts (2006), for example, calls for standard setters to both ‘require
verifiability’ and ‘allow conservatism’.
While conservatism thereby rules out recognising asset values that are estimates as opposed to
observable measures, the same need not apply to liabilities. Rather, conservatism encourages their
recognition (Ball and Shivakumar 2005). Referring back to Table 2, if, in practice, entry values
and exit values are unavailable, the principle of conservatism is conventionally applied. In the
case of a lawsuit under IAS 37, for example, a liability of uncertain amount is typically recognised
in the accounts of the defendant, because ‘except in extremely rare cases, an entity . . . (can) make
an estimate of the obligation that is sufficiently reliable’ (IAS 37:25). Yet, even with no difference
at all in either the amount under consideration or the associated uncertainty, an asset is typically
not recognised in the accounts of the plaintiff until it is ‘virtually certain’ . . . ‘since this may result
in the recognition of income that may never be realised’ (IAS 37.33). This is an application of
conservatism, of differential verifiability, whereby immeasurable liabilities are recognised, but
not immeasurable assets. In the case of liabilities therefore, and in contrast with assets, it is not
possible to equate conservatism with the use of verifiable measures.
In practice in IFRS, conservatism is applied in accounting standards themselves while being
simultaneously denied conceptually in the Framework. The IASB has explicitly rejected the
concept of conservatism, through its use in the Framework of the language of measurement,
by which anything that is deemed to be representationally faithful is treated conceptually as a
measure. In evaluating conservatism as a candidate for ‘an aspect of faithful representation’,
the Framework (BC3.27) argues that its inclusion in this regard would be ‘inconsistent with neu-
trality’, where neutrality is defined as ‘without bias’ (para QC14).
The difficulty here is in the application of the concept of bias. In cases where there is an obser-
vable measurement attribute, it is straightforward to argue that accounting measurement should
not be biased. The demand for conservatism does not, however, arise in such cases but instead
in cases where verifiability is unattainable, as, for example, in the ‘No-No’ category in Table
4. In appealing to the concept of bias in order to rule out the practice of conservatism, the Frame-
work is therefore arguing from a position that presumes the possibility of observable measure-
ment, and yet the theory of conservatism outlined above applies only when such conditions do
not hold.30 The Framework therefore dismisses conservatism on inappropriate grounds, misinter-
preting it as a deliberate process of biased measurement, rather than regarding it (in the context of
liabilities) as a justification, based upon asymmetry of information and payoffs, for recognising
estimates of obligations in the absence of observable measurement.31 In effect, the choice
between requiring verifiability and allowing conservatism is resolved in the wrong way: measur-
ability is assumed rather than immeasurability being acknowledged, and conservatism is rejected
rather than required.
Conservatism is also not used to support IASB proposals for requirements in standards, even
when it would be a natural argument to use. For example, in terms of conservatism, not having a
probability recognition threshold for liabilities is more conservative than having one. But the
IASB does not use conservatism as a justification for the proposed removal of the threshold
from IAS 37. All its arguments are based on the flawed presumption of measurability discussed
above, which leads to the conclusion that all liabilities can be measured and therefore should be
recognised.
Conservatism also could be employed by the IASB in the analysis of credit risk. The IASB is
aiming for a measurement attribute of the amount that an entity would pay to transfer or settle the
liability at the reporting date. This would include the effect of its creditworthiness. However, con-
servatism would argue against estimating a liability at the smaller amount caused by including the
effect of credit risk, and also against recording a gain when an entity’s creditworthiness decreases.
Although the IASB has acknowledged the ‘counter-intuitive’ nature of the inclusion of credit risk,
it does not advance conservatism as the reason for this counter-intuition, preferring instead to
depart from its stated measurement attribute for pragmatic reasons, without any theoretical justi-
fication (IASB 2009, p. 48).32
It is only in the insurance and revenue recognition projects that conservatism is acknowledged
as a desirable concept, albeit not by name. The basis for conclusions to the insurance contract DP
argued that the observed price for the transaction with the policyholder, although useful as a
reasonableness check on the initial measurement of the insurance liability, should not override
an estimate of the amount another party would require to take over the insurer’s contractual
rights and obligations. The justification for the IASB’s subsequent change from this approach
in the insurance ED was the desire to avoid day one gains, consistent with the revenue recognition
project and consistent also with conservatism.
In summary, while conservatism does not find theoretical endorsement in IFRS, it is neverthe-
less prevalent in accounting standards themselves, and it is therefore in practice consistent with
the theory outlined above from the literature. A simple need, therefore, is to embed a theory of
conservatism from the literature into IFRS. Where the literature falls short in this regard,
however, is in the relative absence of normative contributions. Empirical evidence points to
the existence of conservatism in practice, and underlying theory explains this practice in terms
of economic benefits. This is a positive approach, describing and attempting to explain behaviours
that have evolved in practice. Yet standard setting is a normative activity. It exists as a market
intervention, as a mechanism of policy with the explicit aim of creating outcomes that the
market itself would not be expected to generate. Viewed in this light, the literature does not suffi-
ciently explore the conflict described here between conservatism and verifiable measurement,
thereby leaving open the important question of how this conflict might be resolved. There is there-
fore an implication for future research, as will be discussed in the final section of the paper.
7. Conclusions
We set out to understand why IFRS contain multiple and inconsistent recognition and measure-
ment requirements for liabilities. We apply a distinction between observable measures and esti-
mates to extant and proposed IFRS. We argue that, while measurement attributes for liabilities
are conceptually analogous to those for assets, measurement is relatively problematic for liabil-
ities in practice, primarily because conservatism encourages the recognition of liabilities that
have no observable measure. However, the IASB does not acknowledge either the limitations
of measurability or the existence of conservatism. This leads the IASB to seek all its answers
within the context of measurement. In contrast, conservatism has become increasingly important
in the literature, in particular in positive empirical studies. The literature does not, however, offer a
sufficiently normative theory of conservatism, and it therefore falls short from the perspective of
adoption by the IASB in the Framework and in accounting standards. Our paper therefore has
implications for both revisions to IFRS and for further research.
The implications for revising IFRS are as follows. First, measurement should be defined more
tightly in the Framework and contrasted with estimation, in line with the analysis in Sections 3
and 4. This tightening would make verifiability a necessary requirement for measurement, in con-
trast with the present state where verifiability is ‘desirable but not necessarily required’. The tigh-
tening would also clarify that the current notion of faithful representation in the Framework
covers two distinct concepts, being the accurate reporting of an observable amount and the faith-
ful description of the process of estimating an unobservable amount. Second, the recognition
thresholds in the Framework should be re-defined in line with Figure 1 and the associated analysis
in Section 4. Accordingly, all measurable amounts would be recognised, with the criteria of
reliable estimation and probable outflow being reserved for estimates. Third, the probable
outflow recognition threshold should either be justified conceptually in the Framework or elimi-
nated. Such justification cannot in principle be based upon the concept of measurability, for the
reasons argued in Section 4, but needs to be set in the context of whether estimation (albeit
reliable) of unlikely outflows provides useful information. Fourth, and in line with the analysis
in Section 5, individual accounting standards should make a clear distinction between amounts
that are measures and those that are estimates, noting that only the latter give rise to the subjective
issues of probability distributions of expected cash flows, discount rates and risk-adjustments.
Beyond these proposed changes to IFRS, there is also scope for further improvement, yet for
this to be possible there is a need for a normative theory of conservatism. Meeting this need is an
implication of the paper for further research. The potential for research in this area can be illus-
trated with two examples.
The first example concerns the degree of differential verifiability that IFRS should require for
the recognition of gains and losses, and the extent to which this should vary in different appli-
cations. For practical purposes, accounting standards need to specify not just whether conserva-
tism should be applied, but also to what degree. This requires understanding the potential benefits
of conservatism in different settings, for example, where there exist different asymmetries of
incentives and information. One possible line of enquiry would be to address the underlying be-
havioural aspects of conservatism, for example, by modelling a decision-maker’s utility as a func-
tion of his or her degree of ambiguity aversion, which in turn determines the desired level of
conservatism (Gilboa and Schmeidler 1989). In such a setting, which could be modelled analyti-
cally and/or tested experimentally, the level of ambiguity can be determined endogenously by the
game-theoretic actions of other players, enabling analysis not just of information asymmetry but
also of incentive asymmetry.
The second example concerns financial statement presentation, in particular whether estimates
recognised conservatively should be presented differently from amounts reported as observed
measures. On this question, a normative approach would seek to develop financial statement pres-
entation in a way that is currently not required. Not least, an implication of the IASB’s presump-
tion of measurability is the effective denial of the role of forecast error in balance sheet valuation,
because errors are presumed to arise from measurement alone (Christensen 2010b). Yet if the
concept of forecast error is acknowledged, amounts recognised on the basis of an estimated prob-
able outflow provide useful information, albeit of a different nature than observable measures.
Management’s willingness and ability to forecast future outcomes provide information both ex
ante, at the time of the forecast, and ex post, in comparing the outcome that was forecasted
with that which ultimately arose. Acknowledgement of the role of forecasting error, and of a dis-
tinction in financial statement presentation between measures and estimates, and between ex ante
forecasts and ex post forecast revisions, would enhance the informational usefulness of the finan-
cial statements (Barker 2004, Glover et al. 2005, Gassen and Schwedler 2010).
In conclusion, our paper is motivated by extant and important conceptual inconsistencies in
accounting for liabilities in IFRS, for which the literature offers limited directly relevant analysis.
We seek to apply a distinction between observable measurement and estimation in order to
explain these conceptual inconsistencies, which leads to three conclusions: first is the need to
revise the treatment of recognition and measurement in IFRS, in order that it can encompass
the concept of estimation as well as that of measurement; second is the need to introduce a
theory of conservatism in IFRS, in order to justify the recognition of estimates; and third is the
need to develop a normative theory of conservatism in the literature, in order to enable and
justify a greater impact on policy and practice.
Acknowledgements
The authors gratefully acknowledge input and support from the editorial and review process at Accounting
and Business Research; seminar/conference participants at the Universities of Aberdeen, Cambridge, Edin-
burgh and Oxford, and at the FRC’s Academic Panel, ICAS and the EAA (Ljubljana); workshop funding
from the ICAEW Charitable Trusts, EFRAG and the University of Aberdeen.
Notes
1. See Section 5 and Table 2.
2. Of course, expectations of the future do currently exist. The extent to which they should be used as the
basis recognition in the financial statements is discussed later.
3. As noted above attributes may or may not have a currently observable measure. If not, they are not
measurable, and hence are not strictly ‘measurement attributes’. However, the literature (both aca-
demic and professional) often refers to all attributes considered for recognition as measurement attri-
butes. To make easy reference to that literature, we also use measurement attribute in that general
manner, but distinguish in our analysis between attributes with currently observable measures and
those that are estimates.
4. While our focus is IFRS, our analysis is equally applicable to US GAAP (Benston et al. 2007). The
FASB’s conceptual framework provided the foundation and logical structure for the IASB’s Frame-
work (Storey and Storey 1998), and the 2010 revisions to both frameworks were carried out jointly
by both IASB and FASB, and adopted simultaneously by both, consistent with the 2002 ‘Norwalk
Agreement’ to achieve convergence (FASB 2006).
5. A more detailed summary is given in Table 2, which we discuss later in the paper.
6. This holds notwithstanding that the challenge in practice is reduced if there is, first, a larger sample of
underlying events determining the value of the liability and, second, greater relevant past experience;
both factors improve confidence in forecasting, as well as the information content of subsequent re-
measurements. See later discussion on ‘reliable estimation’.
7. The definitions in this section are those, still extant, from the 1989 version of the Framework.
8. See EFRAG et al. (2013a) for a discussion of these alternative approaches.
9. In practice, an interpretation such as ‘more likely than not’ is consistent with both the Framework
(Botosan et al. 2005) and with the binary nature of recognition (an item is either recognised or it is not).
10. See EFRAG et al. (2013c) for a discussion of this issue in the context of the current IASB project to
revise the Framework.

11. This assumes that the attribute in question is determined by a single observable measure, for example,
cost given by the price in an actual transaction. It is the case that sometimes the definition of an attribute
may involve a choice between two or more observable measures. For example, determining fair value
may require a judgement to be made about which market to observe the transaction price. Two attri-
butes, a retail market price and a wholesale market price, may both be observable, but determining the
attribute of fair value as defined by the IASB still requires a judgement, and hence leaves open the
possibility of lack of consensus. We do not discuss in this paper whether in such cases the attribute
of fair value is currently observable or not. The point is that the IASB has extended the notion of ver-
ifiability beyond that in the academic literature.
12. The 2010 revision to the Framework explicitly removed the word ‘measurement’ from the text.
13. The IASB’s approach to faithful representation is consistent with its own (1989) definition of measure-
ment, but this is only because that definition is similarly loose. The Framework states that ‘Measure-
ment is the process of determining the monetary amounts at which the elements of the financial
statements are to be recognized and carried in the balance sheet and income statement’ (para 99).
Under this definition, anything that ends up being recognised in the financial statements has been
through some (undefined) process of measurement. Equally, a ‘numerical depiction’ can be deemed
to be faithfully representational even if it cannot in principle be verifiably complete, neutral or free
from error. In short, these definitions broaden, and so weaken, the definition of measurement to the
extent that it loses any effective meaning. Such an approach opens the door to an alternative interpret-
ation of the role of measurement in accounting. Power (2004) notes that ‘the contemporary perform-
ance measurement imperative does not depend on a view that measurement reveals things as they
really are’. A ‘measure’ in this context can be socially constructed, functioning as a measure
without actually being one.
14. The leases ED does, however, propose that, for the purposes of estimating the cash flows for a lease
liability, the term of a lease should be determined as the longest lease term that is more likely than not
to occur. This approach is described as a recognition approach to determining the cash flows.
15. In this context, the IASB has stated ‘The IASB regards aligning IAS 37 with other IFRSs – so that all
liabilities are recognised – as more important than preserving consistency with all aspects of the exist-
ing 20-year-old Framework’ (IASB 2010).
16. IAS 19 requires an entity to recognise a liability for profit-sharing and bonus payments only if, inter alia,
a reliable estimate of the obligation can be made, and it gives specific conditions for this to be the case.
IAS 19 also requires an entity to account for its share of a multi-employer defined benefit plan as if it were
a defined contribution plan (i.e. not to recognise a liability for any deficit in the plan) if it cannot identify
its share of the underlying financial position and performance of the plan with sufficient reliability for
accounting purposes. For other defined benefit plans, IAS 19 explicitly assumes that an entity can use
actuarial techniques to make a reliable estimate of the benefit that employees have earned.
17. The attributes described in the Framework are historical cost, current cost, settlement value and present
value.
18. The requirement in IFRS for the use of unobservable fair values should not be over-stated. For
example, Gebhardt (2012) reports, for non-financial companies in the STOXX Europe Large 200
Index, that only 6.4% of financial liabilities are carried at fair value and that 90.7% of these are
based upon observable data (Level 1 or Level 2).
19. Some measurements allowed under IFRS 4 may not be discounted.
20. The reason given in the basis for conclusions is that this approach is consistent with a cost-based
measurement. The leasing project seems to be the outlier in this respect. The discount rate is not
updated, even when the cash flow estimates are.
21. The ED notes that the effect of credit risk in such transactions should be minimal, because policy-
holders do not take out insurance with companies that they expect to default.
22. For a review of empirical contributions, see Botosan et al. (2005).
23. In practice, of course, asset and liability values may differ for loans and other financial instruments also
(e.g. Gray 2003).
24. The cost of release is captured by the amortised cost method if there is an absence of cancellation
charges or similar contractual clauses (This need not hold universally – for example, if initial recog-
nition in an entity’s accounts does not coincide with initial inception of the loan, or where there are re-
measurements.) In the case of the fixed-rate bank loan, this (entity-specific) amount will be higher than
fair value if there is an increase in either the rate of interest or the entity’s credit risk (Lipe 2002).
25. Insurance is a hybrid between pensions and deferred consideration: the liability is an expected but
uncertain outflow of cash, not products or services.

26. Entity-specific measurement limitations can be assumed away in the standard-setting literature, as, for
example, illustrated in Leisenring et al. (2012).
27. By provisions we mean liabilities under IAS 37. We do not discuss adjustments to asset measurements
such as impairments of accounts receivable, which are not liabilities.
28. This approach of indirect, proxy measurement can be argued to provide the prevailing logic of histori-
cal cost accounting (Paton 1922, Sterling 1970). The converse case to that given above can be true also:
the example of an asset generated by (some) share-based compensation illustrates the case of an exit
value that is observable with an entry value that is not observable.
29. The carrying amounts of assets can also require estimation, on initial recognition for assets held under a
finance lease, and on re-measurement for assets that have become impaired. Setting standards on
impairment throws up similar issues to those discussed above in relation to estimating liabilities, pre-
cisely because it involves a process of estimation rather than measurement (O’Hanlon 2013). Finance
lease assets, although not having an observable measure, can be estimated within a relatively narrow
range if there is sufficient evidence from other sources of an appropriate cost of finance.
30. In this respect, the 2010 version of the Framework suppresses the discussion of the 1989 version,
which had explicitly justified conservatism in terms of greater verifiability requirements for assets
than for liabilities, based upon a presumption of opportunistic incentives arising from an agency
relationship. See EFRAG et al. (2013b) for a discussion of these issues in the context of the current
IASB project to revise the Framework.
31. In the light of the earlier discussion of measurability, it is ironic that the IASB is in agreement with
Sterling (1970) in rejecting conservatism.
32. For listed debt, changes in market value are currently observable and so absence of measurability
would not be a justification for non-recognition (Archer and Peasnell 1985). This observability does
not hold in general, however, and conservatism could justifiably be positioned as the basis for consist-
ency in accounting practice.
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Accounting and Business Research

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Why is there inconsistency in accounting for

RICHARD BARKERa∗ and ANNE MCGEACHINb∗

# 2013 Taylor & Francis

2. Research method: analysis, application and development of theory

Table 1. IFRS sources on liability recognition and measurement.a

IFRS 4 insurance contracts 2004 N/A N/A

3. The boundaries of measurability

4. Recognition and measurement in the conceptual framework

Figure 1. Recognition algorithm for liabilities.

Forming part of a conceptual shift that Power (2010) characterises as a ‘transformation of

own deﬁnition of faithful representation to be interpreted and applied incorrectly as a deﬁnition of

5. Recognition and measurement in accounting standards

Recognition Measurement/ Estimation

Accounting and Business Research

for other deﬁned corporate bonds

R. Barker and A. McGeachin

Accounting and Business Research

outﬂow (2) Reliable (4) Observable (5) Expected value

R. Barker and A. McGeachin

6. Conservatism and the distinctive nature of liabilities

Table 3. Assets vs. liabilities – measurement attribute analogues.a

service potential of the existing replacement of the liability)

Table 4. Measurement attributes on initial recognition.a

revise the Framework.

uncertain outﬂow of cash, not products or services.

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