The Accounting Onion

Merrily We Roll Along -- Forward and Up

It took seven years for the FASB and IASB to publish its "preliminary views" exposure draft (ED) on the fundamental issues addressed by the Boards' joint financial statement presentation project. And just recently, the FASB staff has posted a ten-page tabular summary of their "tentative decisions as of December 2009."

My own views, which I have expressed in four previous points (see the list, below) are neither "preliminary" nor "tentative." Granted, I am not bound by due process constraints, but eight years and counting has been far too long to wait for closure on a project that will have absolutely nothing to say about recognition or measurement. As my previous posts will indicate, I have also been extremely frustrated by some of the puff-pastry notions contained in the DP—and that are still on the table in some form or another:

First, there is no investor value created from allowing management to determine how a transaction is classified on the financial statements. Yes, every business is different, but there are still only two principles-based categories of transactions/events in which an enterprise may engage: 'financial' and 'non-financial.'

Even rudimentary delineation of the non-financial category into 'operating' and 'investing' activities has proven futile, and should be abandoned. For example, is the acquisition of inventory an investing or operating activity? Is purchasing one new machine to replace a worn-out machine on the factory floor arrayed with 1000 machines an investing or an operating decision? At best, even the operating/investing dichotomy it is too subjective to be audited, and at bottom, it is a distinction without a substantive difference.

Even allowing that there are some informative ways to further delineate ongoing operating activities, affording management the latitude to make those determinations is a loser before the opening bell is rung. Accounting standards should require a principled separation of financing from non-financing, but that would challenge the sacred cow of interest cost capitalization—so it ain't gonna happen.

Second, no investor value can possibly be created simply by re-arranging the financial statement deck chairs, even in the name of a newly coined "cohesiveness principle." Disaggregation is where it's at, and in that regard there does happen to be a role for that idea; as I am about to explain, however, it appears to not a role envisaged by the Boards.

A Promising New Direction

Having gotten that off my chest, I do very much want this latest missive to be seen in a positive and constructive light. To wit, there is one new piece of information, to be found in the very last item of that ten-page table that knocked my socks off. It's somewhat lengthy, but worth repeating:

"Replace the proposed reconciliation … [of cash flows to comprehensive income] with an analysis of the changes in balances of all significant asset and liability line items. Each line item analysis should distinguish the following components:

a. Changes due to cash inflows and cash outflows

b. Changes resulting from noncash (accrual) transactions that are repetitive and routine in nature (for example, credit sales, wages, material purchases)

c. Changes resulting from noncash transactions or events that are nonroutine or nonrepetitive in nature (for example, acquisition or disposition of a business)

d. Changes resulting from accounting allocations (for example, depreciation)

e. Changes resulting from accounting provisions/reserves (for example, bad debts, obsolete inventory)

f. Changes resulting from remeasurements

Present information about remeasurements in the financial statements.

• FASB: require disaggregation of remeasurements on the face of the statement of comprehensive income (SCI) in a columnar format. Those two columns should be labelled total comprehensive income and remeasurements.

• IASB: require presentation of remeasurements in the notes to financial statements.

Modify the definition of a remeasurement. The working definition of remeasurement is: an amount recognised in comprehensive income that reflects the effects of a change in the carrying amount of an asset or liability to a current price or value (or to an estimate of a current price or value). A current price or value includes the following measurement attributes: fair value, fair value less costs to sell, value in use and net realisable value. [bold italics supplied; dates omitted]"

This is pretty big news, AND IT COULD BE HUGE! However, I'm afraid the devil will be in the implementation details. That's why I'm going to spell it out for the Boards in simple terms: what is actually needed, why it's needed, and how to do it.

The What — The Boards enunciated in their original exposure draft an objective that financial statements should be presented in a manner that "presents a cohesive financial picture of an entity's activities." I'm not exactly sure what they mean by "cohesive" even after looking up that term in a few dictionaries.  Nonetheless, as a metaphor to financial reporting, the term resonates as regards the relationship between financial statement notes and the financial statements themselves. "Cohesiveness" should mean that the financial statements hold together, in a coherent or cohesive manner, the quantitative information in the notes. Stated even more plainly, every balance sheet line item should be "rolled forward", and each line item in the 'flow financial statements' (e.g., income statement, statement of cash flows, statement of changes in shareholders' equity) can be found to be the sum of line items in those balance sheet item roll forwards. That's what I mean by HUGE.

The Why — As I have already stated, disaggregation is where it's at. With XBRL around the corner, analysts will most certainly be competing with each other to create the sexiest non-GAAP measures of financial performance they can by plucking a little tagged something from here, and combining it with a little tagged something from there. If you're a sports fan, you are probably aware of all the new and interesting baseball stats created by imaginative analysts—once they were able to get their hands on the underlying data.

The statistics revolution in financial reporting should make the baseball stats revolution look like—well, what it is—a mere game. To pick just two of hundreds of possibilities an analyst should be able to identify each component of a foreign currency translation adjustment, and decide whether to accept it as presented, or to make one's own pro forma adjustments. Or, if you don't like capitalized interest, an analyst should be able to reverse every stinking dollar of it.

A more subtle, but equally important reason for comprehensive roll forwards is that it will be a huge enhancement to external controls over financial reporting (and along with that, something for an auditor to really audit). Much has been said and written about the importance of internal controls over financial reporting, but a financial regulator's basic responsibility is not merely to mandate internal controls, but to impose substantive external controls. Any control expert should tell you that if you can't roll forward a balance sheet account, you can't hardly test its accuracy. If everyone should be doing their roll forwards internally, and they are quite obviously an efficient form of disclosure, then what is keeping regulators from mandating them? (The sad answer to this question shall be provided anon.)

The How — The extract I have provided from that ten-page table leaves a lot of implementation questions unanswered; and admittedly, it's only a summary of what the Boards may be thinking. The area of greatest concern to the Boards appears to be the level of detail to be provided in the roll forwards.

Once again, that new-fangled "cohesiveness principle" makes the answer to their dilemma straightforward: the Boards need merely to specify that the line-item detail of the roll forwards must be sufficient to allow "roll ups" to each of the lines in the flow statements. For example, if the FASB wants to separately identify "remeasurements" (more on that unfortunate term later) on the statement of comprehensive income, then the remeasurement components in a balance sheet line item roll forward must perforce be set forth.

I am compelled to add as an aside, though, that if the board is struggling to define "remeasurement," they should first acknowledge that the term is already spoken for in another part of GAAP. ASC 830-10-45-1 (within the Foreign Currency Matters topic) identifies remeasurement as a process by which the books of record of an entity are converted to its "functional currency." Contrary to the Boards' proposed new definition, what is currently regarded as remeasurement does not necessarily result in "current prices" or "current values." So, if new terminology is indeed required, which I recognize is likely the case, I would humbly suggest a couple of terms that convey the objective more straightforwardly: like "revaluaton" or "valuation adjustment."

Alas, the "Why Not"

The sad reality is that issuers will balk severely and senselessly at comprehensive roll forwards. And, who knows whether the toes-in-water approach now suggested by the Boards will prevail, or perhaps ultimately drive a wedge between them? I'm betting that the FASB will insist on something at least close to the sensible approach that they have finally put forward.  Meanwhile, the EU will threaten to ditch the IASB unless they get back with the a la carte chicken-salad-for-issuers program they have ordered.

As for yours truly, I don't believe issuers who will claim that balance sheet roll forwards (much less a direct cash flow statement) are a bridge too far – and neither should any reasonably intelligent undergraduate accounting major. If consolidated income statements already articulate to consolidated balance sheets, then why can't the components of those statements articulate? The simple answer is that they should – and they must.

Simple can be beautiful; that's why I like accounting. Comprehensive roll forwards that permit comprehensive roll ups would not solve every single problem that exists in regard to financial statement presentation.  But, by comparison to every other concept or objective offered up by the Boards during the past eight years and counting of this project, everything else is weak tea.
-------------------------------------------------

*Those four posts are as follows:

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

Financial Statement Presentation: The Sequel

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Financial Statement Presentation: Will Issuers or Investors Prevail?

Goodwill Impairment: I Love a Charade (Re-posted)

Kind readers:  To the best of my knowledge, the first version of this post was not picked up by the software that magically distributes it to my email subscribers; therefore, I am re-posting it for them. I apologize to anyone who has received duplicate notices. 

I have written about initial recognition of goodwill on numerous occasions. I suppose it might be less bothersome if goodwill had the good grace to sit and stay like a good dog on the balance sheet at its opening 'value'; but alas, such is not the case. Not even close.

Goodwill impairment tests chew up good money, and as I am about to describe, they screw up the accounting for just about everything else. Even in the best of circumstances (by which I mean that goodwill could actually be something more than a garbage can for overpayments, mis-measurements and measurement exceptions) the goodwill impairment test is a ludicrous charade.

To Illustrate

Let's start with a simple set of made-up facts, albeit loosely based on a real situation as described to me. The teller of the tale attended a business combinations workshop that I had recently led:

Acquiror Company purchased 100% of the outstanding shares of Target, a consulting company for $1,000. None of Target's liabilities were assumed; the only asset eligible for recognition other than goodwill was a customer-related intangible, with a fair value of $400 million and an expected economic life of 8 years. Therefore, goodwill was initially "measured" (the FASB's misleading term, not mine) at $600 million (=$1,000-$400). Why such a high amount for goodwill? Acquiror viewed Target's assembled workforce to be its most valuable asset, which may not be recognized separately under GAAP (or IFRS).

One-year later, negative events associated with the recession significantly diminished Target's prospects. Principally, the value of the previously recognized customer related intangibles declined significantly; however, their remaining expected economic life still has seven years to run. (The remaining expected economic life of the asset is not particularly relevant to my analysis to follow, but there it is, anyway.)

U.S. GAAP requires that the customer-related intangible be tested for impairment before the goodwill is tested. To make a long story mercifully short, one first assigns the current carrying amount to the smallest cash-generating unit (CGU) for which cash flows can be reasonably attributed. Acquiror determines the CGU to be Target itself, and then determines the expected undiscounted cash flows to be just slightly greater than $350 million (which is the carrying amount of the CGU. Thus, no impairment of the customer-related intangible is recognized, even though its value is surely far below the carrying amount.

Now, it's on to the goodwill; and for the FAS 142 cognoscenti among you, we shall stipulate that Target constitutes a "reporting unit." Cutting to the chase again, GAAP requires that the current fair value of Target be compared to its carrying amount. Let's say that the fair value of Target is determined to be $300 million. Since that's less than Target's carrying amount of $950 million (=$350 + $600), Acquiror must launch itself through the gauntlet of the goodwill impairment test, known as "Step 2."

Step 2 requires Acquiror to pretend that it purchased Target today for its fair value, and to figure out what goodwill would be recorded at today, should that impossible fantasy somehow be the reality. So, let's see: assuming a purchase price of $300 million and a fair value for the customer related intangible of $200 million, the "implied fair value of goodwill" (another fabricated and misleading term to add to one's collection) comes to $100 million.

Thus, a "goodwill impairment" of $500 million (=$600 - $100) must be recorded, even though everyone and their brothers and sisters all know that it is the customer-related intangible that is deep underwater. Acquiror's management knows that the customer-related intangible is worth $200 million less than the amount reported on the consolidated financial statements, but investors don't know that. All they see is a writedown to goodwill; which everyone and their brothers and sisters dismiss as merely the result of an arbitrary recalculation of an arbitrary calculation.

So now you know why issuers don't complain too much about goodwill impairment accounting, even though the charade by which it is calculated can be a gigantic pain in the tuchas. It's just one more line of defense for hiding information about real impairments on any kind of long-lived asset other than goodwill that you can imagine. Nothing actually re-measured, only goodwill actually lost.

Is IFRS Any Better?

No. It's worse and with no prospects of improvement anywhere close to being on the horizon. Unless management elects to separately estimate the "recoverable amount" (higher of net fair value and "value in use"), then all of the goodwill and customer-related intangibles carrying amounts are thrown into the CGU bucket. If the CGU's fair value is less than its total carrying amount, then you will always write down goodwill before you touch any of the other long-lived assets.

Although in this case the GAAP and IFRS answer would be identical, the difference is that under GAAP there is at least some chance that non-goodwill assets would be stated at a more realistic value for them. Moreover, the SEC has demonstrated its awareness of the anomaly and willingness to hold a registrant's feet to the fire. For example, here is one case of an SEC comment letter to a company expressing its incredulity that goodwill was written down while miraculously preserving the carrying amounts of its non-goodwill assets:

Taking into consideration the circumstances that caused you to recognize an impairment charge on the Birmingham market goodwill, tell us whether you first tested your long-lived assets … If you did test your long-lived assets for impairment, explain to us in why an impairment charge was not recognized. If you have not tested your long-lived assets for impairment explain to us why not. Please also tell us how you group your long-lived assets for purposes of testing your long-lived assets for impairment …. [Letter from the SEC to Cox Radio, Inc., dated July 17, 2006]

Don't Worry, Be Happy

Small wonder that goodwill and long-lived asset impairment is not on the rush-rush 2011 convergence agenda, or even anytime thereafter. The financial crisis has clearly demonstrated, asset impairment accounting is a sacred cow that may only be approached in circumstances involving extreme unction. Not very long ago, it was hard enough for the FASB to push through any sort of consistent impairment standard for long-lived assets. Now, with the EU already threatening to jump ship on financial instrument impairment, the only choice the Boards have is to pretend that the shortcomings of impairment standards are not a high priority, not to mention the gaping inconsistencies within and between IFRS and GAAP.

I love a charade.

The FASB's Mission Incomprehensible

I had believed that one of the few positives that would come out of the wave of accounting scandals that broke at the beginning of the just-completed decade would be a general awareness of the critical role that financial reporting and its regulation plays in the functioning of large economies. There certainly seems to be more in-depth coverage in business periodicals, but little else. For example, I was appalled at how little coverage my hometown paper, the Arizona Republic gave to the SEC investigation of Phoenix-based Apollo Group's revenue recognition policies.

But, the NYT's Paul Krugman soothed my feelings more than a little in his last column of 2009 (which incidentally was at the top of the Times' 'most emailed' list for about a week:

"For as the decade began, there was an overwhelming sense of economic triumphalism in America's business and political establishments, a belief that we — more than anyone else in the world — knew what we were doing.

Let me quote from a speech that Lawrence Summers, then deputy Treasury secretary (and now the Obama administration's top economist), gave in 1999. 'If you ask why the American financial system succeeds,' he said, 'at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles: it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities.' And he went on to declare that there is 'an ongoing process that really is what makes our capital market work and work as stably as it does.'

So here's what Mr. Summers — and, to be fair, just about everyone in a policy-making position at the time — believed in 1999: America has honest corporate accounting; this lets investors make good decisions, and also forces management to behave responsibly; and the result is a stable, well-functioning financial system.

What percentage of all this turned out to be true? Zero." [my emphasis]

And this assessment comes from a guy who has repeatedly displayed a soft spot for financial regulation. Considering the sheer size of diversity of Krugman's audience, it is a devastating indictment that should make the FASB's ears ring.

It All Begins with a Mission Statement

My dear wife, Jane, had a long and distinguished career as an information systems consultant; and her engagements usually began with an in-depth examination of the client's mission statement. Thusly is writ the first sentence of the FASB's:

"The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information. …"

 

Jane has very patiently explained to me on multiple occasions the purpose of a mission statement, and what it should say about an organization. I have to confess, however, that my mind doesn't work on that level. But, I did absorb enough to know that one's mission should be clearly stated and universally understood.

I have studied accounting intensely for more than thirty years, and I don't understand the FASB's mission statement. The only substantive indication I can glean from it is a clear intent to be unclear, thereby rendering the processes in place for setting accounting standards as muddled as the standards themselves. Aside from just being able to state that one does indeed have a mission statement, its only apparent use to the FASB is as a sort of blank check to throw a bone whenever it wants to whomever it wants.

Of course, methinks it should be quite easy to write a sensible and comprehensible mission statement. I offer this one, which I threw together in about 15 minutes, just to kickoff the rest of this conversation with myself.

The mission of the FASB is to establish and revise standards of financial accounting and reporting that significantly improve the usefulness of financial statement information to current and potential investors. Recognizing that significant improvements are urgently needed in numerous aspects of accounting and financial reporting, the Board is to continually evaluate the pace of change, and whether its short- and long-term goals are appropriate considering the current informational needs of investors.

The Board also gives due consideration to the feedback from non-investor stakeholders – principally auditors, preparers, attorneys and other finance professionals – to the extent that such feedback provides relevant information regarding cost and feasibility of a proposed change to standards. However, the evaluation of a proposed standard's effect on relevance and reliability, is to be made independent of feedback from non-investor stakeholders.

Now, that's a mission statement I hope Jane would be proud to read. It's a clear a set of marching orders that identifies the organization's 'customers', what to produce, and how to produce it.

Convergence: Mission Impossible

Convergence with IFRS could be the clearest and most timely example of how a true mission statement would direct the FASB goals and processes; there should be general agreement that standards production efforts over the past decade have been focused on attaining convergence with International Financial Reporting Standards. Yet, convergence is neither a necessary nor a sufficient condition for producing significant improvements to the quality of accounting and financial reporting.  As such, according to my own view of what the FASB's mission should be, it is a non-core activity. Indeed, a decade's worth of "zero," as Paul Krugman would have it, must perforce lead one to conclude that convergence has been a prime sourcesof standards production inefficiencies.

I could cite any number of examples of counterproductive behavior resulting from convergence fixation, not the least of which would be the current idiotic "debate" over fair value for financial instruments. But I cannot possibly do any better than Dennis Beresford, erstwhile FASB chair, in a recent posting to the AECM listserv (frequented by about 700 academics and other interesting people):

"But what I find most interesting about the recent decision for the Boards to start meeting every month and to complete the converge plan by 2011 is that these are projects that have begged for a solution for decades in some cases and now they will supposedly be finished in two years. The consolidation project, for example, was added to the FASB's agenda in 1982 and the Board has never been able to operationalize a definition of 'control.' But somehow the joint efforts of FASB and IASB will now solve that issue in 24 months, including all of the normal due process.

 

And the IASB has just issued an exposure draft on financial instruments impairment and other issues. One 'feature' of that ED is that loan losses will be accounted for using an expected loss model rather than the incurred loss model we have in SFAS 5. This means that companies will have to predict future losses over the lives of loans and not just record what has already happened. Some of the old timers on this list may recall that one of the main reasons the FASB issued SFAS 5 was to eliminate the practice of accruing "catastrophe losses" in advance. In other words, casualty insurance companies that previously priced policies and accrued for a portion of expected future losses for floods, hurricanes, etc. could no longer do so. The new IASB exposure draft deals with with [sic] loan collections and not casualty losses but the principle is the same and applying it would move us back to the pre-SFAS 5 accounting. Is that progress? More importantly, is that something that is capable of being accomplished before the end of 2011?" [italics supplied by me]

Here we have yet another devastating indictment of the process that has dominated standard setting for the past decade. Some convergence has been achieved, but far short of a reasonable goal, even if one were to believe that convergence, in and of itself, were a valid goal to embrace. Just one implication of Denny's comments is that the legacy of the FASB's fixation on convergence could be the entire world ending up with German-style hidden reserves all over again. (I can't resist pointing out that I am writing this while on a plane heading to Frankfurt!)

Convergence has been the tail wagging the dog of high quality accounting standards. The FASB could be much better by starting 2010 with a reconsideration of its mission statement, instead of a head-over-heels run to a finish line – precisely situated at the edge of a cliff.

A Modest List of Financial Analysis 'Red Flags'

My blog 'readership' (shame on me for using such a stuffy term!) primarily consists of preparers, auditors and journalists. But, for those intrepid analysts who actually do read my blog, this week I have something especially for you! I humbly offer you a list of red flags for you to think about adding to your own personal collection.

But first, permit me this minor rant.

I have given some thought as to why analysts may be somewhat indifferent to my commentary – or more importantly, why very few submit comments of their own on SEC/FASB rulemaking proposals. My gut feeling is that analysts tend not to create much value for themselves by taking time to think about what financial reporting should be. To do so would just take time away from one's core activity of decoding the steady stream of dressed-up offal, prepared according to the latest financial reporting recipe book and tastily seasoned by management.

My objective in pointing this out is to make the point that it is a grave mistake for policy makers to believe that analysts are interested in accounting rules that make the world a better place. Just like most everyone else, financial analysts are focused like laser beams on creating value for themselves. The policy implication is that, instead of pining for more comment letters from investors, the FASB and SEC (and IASB) should acknowledge the free rider problem in their 'due process' deliberations. To my way of thinking, investor protection is usually accomplished by the exercise of common sense a la Justice Louis Brandeis' sunlight being the best disinfectant rule of thumb, and policymakers should have the gumption to act accordingly. Comment letters from special interests urging some other path are dross, even if they outnumber investor comments by a margin of 100 to 1.  

Now, on to the red flags.

#5 – Younger companies meeting growth projections for the umpteenth time in a row. I am suspicious when a relatively young company has consistently generated above average returns even while its product portfolio is clearly maturing, and its industry has become more competitive. It is often the case that management seeks to extend its recent record of rapid growth in sales and profitability by unconventional means, because it has not been able to identify investment opportunities within its historical core competency (generally, some form of cost reduction or product differentiation strategy). That's when the earnings games begin: aggressive estimates, drawing down 'earnings banks', selling assets for accounting gains, taking on excess leverage, or entering into byzantine financial transactions.

The Apollo Group, which I wrote about regarding the SEC's investigation into its revenue recognition policies, seems to fit the profile. It entered the for-profit college degree business when it was still young, and appears to have established the model for later entrants to emulate. Moreover, one of its more distinctive products, online classes, seems to be becoming commoditized as non-for-profits have undertaken changes in their "business models" to better respond to the needs of part-time and geographically distant students.

#4 – Management has adopted a minimalist approach to disclosure. My suspicions, and my hackles, are raised by multibillion dollar companies claiming that they have only one reportable segment. Some might say that that management, by evading segment disclosure, is fighting the good fight so as to prevent actionable information from falling into the hands of competitors. But, something is rotten in Denmark when companies alter their internal communications for the apparent purpose of floating a disingenuous tale that their "chief operating decision maker" is willingly in the dark when it comes to significant components of its operations.

When ITT Educational Services Inc. reports having an executive officer of its "online division," yet implicitly claims that it has no obligation to provide disaggregated information on that part of their business (either in MD&A, or the financial statement notes), I become suspicious. Although Apollo does provide some segment disclosures, its annual report is notably silent on the effects of online courses on recent earnings trends. (Some unsolicited advice to both companies: I respectfully suggest that they read the SEC's enforcement release regarding Sony's MD&A deficiencies and take heed. All it could take is one impairment charge or restructuring to put the Enforcement Division on their tails for similar omissions.)

I also blanch at boilerplate MD&As, particularly when no overview section is provided, the summaries of critical accounting policies are rote recitations of standard GAAP, and mechanical recitations of numbers masquerade as "analysis."

Here's a portion of Apollo's MD&A that caught my attention, and which I did not to mention in my earlier post. To set the stage, you should know that Apollo reported gross student accounts receivable of $380 million less an allowance for doubtful accounts of $110 million. Total revenues reported were $3,974 million.

"For the purpose of sensitivity, a one percent change in our allowance for doubtful accounts as a percentage of gross student receivables as of August 31, 2009 would have resulted in a pre-tax change in income of $3.8 million. Additionally, if our bad debt expense were to change by one percent of total net revenue for the fiscal year ended August 31, 2009, we would have recorded a pre-tax change in income of approximately $39.7 million."

Even ignoring the wow factor of Apollo's gigunda allowance for doubtful accounts, SEC rules imply that a sensitivity analysis should flex base estimates by a minimum of 10% (see Regulation S-K, Item 305, on sensitivity analysis for "market risk sensitive instruments) to be reasonably indicative of the underlying risks being modeled; Apollo's is only 3.5% (= 3.8/110); by comparison, a grudging token.

On the other hand, Apollo does report that if their allowance were an additional 1% of revenues, net income would be reduced by a much more significant sum. However, that statistic hardly qualifies as a "sensitivity analysis." That's because cash flows underlying revenues can come from either tuition payments made in advance (a very substantial amount in Apollo's case), or from payments made in arrears. Multiplying a non-collection rate, however determined, by cash flows that have already been collected makes no sense.

Finally, another pet peeve of mine is when there are no substantial differences between this year's and last year's MD&A, except for different numbers inserted between the words.

#3 – Management is obsessed with earnings reports. Beware of companies whose management appears to be fixated on reported earnings, usually to the detriment of attending to real drivers of value. Indicators include the aggressive use of "non-GAAP measures of performance," "special items" or "non-recurring charges." Watch out as well for highly decentralized operations where division managers' compensation packages are heavily weighted toward the attainment of reported earnings or those non-GAAP measures of performance.

Here are two examples of apparently obsessed managers. The older example is one that I have written about in the past. GE, under Jack Welch's leadership, had acquired Kidder-Peabody in the mid-1980s.  It was ultimately determined that much of the earnings that Kidder had reported were bogus.  As a consequence, GE was would announce within two days that it would take a non-cash write-off of $350 million.  Here is how Jack, "there was only one way – the straight way," Welch described the ensuing meeting with senior management in his memoir, Straight from the Gut:

"The response of our business leaders to the crisis was typical of the GE culture [my emphasis].  Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap.  Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise.  Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people." [p. 225]

I doubt if, in this post-Enron and S-OX 404 environment, a CEO today would so openly express such a blatant disregard for reporting to investors, but I also doubt if things have changed much at many companies – especially those where the CEO and board chair are one and the same, stock options to the CEO have the potential to dwarf the other compensation components, and the audit committee lacks gumption and sophistication.

A more current example is Overstock.com, which Floyd Norris very colorfully described in his NYT blog. In brief, their CEO fired the company's newly-appointed auditor before it could even render its first opinion on the company's annual financial statements. The auditor's crime, it appears, was to have changed course on the treatment of a non-recurring gain: whether it should be reported as income in the current year, or should have been pushed back to a prior year. In other words, no cash flow effect, and no discernable consequences on future operations. I would not be surprised if the accounting treatment directly affected the CEO's 2009 cash bonus, or tips the company toward the wrong side of a loan covenant.

#3 – Restructuring and/or impairment charges. Years ago, it was often the case that a company's stock price would rise after it recognized a "big bath" charge to the current period's earnings. The conventional wisdom was that accounting recognition signaled either that management was now ready to part with the lagging portion of a company, so as to re-direct its attention and talents to the potential 'stars'; and/or the earnings charge itself should be ignored, because it related to past events of no relevance to an assessment of the company's future earnings potential.

My take, however, is that the events leading ultimately to the big bath on the financial statements didn't happen overnight, even though the accounting for those events sure makes it look like the world was destroyed in one fell swoop. Management may want you to believe that the balance sheet cleanup will put the company back on the old path, but the problem is that the old path of reported earnings wasn't itself real. Restructuring charges and impairments mean that expenses of prior years' earnings were very likely overstated relative to economic earnings, even if all was strictly according to the letter of GAAP. When I had students, I counseled that if one cared to extrapolate historic earnings trends, one should make a pro forma haircut of prior years' earnings for a reasonable share of the current period's restructuring and impairment charges.

#2 – Management has the M & A bug. Business combinations accounting has forever been a fertile ground for earnings management. Take Tyco. According to SEC documents, from 1996 to 2002 it acquired more than 700 companies. First, beware of a growth-at-any-cost corporate culture and the likely ineffectiveness of both operational and financial reporting controls to efficiently absorb all of those changes. Second, the SEC claimed that Tyco used just about every business combinations accounting trick in the book to juice earnings. Granted, the rules of the game have been changed somewhat by FAS 141R, the newest business combinations standard, but opportunities to juice earnings and to create 'earnings banks' still abound by understating assets acquired and overstating liabilities assumed.

#1 – An SEC investigation.  The SEC's investigation of Apollo may only have as its initial focus one particular area of revenue recognition. But, where there is smoke, there could be a forest fire. The SEC may find grounds to challenge Apollo's entire revenue recognition policy. Or, with their subpoena powers wielded broadly, the SEC could stumble onto other questionable areas as well. Is Apollo willfully hiding lackluster performance of, say, its online programs a la Sony; or is it juicing consolidated earnings with questionable accounting for recent acquisitions? Who knows?

For that matter, will Apollo's public company competitors (like ITT) get caught up in the SEC's web? Who knows?

A Final Caveat

Numerous commentators and researchers before me have discovered some pretty powerful systems for extracting negative indications of financial health from accounting data. I am in no way trying to replicate that work, nor am I suggesting that the red flags I have proffered are the product of a similarly rigorous and systematic approach, or the state of the art. My goal has been only for each reader to think just once, "I hadn't thought of that one; it could make sense."

 

Making Revenue Recognition Simple and Informative

One thing that everyone should be able to agree on is that the accounting rules for measuring and reporting revenue ("revenue recognition") are a huge mess. There are too many of them, and far too many inconsistencies amongst them.

One of my favorite examples for illustrating how dysfunctional the rules can be is this illustrative example taken from a 1999 SEC Staff Accounting Bulletin (No. 101):

"A registrant sells a lifetime membership in a health club. After paying a nonrefundable "initiation fee," the customer is permitted to use the health club indefinitely, so long as the customer also pays an additional usage fee each month. The monthly usage fees collected from all customers are adequate to cover the operating costs of the health club. … Question: when should the revenue relating to nonrefundable, up-front fees in [this type of an arrangement] be recognized?"

If all you knew about accounting was that "assets" are what you have and "liabilities" are what you owe, then you should respond that the revenue should be recognized "when cash is received"; the health club has received an asset (from a non-owner), and it has no obligation to return cash at a later date, or even to provide services, under any circumstances.

The SEC, however, enunciated a different point of view in SAB 101, which can now be found in Topic 13 of the SAB Codification:

"Unless the up-front fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process, the deferral of revenue is appropriate. … [T]he staff does not view the activities completed by the [registrant (i.e., selling the membership) as a discrete earnings event.]"

The implication of this illustration is that revenue recognition under GAAP involves more than just the receipt of assets that you don't have to pay back; an implicit performance obligation to provide the customer with future services is deemed to exist, even though the customer has no legally enforceable right to receive the services.

In other words, current revenue recognition practices are dependent on factors that don't play into whether or not the definition of an asset or liability has been met for recognition, its subsequent measurement, or conditions for its derecognition. This disconnect of revenue recognition from the balance sheet, has led to a jagged path of positions hatched industry-by-industry, over decades of political wrangling with issuers and auditors. The resulting complexities, subtleties and inconsistencies within the revenue recognition rules are, at their very best, second only to the tangled web that is financial instruments accounting.

The Epic Revenue Recognition Project

The FASB/IASB joint project on revenue recognition seems to have been initiated as a good faith attempt by them to recapture the high ground from the SEC post-SAB 101 on a topic that arguably is the most consequential to the most financial statement issuers. After seven years (yes, the project was proposed back in January 2002) of consideration, the Boards' position has evolved essentially to these major positions as expressed in a discussion paper for which the comment deadline expired six months ago:

• The scope is limited to arrangements whereby an entity exchanges promises with a customer, leading to rights and obligations.  
• Increases in rights or decreases in obligations to customers are recognized as revenue.
• Performance obligations are to be initially measured by the transaction price, or an allocation of the arrangement consideration; subsequent measurement is still unsettled, but is likely to be a function of the initial measurement (as opposed to a market-based valuation).

The good news is that a new standard would supplant all extant revenue recognition guidance, and become the sole source of guidance on revenue recognition. The bad news is that it won't change much else. I see three major flaws.

First, revenue recognition should be nothing more than a question of income statement classification. If the FASB were fully committed to a balance sheet approach to financial reporting, it would plainly acknowledge and implement the principle that net income is merely a number derived from the changes in assets and liabilities during a period that resulted from transactions with non-owners. Hence, the only revenue recognition problem is determining which of those changes should be reported on the income statement as "revenues."   As it is invariably the case with both Boards, a piecemeal approach is being taken to avoid the larger contentious debate of accounting for rights and obligations in general.

Second, nothing worthwhile can come from including constructive performance obligations in the conceptual definition of a liability. The health club initiation fee example is the most straightforward example I can think of to illustrate this. The timing of services provided will cease to be a criteria, but the Boards are not willing to throw out the notion of a constructive obligation from their respective conceptual frameworks:

 "Sometimes an entity establishes a practice of providng particular goods or services, such as a warranty service.  Even if neither the contract nor the law explicity requires such a service, the entity by its customary business practice may have implicitly or constructively created an obligation that would be enforceable." (para. 3.6]

An "enforceable" constructive obligation?  I don't know what that means.  I imagine that what they are trying to say, but too embarassed to say directly is this: even though no legal obligation exists, an entity would harm itself by more than it would benefit if it just took a customer's money and ran.  Thus, economic forces make a constructive obligation "enforceable" through some sort of market mechanism.

I might be less cynical about the reasons for wanting to recognize constructive obligations if we actually had effective financial reporting gatekeepers. How many auditors will call a potential constructive obligation the way they see it – as opposed to the way management sees it? Investors don't need that kind of financial reporting any more, and their returns don't need to be burdened with the considerable costs of amortizing upfront fees over some fuzzy measure of the expected relationship period. 

Third, measurement of customer-related assets and obligations by allocating arrangement consideration to them is a step backwards from the FASB's putative goal of measuring financial assets and liabilities at their fair values. I presume that the FASB is legitimately concerned about introducing more subjectivity into measurement of assets and liabilities; and more fundamentally, they are rightly concerned that exit values for liabilities will inevitably generate Day 1 gains for vendors.

I can't say that there is a sure-fire solution to fair value measurement's subjectivity, for that will always be present in any approach to current valuation.  But, there is a straightforward way around the problem of Day 1 gains. Consider, for example, a one-year fire insurance policy with a $1,000 up-front premium. If an exit value approach were taken to measure the performance obligation on Day 1 (i.e., the obligation to stand ready to pay for the insured's loss should a fire occur), it would likely cost the insurance company less than $1,000 to cede the liability to a reinsurer; hence, the Day 1 gain the Boards are worried about.

But, here is, yet one more time, the compelling economic logic of replacement cost measurements. As I have stated in numerous prior posts, a liability is most appropriately measured by the replacement cost of the corresponding insurance asset in the possession of the policyholder. That number would, by definition, still be $1,000 on Day 1. Presto change-o, the problem of Day 1 gains disappears!

Summing Up

Revenue recognition is arguably the most significant project the FASB and IASB can undertake. But momentum, such as it was, appears to have stalled following the issuance a full year ago of that discussion paper purporting to contain the Boards' "preliminary views."  I believe this is because the standards setters keep bumping up against inevitable logical inconsistencies. First and foremost, is that the predilection for exit values is birthing a frightening brood of financial reporting anomalies. Here are five that come to mind without thinking about it for more than 30 seconds:

• Day 1 expensing of transaction costs when acquiring financial assets or applying the "acquisition method" to a business combination;
• Assigning an exit value to a leased asset that, by contract, cannot be transferred.
• Recording gains on the completion of a manufactured good before it is sold (specifically scoped out of the discussion paper).
• Liabilities that cannot be transferred.
• Asset markets that are either illiquid, or temporarily taken over by distressed sellers. 

I have been told by someone with access to inside information that FASB chair Bob Herz is a replacement cost guy deep down; but, he can't seem to muster the political momentum to alter course away from exit prices. The way I see it, if we continue to reject replacement cost, we are doomed to chasing our tails: (1) try exit values; (2) become discouraged as the logical inconsistencies destroy representational faithfulness; (3) give up and settle for reporting computer-generated random numbers seeded by an historic cost.

As significant as the revenue project is, a reasoned solution is being lost by a destructive problem solving strategy that the late Nobel laureate Herbert Simon and his co-author Allen Newell called "means-ends analysis"  in their 1972 treatise, Human Problem Solving. The danger is that dogged "forward progress" on a portion of a problem may actually set back the solution of the larger problem to which it is apart. After eight years of hemming and hawing, the FASB surely must realize that its approach is clearly not working. Rather than continue to propose partial fixes to flawed models, it would be better off postponing the project until it establishes more pragmatic definitions and measurements for assets and liabilities.   

If it could only solve the larger problem, the problem of revenue recognition would practically solve itself.

Going to School on Revenue Recognition

I'm a night owl, but once I hit the sack, I'm out like a light for 8-9 hours. In fact, the two things I would say that I do best are type fast and sleep like a log. One recent night was a rare exception, though. I woke up only about two hours into my hibernation and couldn't fall back asleep. After about another hour, I gave up. It was too late to have a toodle, so I decamped to my office and turned on the computer.

The first thing on the web to catch my eye was a blurb in the Chronicle of Higher Education, in which it was reported that the revenue recognition policies of the Apollo Group Inc., the parent company of the University of Phoenix, were the subject of an "informal inquiry" by the SEC's Division of Enforcement. Apollo has declined to provide any further specifics, but their share price declined about 18% around the time of the announcement. Hmm.

I decided to look further into this for three reasons: (1) I thought it might help me get to sleep; (2) I was in the midst of preparing to lead a one-day workshop on revenue recognition, so I could actually benefit by a review of some of the rules; and (3) Apollo's headquarters are in Phoenix, where I live.

What I Found – Before I Went Back to Bed

The first thing I did was to download Apollo's most recent 10-K and to read their description of critical accounting policies on revenue recognition. I also pulled 15 years worth of financial statements in spreadsheet format from a data service.

Here is what I found after a few minutes of perusal:

• Students are billed on a course-by-course basis. But, judging by the ratio of the allowance for doubtful accounts to gross student accounts receivable, 29%, it appears that a significant number of student accounts are eventually written off as uncollectible.
• Upon the first day of attendance, Apollo records a receivable and deferred revenue in the amount of the billing. As I will explain later, I was surprised to learn this; 'executory contracts' are usually not recognized (with the notable exception of capital lease accounting).
• Tuition revenue is recognized pro rata over the duration of the course, which is generally 6 - 9 weeks. As we say in the trade, it appears that Apollo has adopted a 'proportional performance' revenue recognition model. A more conservative choice would be a 'completed performance' model.
• Apollo recently changed its refund policy whereby students who attend 60% or less of a course are eligible for a refund for the portion of the course they did not attend.
• Apollo prepared its statement of cash flows under the direct method through 1997. They switched to the indirect method in 1998. I would have thought that a 'preferability letter' for such a change would have been included in the 1998 10-K, but I was unable to locate one.

What Could the SEC Be Looking At?

It appears that the SEC Enforcement Division received a referral from the Division of Corporation Finance, which reviewed Apollo's most recently filed 10-K, issued a comment letter, and received a reply from Apollo. Corp Fin's comments addressed, among other things, Apollo's revenue recognition policy for refunds, and whether bad debt expense and revenue were both overstated (i.e., certain amounts of bad debt expense should have been treated as reductions in revenue).

My own questions start at a much more basic level than Corp Fin's comments: when, if ever, it would be appropriate for Apollo to recognize revenue prior to the receipt of payment?

Accounting for the Students Who Pay in Arrears

The general rule in GAAP is that revenue cannot be recognized until it is earned, and realized or realizable (see Statement of Financial Accounting Concepts No. 5). The SEC staff has interpreted this general rule in Topic 13 of the Codification of Staff Accounting Bulletins (SAB Topic 13) to mean that four criteria must be met in order for revenue to be recognized. I won't go into all of them, but the last criteria is that "collectibility is reasonably assured." If the probability is 29% that a student won't pay Apollo, can it be said that collectibility is reasonably assured?

Apollo and its auditors might respond by stating that 71% of the billings to students are reasonably assured; moreover, Apollo has accumulated an extensive history of course delivery that enables them to reliably estimate the allowance at 29%.

But, there is no language in SAB Topic 13 that specifically allows Apollo to combine similar arrangements for the purpose of determining whether collectability is reasonably assured. SAB Topic 13 does provides that one can estimate future liabilities for warranties and returns by aggregating similar customer arrangements and estimating an average for the group; however, it did not specifically provide that those procedures were available for non-payments of enforceable claims. Notwithstanding, historic experience may not be all that helpful in determining the non-payment rate in the current economic environment. For companies with low non-payment rates, maybe, but for companies with a 29% payment rate, perhaps not.

I suppose it would have been clearer if SAB Topic 13 stated what was to be accomplished by providing that collectibility must be reasonably assured; and/or had specifically prohibited combining accounts when evaluating the criteria. Nonetheless, the following example may serve to illuminate the SEC's intent.

Take two companies, A and B; they are equally profitable and differ principally in collectibility rate of accounts receivable. Company A estimates its allowance for doubtful accounts to be 2% of gross accounts receivable, and B's allowance is 30%. Both companies discover, after the fact, that the real allowance was only two-thirds of what it should have been: that is, 3% for A and 45% for B. The premature recognition of earnings by Company A may or may not be material, but for B, it will be as cataclysmic to the income statement as was the AZ Cardinals loss last Sunday on a final-play touchdown pass to my son. It could be permissible to estimate an allowance for doubtful accounts for a group of similar arrangements, but it does not seem appropriate to determine that collectibility is reasonably assured on the same basis.

When is Revenue from a Course Earned?

While collectability may be an issue for some arrangements with students, many of Apollo's students pay in advance. The comment in this section apply to all arrangements, regardless of the timing and/or uncertainty of cash flows.

SAB Topic 13 provides that revenue should not be recognized for "delivered elements" (i.e., classes in Apollo's vernacular) if remaining elements to be delivered to the customer are "…essential to the functionality of the delivered … services." The staff created an exception to this rule for undelivered elements that are "inconsequential" or "perfunctory," but it is not applicable if failure to complete the activities would result in the customer receiving a full or partial refund … (or a right to a refund…)." Stated from a balance sheet perspective, the underlying principle is that one is generally precluded from recognizing a receivable that is not backed by an enforceable right to collect it.

I am unfamiliar with the way courses are conducted by Apollo, but I assume that they all end with an evaluation leading to a final grade. In my experience, students will not pay for a course that doesn't provide them with a grade. Grading is an essential function of the service provided; therefore, it would seem that SEC guidance would require Apollo to defer revenue related to a course until a grade is given to the student.

But, to be fair, I did check the revenue recognition policies of a number of other public companies in the same industry as Apollo, and they all recognize revenue in some ratable fashion as courses progress. For me, that is just one more reason why the SEC's investigation of Apollo's revenue recognition practice is significant. It could better the practices of an entire industry.  (And, by the way, numerous competitors have non-collectibility rates that are roughly the same as Apollo's.)

Accounting for Students Who Drop a Course

The question that the SEC seems to be homing in on is whether Apollo has properly allowed for refunds to students who may drop the course before the 60% point. That also happens to be the only revenue recognition issue that analysts were asking about in Apollo's fourth quarter earnings conference call.

It could be that the analysts and the SEC are both missing the boat. The SEC may believe that Apollo should allocate a portion of the deferred revenue to an estimated liability for refunds. That would initially affect balance sheet classification of liabilities, and it may affect the pattern by which revenue hits the income statement; but it doesn't seem to be that big a deal to me. Yet, it must be said that Apollo's stock price did take an 18% hit around the time of the announcement of the SEC investigation.  If the accounting for the new refund policy is the reason for the stock price drop, then so be it.   

Other Red Flags

I have two final thoughts regarding items that I noticed in my relatively brief perusal of the financial statements. First, even though the ratio of the allowance for doubtful accounts to accounts receivable is around 30%, the ratio of the allowance to receivables for which Apollo actually has enforceable rights could be significantly higher.

That's because Apollo has a practice of recognizing receivables for which it has no enforceable rights. Recall that Apollo recognizes a receivable and deferred revenue for the price of a course when the student shows up for the first day of class. I suppose Apollo is reasoning that both parties have gone down the road somewhat, but it pretty much looks like an executory contract to me. Be that as it may, the SEC should be asking whether the allowance for doubtful accounts is based on the total reported balance of accounts receivable, or just the portion representing enforceable rights. It makes no sense to me to create an allowance for doubtful accounts (and an offset to bad debt expense) on a 'receivable' that is not owed, and may never become owed if the student drops the course. If Apollo sees it the same way, the ratio of doubtful accounts to enforceable student receivables could be significantly higher than even the 29% reported.

Second, regarding the change in the method of presenting cash flows, it would be a pretty big stretch for an auditor to maintain that the switch in accounting was to a preferable method; the FASB has stated in SFAS 95 that the direct method is the approach they encourage issuers to employ as "the more comprehensive and presumably useful." (para. 119) I sure would like to see the SEC ask Apollo and their auditors about that one.

And, perhaps, here is a Hanukah present to the FASB: Apollo could be their poster child for why the direct method for presentation of cash flows should be required. Would 18% of total shareholder value have been destroyed in one fell swoop, had Apollo reported cash flows to investors using the direct method? Perhaps not, because trends in the amount of cash collected from customers would have been disclosed.  The direct method of presenting the statement of cash flows reduces the criticality that investors accurately evaluate the quality of an issuer's revenue recognition policies.  

Winding Up

My goal for this posting was simply to raise interesting questions about Apollo's revenue recognition policies. I want to explicitly state that my intention is not to pass judgment on any of Apollo's choices, even though the market may have spoken to that effect by devaluing Apollo's shares.

Indeed, there are many more questions suggested by this case, and they go beyond the specific effects on Apollo. For example, one could consider whether the revenue recognition rules applicable to Apollo's arrangements with students are themselves representationally faithful or appropriate. We might also ask whether a different result would obtain if the revenue recognition rules under IFRS were applied. Finally, and perhaps most interesting, we could ask how the revenue recognition project being undertaken by the FASB and the IASB jointly has the potential to improve the quality of financial reporting by companies like Apollo. Unfortunately, I am not confident that the proposed approach would be an improvement, but that's for another post.

To Head in the Right Direction on IFRS, the SEC Should Make a U-Turn

In my first post with results of our IFRS opinion survey, I focused on three questions that indicated respondents' overall attitude towards IFRS adoption without getting too deep into the specifics. In this second and final post, I am going to peel the onion a couple of layers deeper: (1) down to the touted benefits of IFRS as compared to GAAP; and (2) the policy question of convergence—irrespective of IFRS adoption.

If you would prefer to be given an executive summary before (or without) reading further, it is this: (1) IFRS is not perceived to be better, in the respects examined, than GAAP; and (2) continued efforts to bring the two bases of accounting closer together are not expected to be worthwhile—unless you are a Big Four auditor or work at a Fortune 500 company. Bottom line: the SEC should make a U-turn on its roadmap proposal.

Benefits of IFRS—Or More Accurately, Complete Lack Thereof

One of the clearest messages to come out of our survey, which I described in my first post, was that only 23% of all respondents believe that the benefits of IFRS adoption would exceed the costs. Of that minority, a disproportionate number work for the Big Four or the Fortune 500 ("B4+F500"). These two groups comprise slightly more than 1/8 of the respondents, but are about 1/4 of the minority view.

Some of the survey questions peel the onion on the benefit side of the cost-benefit tradeoff: the two most touted benefits of IFRS relative to GAAP being greater comparability, and enhanced relevance and reliability. For example, we asked whether the greater latitude afforded to issuers of financial statements by IFRS affects the relative value of financial statements prepared according to IFRS ("value" is a broader concept than comparability or relevance and reliability):

 

One of the most lopsided results of the survey is the almost 5:1 verdict against the information value of the management judgment afforded by IFRS. Even the B4+F500 are on the same side on this question, albeit by a lesser (approx. 1.5:1) margin.

I should point out that I did not intend for this question to be a referendum on "principles-based accounting standards." I interpret the responses as expressing a preference for detailed guidance when no universal principle or objective has been provided as a benchmark. Such is most often the case with both IFRS and U.S. GAAP. As an analogy, detailed rules and interpretive guidance has been the modus operandi of the SEC, and perhaps its most distinctive characteristic as compared to other national regulators. Notwithstanding the hiccups of the last decade, which I believe are more broadly attributable to an apalling lack of effectiveness on the part of the private sector gatekeepers, it has been the detailed rules and guidance toward the objective of full disclosure, combined with a narrow focus on investor protection, that has made our capital markets the global benchmark.

Specifically in regard to comparability, proponents of IFRS adoption claim that U.S. companies should experience greater access to global capital markets if those companies were to report under IFRS. One may suppose that analysts would be able to make comparisons among potential investments more efficiently. However, only 42% of respondents believe that IFRS adoption within the next ten years would positively affect comparability, and less than 10% would characterize the effect on comparability to be "significant":

 

The above chart also indicates that, once again, that the B4+F500 are disproportionately represented within the minority view.

Regarding relevance and reliability, only 21% of respondents are of the opinion that IFRS would enhance relevance and reliability:

The Value of Convergence, Or More Accurately, Lack Thereof

Even before the SEC's IFRS Roadmap proposal, the Big Four strategy has been to browbeat the rest of us into submission with incessant mantra-like repetition of "IFRS is inevitable." A variation on that shtick, "apple pie" characterization of convergence. Our survey results indicate "cow pie" may be more apt:

It appears that hardly anyone, save the B4+F500, are of the opinion that convergence efforts over the past several years has significantly improved U.S. GAAP; and 58% believe that the process has either been a dud or has somewhat diminished U.S. GAAP.

So, the answer to the convergence policy question, "What's in it for us, the U.S. investor?" seems to be—not much. Indeed, although it is impossible to tell to what extent convergence has retarded the already glacial pace of standard setting in the U.S., it is safe to assume that projects like financial statement presentation, leasing, loan fair value and even revenue recognition could be much closer to completion without the helpful input of the French, et. al.

There does not seem to be a great deal of optimism regarding future convergence efforts, either. Only 32% of respondents disagree with the statement that a single set of accounting standards is a realistic goal:

Moreover, a whopping 70% of respondents (including the B4+F500) don't think that the boards will resolve all of the significant differences between GAAP and IFRS:

I suspect that "convergence" is less a defined term than it is a marketing gimmick. If you think I am being too cynical, kindly recall that the "convergence" euphemism replaced the even more mellifluous term, "harmonization." Neither term of art can be matched to a corresponding dictionary definition that remotely indicates the underlying policy objective. At their best, they are metaphors for … who knows? Now that even the IFRS proponents have been forced to admit that identical standards is no longer a possibility, it is high time to get more specific about what "convergence" is intended to accomplish. Getting "close enough for government work" is a better match for processes that have taken place to-date, but respondents (including, for once, B4+F500) don't even expect even that amorphous objective to be met.

Final Words 

Given my oft-mentioned preferences against IFRS adoption, one would not be unreasonable to be skeptical of any claim of absence of bias in my analysis. That's just one reason why the entire database of responses is available here.

You could also make a valid point that, in addition to the caveats mentioned in the companion post, academics are over-represented among the respondents and investors are under-represented. As to the academics, the data does not indicate to me that the views of academics are radically different than any other group, save the B4+F500 zealots. Others have also remarked that my survey may be the most comprehensive data available thus far on the opinions of academics regarding IFRS. I also can't see that academics as a group have ecoomic incentives that would cause them to support or oppose IFRS adoption, but that may be a reflection of my own biases.

As to under-representation of investors, it remains a mystery as to why they appear so reluctant to weigh in on the issue of IFRS adoption. For example, the CFA Institute surveyed approximately 97,000 of its members worldwide. Their response rate was 1.6%. 1,576 responses sound like a lot, but the potential for non-response bias must be very high. I have no way of knowing how many persons viewed our invitation to be surveyed, but I am guessing that our response rate was more on the order of 10%.

Sarbanes-Oxley and Smaller Reporting Companies: There is a Better Way

I apologize for the long interval between this and my last posting – especially to those of you who have privately thanked me for material just boring enough, and long enough, to induce a good night's sleep. Tax blogs, I am told, are much too potent unless one is planning to spend an entire holiday weekend in bed.

This long-awaited naturopathic sleep remedy is based on Floyd Norris' recent critique of efforts to roll back some of the provisions of the Sarbanes-Oxley Act. Roughly in descending order of offensiveness, we have movements afoot to:

1. Place the FASB under the supervision of a systemic risk agency, which would in turn be heavily influenced by the banking interests who still blame fair value accounting for the financial crisis;
2. Rescind for companies that have a public float of less than $750 million the requirement that an auditor attest to management's assertions regarding the effectiveness of internal controls (S-OX 404(b));
3. Challenge the constitutional legitimacy of the PCAOB; and
4. A House of Representatives committee vote to exempt the 6,000 'smaller reporting companies' (i.e., market cap. < $75 million) from complying with S-OX 404(b).

If I had been writing a blog back in 2002 as S-OX was being rushed to a vote in spasms and fits of self-righteous bipartisanship (did blogs actually exist?), I would have predicted something like this would be happening about now. Having nothing whatsoever to do with the philosophical leanings of the party in the majority, such is the formula by which U.S. political dramas are scripted. Declarations of war (figuratively and literally) through zealous and hastily enacted statutes are inevitably followed within just a few years by reversals to more moderate positions. Regarding the securities laws (and holding the frightening prospect of IFRS adoption aside), we are clearly in a period of moderation, albeit more misguided than usual.

While I echo Norris' sentiments on the first three items, I had only a few weeks ago expressed my glee that requiring smaller public companies to comply with S-OX 404(b) might soon be trashed. I had previously observed that S-OX 404(b) attestations have appeared to devolve into a go-through-the-motions exercise. Those suspicions are validated to some extent by a recent ruling against defendant Deloitte on a motion for summary judgment in a lawsuit alleging that Deloitte failed to adequately report on internal control deficiencies at WAMU. Jim Peterson of the Re: Balance blog avidly follows the solvency tightrope that each of the Big Four is walking as they try to fend off litigation arising out of 'traditional' public company audits. His view is that auditors should walk away from S-OX 404(b) work while they are still ahead. 

There Must be a Better Way

Even though S-OX could have, and should have, been more tightly focused on measures to prevent another Enron or WorldCom from happening, something was missing in the securities laws for providing reasonable assurance that management public companies, both large and small, are taking their financial reporting responsibilities seriously enough. I just don't agree that S-OX 404(b) was the right way to go about it.  Notwithstanding other merits of a financial reporting regulation, a windfall to gatekeepers, especially those sharing the blame for a lack of confidence in the system, is a reason for any reasonable person to be suspicious. 

Given that change is in the offing, now may be the time to bring back my old war horse, mandatory audit firm rotation. The resistance to mandatory audit firm rotation in the wake of Enron and WorldCom came from the AICPA, which couldn't bear the thought of auditors being audited by other auditors. Their main stated argument had been that switching costs would be too high, as audit efficiencies in the client's environment take a few years to be realized.

Even accepting the AICPA's excuse, which I absolutely do not, it is a fact that the vast majority of audits of smaller firms are much more straightforward. That should mean that the successor auditors can, relatively speaking, take over from predecessors without breaking stride. I would like to suggest to Mary Schapiro that, instead of pushing against the bipartisan will of Congress to let smaller reporting companies out of S-OX 404(b), she should promote mandatory audit firm rotation. There is nothing to suggest that it will impose anywhere near the scale of costs engendered by S-OX 404. With little at risk, it could actually transform audits from a make-the-client-happy exercise to one that moves the U.S. toward the forefront of global capital markets just in terms of basic integrity.

Let's pick 2,000 smaller reporting companies at random and require that they switch auditors within a year; another 2,000 next year, and 2,000 the year after that. If done right, there should be a wealth of data for the SEC and academics alike to analyze. For the next time we take a whirl on the regulate/moderate merry-go-round, we will at least have some hard evidence to take along.

(By the way, I recommend that you try Kevin LaCroix's D&O Diary blog for excellent non-technical summaries of current developments in securities litigation.)

And Our IFRS Survey Says…

This is the first of a series to discuss the results of our IFRS opinion survey. The idea for a survey originated with yours truly, and I was moved to do so (more like propellled with outrage) by the ersatz pro-IFRS "research" coming out of the Big Four and the AICPA propaganda machines. I also decided to seek a collaborator from the ranks of academia through the AECM listserv, and I consider myself very fortunate that Pat Walters, herself an IFRS proponent, volunteered to work with me. Pat's association with this effort should lend, at the absolute minimum, a semblance of balance; which is, ironically, completely absent from published views of the Big Four and their shills.

But, thankfully, I can report that not all CPAs have behaved like pigs at the trough. We owe a huge debt of gratitude to Gaylen Hansen, who has provided us with a clear-eyed compilation of the response letters to the SEC's Roadmap proposal; and to Grant Thornton for their survey, which was published as we were conducting ours. GT asked a question of import ("Ideally, who should set U.S. accounting standards?") properly, and received proper responses from CFOs and senior comptrollers in return. GT reports that only 18% of more than 800 respondents from public companies are of the opinion that the IASB should be setting accounting standards for U.S. companies.

Full Disclosure and Caveats

We received a total of 289 responses. We can't beat GT on sheer number of responses, but we did ask a broader set of questions regarding the perceived relationships between IFRS and GAAP: (1) quality differences; (2) costs and benefits of IFRS adoption; and (3) how the SEC should act on its Roadmap proposal. You can view all of our response data in a spreadsheet format here, and the text of the online questionnaire here. Twenty-seven responses came from non-U.S. residents and 13 from students. Our analysis excludes these two groups, and the tabulation at the end of this post breaks down the respondents we analyzed by all of their occupations.

Before we proceed to the major takeaways from our survey, two further caveats are in order.

First, we sure were hoping to generate a larger number of responses. GT excepted though, our level of participation is well within the range of other "studies" conducted by the IFRS proponents, including the number of comment letters received by the SEC in response to the Cox-instigated Roadmap Proposal. We left our survey open for three weeks; the SEC's comment period extended for months.  

Second, one should always take with a grain of salt unsolicited responses, as opposed to a random sample. But, no study that we are aware of has employed a more open self-selection process than ours. For example, I was solicited for Deloitte's survey apparently because I subscribed to one of their IFRS information services; if that was Deloitte's only method for soliciting responses, the self-selection bias therefrom is self-evident.

The Major Takeaways from Our Survey

As with GT, we asked for opinions regarding IFRS adoption; and our results were very similar to theirs:

My initial interpretation was that 71% of respondents do not agree with the proposition that IFRS should replace U.S. GAAP. Pat pointed out that this may be somewhat of an overstatement—since we don't know why 16% of respondents "neither agree nor disagree." Those respondents, according to Pat, could very well be indifferent to the prospect of IFRS adoption. My own take on that is: if one took the trouble to take the survey and to answer the question, then indifference would not be the most likely sentiment being expressed. Nevertheless, Pat and I agree to this interpretation:  respondents who disagreed with the proposition outnumbered those who agreed by a margin of about 5:3. Anyway you look at it, especially in light of GT's results, it should give the SEC pause before proposing to supplant the FASB with the IASB.  That's as mildly as I can put it.

When I took a closer look at the answers to this question, I was not surprised to see that the frequency distribution of responses from Fortune 500 companies and the Big Four appeared to be negatively correlated with all of the other occupations. To evaluate their impact on the full results, I decided to disaggregate each question by three subgroups: (1) Fortune 500 + Big 4; (2) academics; and (3) everyone else. The chart below repeats the results from above and adds these subgroups:

 

See that tall blue bar on the left? That's Big 4 and Fortune 500 money talking. Notice also that academics (the ascetic purists J), are the least inclined to adopt IFRS (as indicated by the short green bar on the left).

Given these results, it should come as no surprise that a significant majority of respondents do not believe that the benefits to investors of IFRS adoption would exceed the costs of conversion:

77% of all US respondents do not believe that benefits to investors will exceed the cost of conversion. Indeed, although a majority of the Fortune 500 accountants and Big Four auditors believe that the SEC should adopt IFRS, only 44% believe that the benefits to investors would exceed the cost of adoption. Figure that one out.

The bottom-line question we asked pertain to how the US should approach adoption of, or convergence, to IFRS:

These results are, admittedly, somewhat difficult to interpret with precision, but they clearly indicate that few respondents would like to see IFRS adopted before 2014. Moreover, 54% of respondents (including the Fortune 500 and Big 4) would either prefer not to adopt IFRS, or to adopt it starting with 2020 at the earliest. Although an in-depth analysis of the "other" category of responses was not undertaken, my brief analysis strongly indicates that a comfortable majority of the "other" responses more closely resemble those who stated a specific preference to either delay in IFRS adoption beyond 2020, or to abandon IFRS altogether.  If you don't believe me, you can look at the data for yourself.

And, as one might expect, the Fortune 500 accountants and Big Four auditors were strongly in favor of relatively fast-paced IFRS adoption, although it must be said that less than 10% favored adoption by 2012-2013. But, take those folks out, and you have even less interest among respondents for adopting IFRS anytime soon … or ever.

Act II

Thus far, I have discussed the results of only three of the ten questions that we asked about IFRS vs. U.S. GAAP. I promise you, more drama is to come. Also, Pat has agreed to write a guest post with the working title, "How the Survey Result Informs an IFRS Proponent." I'm sincerely looking forward to that.

The Speak-No-Evil FASB

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My previous post lambasted the FASB for shilling the SEC's whacky proposal to measure the year-end value of oil and gas reserves at average prices for the year – instead of the year-end price. Since then, I had two follow-on thoughts; the first one I'll mention is not related to the cheeky title of today's post, but it leads into the one that is.

A More Reasonable Way to 'Modernize' Oil and Gas Disclosures

A week ago, I forgot to mention that there really is a reasonable way to enhance the measurements of year-end values of oil and gas reserves, the ostensible goal of the SEC's recent actions.   But, it has nothing at all in common with the SEC/FASB approach of using averages.  What I have in mind is 'sensitivity analysis.'

Investors can use information about the current value of reserves today, but they also can use information concerning risk of changes in value. Financial reporting rarely reports that kind of information, but there have been movements in that direction of late, and by the SEC no less. Most prominently, Item 305 of Regulation S-K requires quantitative measures of market risk sensitive financial instruments, which often takes the form of some version of a sensitivty analysis.  In addition, Financial Reporting Release No. 60, urges companies to provide a sensitivity analysis covering assumptions underlying critical accounting policies.

So why not provide a sensitivity analysis regarding the value of oil and gas reserves? It doesn't have to be complicated, and the resulting disclosure could be as clear and simple as the following:

Using end-of-year energy prices, the present value of proven reserves is $100 million as of December 31, 20x0. Energy prices during the year ranged from 80 to 130 percent of the year-end prices. If the lowest (highest) energy prices during the year were substituted in our year-end present value calcultions, the lower end of the range would result in a $50 million valuation, and the higher end of the range would result in a $130 million valuation. The range of valuations is not proportional to the range of prices for the following reasons: [would be listed here.]

Sensitivity analysis of valuations can always be informative, but particularly so in the extractive industries. A significant portion of the value of the investment in a project can be traced to 'real options'; e.g., to invest in additional development if prices rise, or to shut down operations until such time as commodity prices recover. In fact, in the three decades since the SEC came out with its original version of oil and gas disclosures, the topic of 'real options' has gone from esoteric to an essential component of any capital budgeting decision by the larger players in the extractive industries. By the same token, investors are in a better position to value options (especially those that are not recognized on the balance sheet) if they can more reliably estimate the volatility of a project's value.

Covering Ears, Eyes and Mouths

Maybe you like my suggestion to add sensitivity analysis to the present value of reserves disclosures, or maybe you don't. Whatever your opinion, you should definitely be incredulous that the FASB appears unwilling to give any alternative to the SEC's hatchet job so much as lip service.

Now that the ball is in the FASB's court, one must ask whether all of them have truly put their brains in neutral, or whether they have even considered alternatives to the SEC's approach.  If they have chosen to put their brains in gear, we certainly can't tell from their proposing document or any other public comments. At least at the SEC, dissenting board members give speeches that reveal their own preferences and reasoning. It appears that FASB members, perhaps as a matter of basic economic incentives (i.e., money), don't dare to do the same. Based on the way the last investor representative on the board was treated, it's pretty safe to assume that, if you are not a go-with-the-flow sort of chap, chances of getting your $500,000/year position renewed for a second five-year term are slim to none.

Here's my prediction as to what is going to happen with the ED. The Board is going to vote 3 -2 in favor of measuring the value of proven reserves at average prices. Two board members, Linsmeier and Siegel, are going to furnish compelling dissents, and maybe another financial columnist will celebrate the dynamic duo for the strength of character they displayed while others around them were busy shilling. But in the final analysis, after-the-fact minority dissents will have no effect on anything real or important. As my father too-often said, "If all you have to stand on are your principles, then you may as well remain seated."

Yes, minutes of open meetings report board members' comments leading up to exposure documents, but who reads them? I might if I were to have trouble falling asleep at night. Why aren't formal dissents registered in exposure drafts? Why don't board members, as SEC commissioners often do, provide their individual views when they go around making speeches? For true 'due process' to occur, we need more open public debate on the issues. Commenters on FASB proposals need to have some idea of the level of consensus within the board.

I suspect that every single FASB member thinks that measuring the value of proven reserves by average, instead of current, prices is a significant step in the opposite direction from quality financial reporting. So, perhaps I am being unfair in calling on only Tom Linsmeier and Marc Siegel to carry the flag of reason and investors' interests. But, no good deed goes unpunished. That's what they deserve for taking principled stands in the past – even if, thus far, they have amounted to little more than empty gestures.

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Haven't Taken Our IFRS Opinion Survey?
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