The Accounting Onion

The FAF Trustees Hold the Fate of Fair Value and IFRS Adoption in Their Hands

This is one thing of which I am certain:

If finalized, the fair value provisions of the FASB's financial instruments exposure draft (file no 1810-100) would be the most significant change to financial reporting since the founding of the FASB in 1973 – or perhaps even since the passage of the securities laws in 1933 and 1934. 

The volume of comment letters already posted to the FASB's website only tell some of the story – there are already 250 of them and the comment period still has a month to run. But, it's hard to find the good ones, as a lot of them go something like this one:

"Dear Director, as a Director and Shareholder of a small community bank, I wanted to voice my opposition to the "Mark-to-Market" accounting proposal. We as a small bank were affected greatly by the FASB 166 change. It has wrecked [sic] havoc with not just our capital levels, but it has also distorted numerous performance ratios. The last thing we need now is another change to current accounting practices.

Sincerely,

[Name omitted]

Sent from my iPhone"

One reason I am writing this post is because there is also some really good stuff buried under the chaff. Ed Trott, former Board member wrote two letters. Trott's first letter strongly supports reporting financial instruments at their fair value, and here's a taste of it:

"I hope that the FASB (and ultimately the IASB) will act with true independence to develop accounting guidance for financial instruments for the benefit of the capital markets. Unfortunately I believe IFRS 9 was developed based on not threatening the IASB's franchise with the European Union rather than the opportunity to develop a high quality standard that could be used globally….

I served as an FASB Board member for 8 years [and before that, 7 years on the EITF and a few more on AcSEC.] In the final 7 years of my service the weighting of my auditor experience [appropriately] became secondary to the weight given to providing useful information to the users of financial statements. …

… My concern about being second-guessed with respect to using fair value measurements for [financial instruments] was overwhelmed by information that could be captured and communicated using a fair value measurement. With continued observation of financial reporting and enforcement, I believe fair value estimates, done objectively, are less likely to be second-guessed than many other parts of financial reporting. …

Although I believe all financial instruments should be reported at value using a fair value measurement and that using a "business strategy" to determine where to display the changes is suboptimal, my comments will accept this approach."  [emphasis supplied]

Trott's second letter thoroughly debunked the "alternative view" expressed with the ED, which for convenience I'll refer to as an historic cost approach:

"The writers raise concern about 'subjective' data being included in financial statements…. I believe the subjectivity introduced in the proposal on recognition and measurement of credit impairments (which the writers seem to agree with) will dwarf the fair value measurement subjectivity. I believe [fair value measurement] is is much less subjective, and many more observable inputs are available, to determine a debt instruments [sic] overall fair value than the impact of only one factor….

Although I am not sure world leaders speak for financial statement users, I would love to see a high quality accounting standard for Financial Instruments that was used globally. However a less than high quality standard, even if converged with the IASB standard, should not be the goals of the FASB. I don't believe a convergence effort starting with two non-high quality approaches can end up with a high quality standard. " [emphasis supplied]

That's really good stuff.

David Mosso also wrote a comment letter, and it was completely consistent with his book, which I recently reviewed, but this excerpt at least will give you a flavor for the strength of his convictions:

"I am dead certain that no matter how many new regulations are written to prevent future financial crises, crises will recur periodically until the GAAP system … are given a revolutionary overhaul to adopt comprehensive mark to market accounting with emphasis on diagnosing companies' financial health."

I have to contrast that with the steady drone of the IFRS adoption machine in the U.S., which too much like those inexorable vuvuzelas at the World Cup irritatingly drone: "inevitable." Mosso is saying that if we fail to adopt IFRS in the U.S., our economy will go to hell in a hand basket. Someone please tell me why, after all we have gone through, that we should really care about IFRS adoption? 

Sorry Guys, But The Fix Is In … Maybe

As I stated above, one purpose of this post is to do my part to ensure that Mosso and Trott don't get buried by the whipped up hysteria of the banking lobby. The other reason is to point out the real threat that their voices will be rendered moot by political interests trumping user interests on the board of trustees of the Financial Accounting Foundation.

The Financial Accounting Foundation (the group that oversees the FASB and the GASB) announced last week that it would be expanding the FASB from five members to the original seven. It was only about a year and a half ago that the FAF shrunk the board from 7 to 5 members. Commenters on the proposal to shrink the Board were almost uniformly against doing so, but the FAF ignored the feedback and did what they said they were going to do in the first place, and in the name of faciliting IFRS adoption in the U.S.

Last week, the FAF announced it has taken another tack: without requesting comments from the masses, it would put the FASB back to seven members forthwith. Yet the stated reason was the same: to facilitate IFRS adoption. Go figure.

Actually, if the FAF wants to completely ignore the protestations of users, and practically everybody else except the largest audit firms and corporations on the topic of IFRS adoption, then re-inflating the Board to seven members makes sense.

The math is as simple as it gets. With one of the three members voting to issue the financial instruments ED, having announced his retirement (Bob Herz), four Board members continue to serve. Two of them favor fair value and two, like the IASB, support some new historic cost-based concoction. By expanding the Board to seven, the FAF can cherry pick enough new historic cost-favoring Board members, so as to overwhelmingly defeat the ED. Convergence and ultimate adoption of IFRS would be, as the horn blowers drone, "inevitable." And, at this juncture, I would have to agree.

Next, let's look at the FAF voting math, which is a little more complicated, albeit just as crucial. There are 14 voting trustees. I'm going to put the three from the audit firms plus the securities lawyer, investment banker and Microsoft executive firmly in the 'historic cost' camp. That's six already, and I am going to assume that only eight are needed to approve a new FASB member.

The three investors and the two academics ought to be 'fair value' folks, but I feel more than a little bit on shaky ground here. Neither academic appears to have big accounting chops—although they both have very strong credentials in finance.

I am also concerned about the three investors, because it is difficult to predict whether they will vote with their conscience or their wallets. It is not always clear that investment managers care for transparent financial reporting, as it could threaten opportunities to create a competitive advantage with proprietary analysis and modeling techniques that can cut through the haze emanating from low quality accounting standards.

The three trustees from government/not-for-profit are huge question marks. I readily grant that it is right and proper for NFPs to have their say on many of the issues addressed by the FAF; but, this ain't one of them. How ludicrous would it be for the NFP bloc to determine such a significant issue -- one noe less that much, if any, impact on their constituencies.

So, that's the math that makes me fearful that the fix is in. I am just as fearful that a 'historic cost' bloc of trustees will control the appointment of two like-minded FASB members. And, since that will be enough to control the FASB via simple majority (which I am against), the third appointee will be nothing more than a $500,000 per year lamp post.

Whatever the ultimate scenario, if there is only one though that you will take from this posting, I hope it is this: 

The fate of the most significant financial reporting initiative in the history of the FASB will not be decided by the Board. It will be decided by the 14 trustees of the FAF.

The timing of the FAF's decision to increase number the size of the FASB, and their control over the new appointments, has rendered it thus; and for or all I know, that's the reason why Bob Herz, the current chairman, chose to retire early. If I were in his shoes, that exactly what I would have done.  Moreover, unless the FAF does the right thing, resign in protest is what Tom Linsmeier and Marc Siegel (the two remaining fair value guys on the Board) should do.

On the other hand, I have not a single shred of direct evidence as to how any individual FAF trustee will vote. Perhaps, they will appreciate why three bright stars of the accounting firmament, David Mosso, Ed Trott and (soon) Walter Schuetze have spoken out and appoint new Board members accordingly. But, the stated purpose of the Board expansion, and the arithmetic of Board voting strongly suggest otherwise--which leaves us with little to do, except to wait for the banks to fail us yet again.

Loan Impairment: A Made-Up Number By Any Other Name …

According to the American Bankers Association's August 5^th letter to Treasury Secretary Timothy Geithner, the banking industry will be fundamentally changed if the FASB were to require banks to account for its loans at fair value. Everybody who thinks that banking practices should be fundamentally changed, please raise your hand.

"The FASB's proposal will … decrease the ability of investors, regulators, and bank customers to undertstand the business of banking, due to the focus on estimates of the market's perception of value rather than the cash value to the bank." (italics supplied)

Let's break this passage from the ABA's letter into two parts: what the ABA appears to be for—reporting loans at the "cash value to the bank;" and what they are against—a "focus on estimates of the market's perception of value."

"Cash Value to the Bank" – Old Rotgut in New Bottles

My inspiration, such as it is, for this post came from a discussion of the ABA letter with a friend (who must remain anonymous). My friend was first to ask what the phrase "cash value to the bank" was intended to mean. As the letter offered no hint of possible alternatives to the FASB exposure draft that the ABA would support, we initially surmised that the phrase in question was the ABA's oblique way of stating that it actually wanted no change to existing GAAP, without actually uttering those preposterous words -- for in these trying times, it is hard to say with a straight face that GAAP's loan impairment rules are anything more than utterly disconnected from reality.

So, we asked the ABA; and, we were right. Here's the gist of my email correspondence with Donna Fisher, ABA's senior vice president of tax, accounting and financial management.

My Question: "Does the term 'cash value to the bank' refer to existing U.S. GAAP as it applies to a bank's loan portfolio?"

Ms. Fisher's Response: "Yes, we are referring to current accounting, in which the amount of principal to be received is the amount that is reported. As in current GAAP, this would not include interest income, but would include fees and discounts. Loan impairment would continue to be shown as a contra-asset on the face of the balance sheet." (italics supplied)

I suppose there is still some uncertainty as to the intended meaning of the term in question. Is Ms. Fisher referring only to the carrying amount before or net of impairment charges? Methinks she must be referring to carrying amounts for loans net of impairment charges; for if she were not, then the ABA shouldn't object to reporting fair value as the net of the principal amount (taking into account fees and discounts) and an adjustment to bring the principal amount to the fair value of the loan. I'm 100% certain that the ABA would not be happy with that!

I think I'm on pretty solid ground when I state that most everyone except for bankers and their auditors have eventually come to realize that extant accounting for loans is a dog's breakfast of wishy-washy criteria and made-up numbers. But, I haven't reached my self-imposed 1000-word quota yet, so let's review the lowlights of what investors and bank regulators are currently being fed.

Residential mortgages—The accounting standards for "large groups of smaller-balance homogeneous loans," including residential mortgages and credit card receivables are about as squishy as accounting can be. All banks will perforce make some accrual for defaults, but GAAP contains no guidance whatsoever for measuring the accrual, other than it must be capable of being measured reliably—whatever that means, and especially since we are told nothing about what the net loan amount is supposed to portray.

The bottom line for loans evaluated on a portfolio basis is that GAAP is an open invitation to bankers to make up a number. Even before the financial crisis, bankers were exploiting with virtually impunity these gaping gaps in GAAP via what former SEC Chairman Arthur Levitt famously referred to as "cookie jar" or "rainy day" reserves. I recall that the SEC staff in 1999, under Levitt, questioned specific banks about loan reserves that were as high as 8% during periods when actual loan loss experience was under 1%. Golly, I wish we could have those days back again, but the point is to show that even after being chastened by the S&L crisis, many bankers were defiantly back to their old accounting tricks, and with nary a peep from their auditors.

Loans identified for individual evaluation—The protocol for recognition and measurement of impairment goes like this:

• Recognize an impairment when it becomes "probable" (helpfully defined as "likely to occur") that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.
• The amount of the impairment is to be measured as the difference between the carrying amount of the loan and the present value of the expected cash flows (as estimated by management, of course!) to be received from the borrower.
• The discount rate used for making the present value calculation is the loan's original yield to maturity (referred to as its "effective rate," in order to avoid explicit mention of the apples-multiplied-by-oranges arithmetic).

First, the definition of "probable" is as clear as mud, and intentionally written so that each bank can have its own special way for determining when that "probable" threshold has been crossed. In practice, "likely to occur" is interpreted to mean significantly more likely than not, and that by itself should speak volumes. Why must investors wait for the bad stuff to be just inches from hitting the fan? By the time investors learn about collectibility problems, there is no getting out of their way.

Second, I probably don't have to explain to anyone how ludicrous it is to discount lower expectations of cash flows with the originally-expected rate of return on investment. Can this be what the ABA refers to as "cash value to the bank"?  Evidently so. 

I'm sorry to have to have to inform the ABA that a made-up number by any other name is still a made-up number. I'm dying to reproduce a Dilbert cartoon here, but with copyright laws what they are, I had better not. So, here's the gist of what those scruffy mutts were saying:

Boss: Your report is nothing but a bunch of made-up numbers!

Subordinate: I know, but studies have proven that made-up numbers are better than real ones.

Boss: How many studies say that?

Subordinate: 58.

(Thanks to Bob Jensen for bringing the cartoon to my attention.)

Third, the requirement in GAAP to consider most loans individually plays even further havoc with the specious "probable" threshold for impairment recognition. Let's say, for example, a bank holds 10 commercial real estate loans, and due to the occurrence of some event after the loan was made, the probability of default for each loan increased from 1% to 5%. Even though the probability that at least one of the loans will default in the future is roughly 60% (= 1 - .95¹⁰) no impairment charge will be recognized. I surmise that only bankers and auditors think that' makes for "fair presentation."

Don't Trust Markets: Only Real Bankers Know How to Value a Loan

The ABA's position is that when it comes to accurate estimates of a loan's value to the bank itself, investors and regulators should rely on ABA members to make those valuations. This we should accept even though two recent banking crises and a cursory reading of Freakonomics tell us otherwise in no uncertain terms.

I certainly don't want to belabor the obvious here, but what is there about a banker's character that makes them different from the rest of us? Yes, they are the ones on the ground working with the entire loan portfolio, but asking them to grade their portfolio is like asking a college student to grade her own work. Surely, we have progressed far beyond the naive view of bankers and their auditors as belonging to some sort of priesthood whose solemn vows place them a cut above the rest of us mere mortals. If we are to accept the ABA's premise that market "perceptions" of the value of financial contracts are structurally flawed, then the problems with our market-based economy run much deeper than deciding how to make the debits and credits.

It's one thing for the ABA to be against fair value accounting, but it's quite another to support the status quo. For that, the ABA decided to invent a high-minded sounding term of art that has no actual meaning except for the dog's breakfast that is current GAAP for loan impairments.  Their motivation is to hide their support for continuing to allow bankers to pretty much decide on their own what made-up numbers they deign to report to shareholders.

And, wherefrom comes the basis for presuming that a banker can divine value more accurately than a market of buyers and sellers (or a neutral valuation expert) possessing essentially the same information that the banker has? Certainly, recent history provides no basis. A huge factor that brought about the financial crisis was that the Big Five investment bankers (supposedly the smartest of the smart), stupidly ate too much of each other's cooking—those overrated tranches of securitized subprime mortgage loans. They all could have fallen on themselves like victims of a Ponzi scheme of their own making had the taxpayers not picked up a large portion of the tab.

Now, the ABA wants us to believe that the old recipe their members followed for cooking their own books is still tried and true, just because they have given it a shiny new name – 'cash value to bank.'

The name I have for that is chutzpah.

GM's Future IPO: Whom Can Investors Trust?

Not only does General Motors' CEO, Edward E. Whitacre Jr., want to take GM public ASAP, he is asking the federal government to sell its $50 billion (!) stake at the same time. That's all well and good, but I have two concerns: (1) whether the SEC will, or can possibly be, an effective gatekeeper of a GM IPO; and (2) whether the contemplated timing (before the end of 2010) would be in the best interests of investors.

Concern #1: We Have Seen the Issuer, and It Is U. S.

A cornerstone of financial reporting regulation in the U.S. is the requirement that an offering of securities to the public must be preceded by a registration statement. This is the means by which required disclosures become public, while at the same time providing the SEC with all the time it needs (usually around 30 days) to review the disclosures for compliance with its rules.

Other jurisdictions claim to have similar protections for its investors, but nothing matches the thoroughness of the SEC's review of prospective IPOs. It is not uncommon for an IPO registration statement to generate dozens of comments, each one of which the issuer must address to the SEC's satisfaction before it will permit the offering to go forward.

The IPO review process isn't perfect, and the SEC in no way guarantees that they caught every "deficiency" in a document they reviewed. Yet, the SEC's reputation as the most active and effective securities regulator in the world is derived in large part from how seriously they take this most basic aspect of their work. But, the imminent IPO registration statement filing by GM could put that reputation to the test—not so much because of the record size of the transaction, but because the issuer and the regulator are one and the same.

Please forgive me for stating the obvious: the federal government holds a 61% of the outstanding shares of GM; GM's disclosures are expected to affect the offering price; and, the government has a direct and significant interest in the offering price. There is just no getting around the fact that the issuer is the government, and that selfsame government will be reviewing what is effectively the sales brochure for the offering for truth in advertising.

I would venture to say that the circumstances of the GM pose a singular challenge to the SEC, and they could be receiving the registration statement in just a few months.  To start the conversation on it can most appropriately defray itsconflict of interests, I humbly submit these ideas for the SEC's consideration:

Make the review process fully transparent.

Comments on registration statements and issuer responses are not normally made public until long after the offering has taken place. As a general matter, some could argue that confidential treatment of "deficiency letters" unnecessarily coddles issuers; but setting that cavil aside, nothing prevents the SEC from making an exception to its own policies. For example, the SEC could keep its initial comment letter confidential until GM provides its written responses. Concurrent with GM's response, both letters could be posted to the SEC's website.

Outsource the registration statement review to an independent third party.

There must be dozens of former SEC staffers in private practice who are qualified and willing to review GM's registration statement. The SEC could appoint, after a transparent selection process, a few individuals from among their alumni to serve on an independent committee whose sole responsibilities would be to review GM's registration statement, and ultimately to draft the comment letter. After appointing the committee, the SEC should recuse itself from the decision to allow the registration statement to become effective.

Review the reviewer

The SEC could hire one accountant and one attorney to oversee and report on the SEC's review of GM. Recusal, as described above, would be preferable, but an additional layer of review from an independent source is more acceptable than business as usual.

Of course, the SEC could choose to nothing special whatsoever -- i.e., proceed as if GM were like every other issuer. But, that would be a denial of reality, something which the SEC has recently become too prone to do (see Bernie Madoff, International Financial Reporting Standards, Bear Stearns, Pequod Capital and too many more). It would be acting as if a conflict between investor protection and the financial interest of the government doesn't even exist—yet that's what I am afraid will happen in the absent calls from investor groups and (gasp) politicians to undertake a singular review process that would be beyond reproach. When the government plays the issuer in the largest IPO in history, the safeguards investors are entitled to require even more reliability than deepwater blowout preventers.

Issue #2: If Timing Is Everything, Then Somebody May Be Getting Fleeced

GM seems to be poised to base its registration statement on its earnings from the third quarter of its current fiscal year. It is not uncommon for a company to time its public offering to follow on the heels of a couple of good fiscal quarters.  Under even normal circumstances, investors would have two concerns with that kind of timing: (1) whether anything like that gangbuster last six months or so can be sustained over the long term, and (2), whether the reported profits of an audited "stub" period will hold up to the scrutiny of the independent auditors.

I know that it has been the government's policy to let the management of GM run things, but after GM gets its money, Mr. Whitacre plans to take the next stagecoach out of Dodge (I noticed the pun only on the third reading). In the case of a restatement or other material error in the registration statement, Whitacre won't be around to take full responsibility for misleading investors, and the new gang in charge will be pointing fingers right and left.

For these reasons, the government needs to dictate the timing of the offering. First and foremost, it must assure that the latest balance sheet and income statement included in the registration statement will be audited (Note: interim period financial statements in the registration statement don't have to be audited under SEC rules).

Second, the CEO who signs that registration statement has to be on the hot seat for at least a year after the IPO. And, third, despite Whitacre's express wishes, the federal government needs to keep its own shares for another year after the IPO takes place. If investors are going to lose money because the IPO was mispriced, the government shouldn't be adding its shares to the public float until GM's share price is determined through a sufficient period of secondary market trading.

I can already hear in my head what the response of GM's management and IPO promoters will be: "Look, we're the ones that brought GM back from the brink. You can trust us."

Right.

Sweet Little Nothings from the IFRIC

In researching an IFRS question recently, I stumbled across a whole new (for me) source of stealth guidance put out by the IASB's International Financial Reporting Interpretations Committee (IFRIC). I am referring to official descriptions of issues that were presented to IFRIC, but not taken onto their agenda.  Notwithstanding that rejection strongly implies insignificance, the IASB has seen fit to compile IFRIC's stated reasons for rejection, going so far as to update references when changes are made to them.  Even so, these compilations are all prefaced by a disclaimer that each snippet (by my count there is a about two hundred of them) is for "information purposes only" and does not "change existing IFRS requirements."  Right.

What follows is the story of just one "information purposes only" comment that clearly was meant to be more than that -- most likely a gift to a highly-valued stakeholders.

A Little Revenue Recognition Question*

During an IFRS course I was teaching to practicing accountants last month, one of the attendees asked me how discounts for early payment should be treated. His company, for example, offered terms of 2/10 net 30, and 99% of the customers took advantage of the discount. However, not all customers actually paid within the discount period; as is common in practice, a significant proportion of customers claiming the discount did so after the discount period lapsed.

If you have studied U.S. GAAP accounting at even a basic level, you would be aware of at least one method for treating early payment discounts, despite the fact that no specific provisions in GAAP dictate the accounting treatment for them. I couldn't even find an answer from a search of PwC own GAAP accounting and reporting manual--normally a rich source of information that I use frequently. Thankfully though, practically every intermediate accounting textbook covers the basics of the 'generally accepted' alternatives treatments of invoice payment terms. Before we delve into IFRS for its requirements, kindly permit me to stipulate that there are two generally accepted approaches under U.S. GAAP:

• The 'gross method' calls for, assuming a $100 nominal price, recording $100 of revenue upon delivery of goods/services offset by accounts receivable. Before the financial statements are issued, however, two accounts receivable allowance accounts are established: one for future exercises of early payment options granted during the period (with an offset to a contra revenue); and as with all sales on account, another for uncollectible accounts (with an offset to bad debt expense).
• The 'net method' will record the initial sale at $98. If the company collects $100, the difference will be credited to financial revenue – usually interest income. The allowance for uncollectible accounts is handled in the same way as per the gross method.

Neither method is completely satisfactory for reasons that I won't go into here, but they are useful benchmarks against which to judge what I found from researching IFRS. As you will see, IFRS was crystal clear—until the IFRIC made one of its "information purposes only" comment about an issue they decided not to comment on.  Go figure. 

I initially focused my investigation of the IFRS treatment on the initial recognition aspect, because that was what my questioner was concerned with; also, the appropriate subsequent measurement would likely suggest itself from initial measurement. International Accounting Standard (IAS) 18, Revenue, provides as follows:

"The amount of revenue arising on a transaction is usually determined by agreement between the entity and the buyer or user of the asset. It is measured at the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the entity." [IAS 18.10, italics supplied]

Stripping out some of the qualifying language, the core of paragraph 10 is about as clear and principled as one could ask for: revenue is to be measured at the fair value of the receivable.

As to that qualifying language, I don't know for sure what "usually" means in this context, but since early payment invoice terms are so common, it should be safe to assume that the general rule enunciated in IAS 18.10 is applicable without alteration. The last phrase of IAS 18.10, "…taking into account the amount of any trade discounts and volume rebates …", also does not appear to pose a problem, although I have to admit that I don't have any firm grasp on its function. A fair value measurement should comprehend all potential economic consequences; why two specific factors are mentioned may be an artifact, which would have become outdated when fair value was formally defined by another accounting pronouncement.

IAS 18.10 is not fully consistent, however, with IAS 39, Financial Instruments: Recognition and Measurement, which provides guidance on accounting for financial instruments for initial recognition at fair value. However, I should note that IAS 39's application guidance does provide a materiality exception for measuring trade receivables at fair value:

"Short-term receivables and payables with no stated interest rate may be measured at the original invoice amount if the effect of discounting is immaterial."  [IAS 39.AG79]

I'm going to proceed for now as if discounting would be material, and deal with undiscounted receivables separately.

Which brings us to subsequent accounting for the receivable. For that, we need to stay with IAS 39, because, trade receivables are within its scope. Specifically, IAS 39.46(a) provides that receivables are to be subsequently measured on the basis of amortized cost using the effective interest method.

A key difference between U.S. GAAP and IFRS relates to recognition of impairment. Under U.S. GAAP, the receivable may be reduced for an allowance for bad debts on Day One. However, this is not appropriate under IFRS because an allowance for bad debts should have already been taken into account when initially measuring the receivable at its fair value. Subsequent recognition of impairment losses may only be made if there is "…objective evidence of impairment as a result of one or more events that occurred after recognition of the [receivable]." (IAS 39.59)

So, the answer that I was going to send to my questioner was going to go something like this:

IFRS requires that the receivable be initially measured at fair value and subsequently measured at amortized cost until the invoice is paid or becomes past due. The receivable would be considered to be impaired if not paid within 30 days (or perhaps at some earlier date if an event occurs that provides objective evidence of impairment). The difference between total cash received from the customer and the initial valuation of the receivable should not be presented on the income statement in the same manner as revenues from the sale of goods.

However, for reasons of materiality, it is common practice to disregard the effect of discounting in the initial measurement of trade receivables. When that is the case, then the net method appears to be most consistent with the principles enunciated in IFRS.  Accordingly, the liberal discount terms would indicate that the original amount of the receivable and the revenue to be recorded would be $98; any amount collected in excess would be financing revenue.

Finally, I must note that IFRS does not address the measurement of impairment if the receivable is measured at its undiscounted amount.  Therefore, I believe it must be presumed that no impairment may be anticipated until a subsequent event provides objective evidence of impairment.

IFRIC the Fixer

Then, this little blurb from the July 2004 edition of IFRIC Update (and as I mentioned above, subsequently compiled with other similar snippets) was brought to my attention:

"Items not taken to the IFRS agenda…. Prompt settlement discounts ... IFRIC members agreed that prompt settlement discounts should be estimated at the time of sale, and presented as a reduction of revenues. ..."

In other words, IFRIC has 'agreed' (without putting the issue on their agenda – and in the absence of a quorum, I should add!) that IFRS calls for the gross method of accounting. Whatever their answer, it sure would be nice to know how they got there!  Cynical me thinks that's precisely why this common question, for which IFRS is clearly not clear on, was not put on the agenda.

One of the criticisms that supporters of IFRS adoption in the U.S. make of U.S. GAAP is that the utterances and scribbling emanating from SEC staff members without due process become de facto rules. Notwithstanding disclaimers like the one that IFRIC employs for its snippets, these and similar sources are considered authoritative by issuers and derogatorily referred to by many as "speech GAAP."

But, a critical difference between SEC speech GAAP and IFRIC's version is that the SEC's interpretations almost invariably constrain the accounting possibilities;  issuers don't like them.  But, it seems pretty clear that issuers would appreciate those otherwise gratuitous comments from IFRIC, which make chicken salad out of even the most principled of international accounting standards.

Perhaps one can also criticize the various promulgators of U.S. GAAP for allowing diversity in practice to persist for such a basic and common question as early payment discounts. But let's suppose for argument's sake that the EITF formally considered putting the issue on its agenda, and then chose not to.  In announcing their decision, would they proffer an opinion as to what the appropriate accounting treatment should be?  That would be inconceivable.  At the very most, IFRIC could publish a statement that they were not going to address an issue because, perhaps, they viewed it as already being settled – or that the existing standards are sufficiently clear. Anything beyond that is merely poorly-disguised "speech GAAP."

One of the many reasons why I am so opposed to IFRS adoption in the US is that I trust the IASB even less than the FASB to stick to its principles or to focus on the needs of investors. Chicken salad speech GAAP from IFRIC is just one more reason to feel that way.

------------------------

*My analysis of this question was enhanced by contributions from two contributors to the AECM listserv: Pat Walters of Fordham University and Carla Carnaghan of the University of Lethbridge.  An earlier version of this posting omitted reference to IAS 39.AG79; sincere thanks to S. Ramachandran for pointing this out to me.

Also, I have slightly altered the circumstances under which I received this question in order to maintain the confidentiality of a client relationship.

FASB Alumnus Trashes GAAP (and IFRS)

When I started my blog almost exactly 3 years ago now, my opening strategy was to work down a rather limited personal inventory of pet peeves. I wanted to stay above the fray, but that proved impossible. I soon became hopelessly drawn to commenting on the helter-skelter stampede of recent developments driven by the Big Four's IFRS putsch and the undeniable role that lousy accounting standards played in the financial debacles of 2007 and beyond. 

But, who really cares what I think?  I suspect that the folks being paid the big bucks to make the tough calls on accounting standards don't pay a lot of attention to to the likes of Tom Whatshisname, even were I to announce that the sky is falling. But, I don't take it personally. Over the past 40 years, any PhD not drawing a salary from the Big Four has been viewed with more suspicion than respect by the standard setting establishment.

I mention all of this now, because there is a new voice, whose credibility and qualifications cannot be so easily dismissed.  That voice belongs to FASB alumnus David Mosso, who has written an 80-page monograph entitled Early Warning and Quick Response: Accounting in the Twenty-First Century).  If you don't want to believe me, take it from him: GAAP is broken.

Mosso is not just some average pedant. He has pretty much done and seen it all when it comes to accounting standards setting, most significantly having spent nearly twenty years at the FASB, and having been a board member for ten of them:

"I spent three decades in helping to create the accounting mess called generally accepted accounting principles, or GAAP. This book is an attempt to make amends." (page 1, italics supplied)

"Eighty years of tinkering [with a broken accounting model] has not done the job. … In the case of business failures, the company's auditors are usually the scapegoats, but I suspect that accounting standards are often more, or at least equally, at fault." (page 78, italics supplied)

I'm not trying to promote Mosso to oracle status, but coming from him—as opposed to whatshisnames like me—this should been seen more as an indictment than merely opinion. (By the way: just to be sure he wasn't just trashing GAAP, I asked David via email what he thought of GAAP/IFRS convergence. He replied that it was like the collision of two garbage trucks.)

Mosso's book has three principle themes:

1. Financial reporting is a vital function; however, the politicization of standard setting has been far more harmful than beneficial. Words like "junk," "trash," and "garbage" permeate the references to current GAAP.
2. GAAP must be fundamentally changed. Mosso's proposed system of accounting rules consists of little more than a few principles, which together comprise his "Wealth Measurement Model" (WMM). The gist of that model is to recognize "all" the assets and liabilities of an entity and to measure them at fair value, which apparently out of convenience is specified to be in accordance with existing FAS 157. Mosso claims that the comprehensive nature of WMM makes it capable of generating timely signals of looming problems to both investors and policy makers.
3. Upon implementation of the Wealth Measurement Model, subsequent accounting standard setting could be limited to a sort of rapid-response version of the Emerging Issues Task Force for addressing implementation issues arising out of innovations in business practices and new technologies.

I don't have much to say about the third theme, because it's not a topic that I spend much time thinking about. I do acknowledge, however, that the current standard-setting system is seriously dysfunctional. And, I can't resist pointing to Mosso's contention that accounting standards should be run by academics, because "…accounting professors are the only group with the untainted standing to represent the public interest." Read, all ye good people, what this brilliant and eloquent man has thusly writ!

As to the pile of trash that GAAP has come to be (#2, above), I licked my chops when in the first chapter Mosso broadly hinted that his readers would receive the down low skinny on those back room machinations, which led to the accounting standards to bring him the most shame. However, there was absolutely none of that in the book. Mosso's only specific mea culpa was this tiny little snippet:

"When standard setting was formalized, standard setters seem to have taken the existing equity classification of [preferred stock, stock purchase warrants and stock compensation options] for granted without much scrutiny. I acknowledge that I did not challenge the conventional classifications when the conceptual framework was under development."

To his significant credit, however, Mosso may be the first real insider to broach the topic of standard setting dysfunctionality so comprehensively, even though I feel more than a little let down by his refusal to dish. Since Mosso is asking his readers to consider proposed solutions from an admitted creator of the problems themselves, I feel entitled to more of something like this:

"We wrongly promulgated X (and I voted for it) because of pressure from Y. The resulting harm was Z1, Z2 and Z3.

I gag every time I think of the quantities of toxic waste that my innocent son and his babe-in-the-woods peers are force-fed from their 1000+-page "intermediate accounting" textbooks. It would be nice if at least one of the authors of the master cookbook strongly advised students that many grains of salt should be added before consuming.

The Wealth Measurement Model

There is a great deal to admire about the WMM. In particular, I strongly support limiting owners' equity to basic ownership interests, and throwing goodwill and deferred taxes onto the trash heap.

But, I do have two important concerns; in regard to how Mosso would measure assets and liabilities, I believe he is not being ambitious enough; and in regard to which assets and liabilities Mosso would recognize, he is far too ambitious.

The Measurement Issues—Although Mosso states that assets and liabilities should be measured at their fair values, I suspect that deep down, he realizes that replacement cost is the attribute of an asset that corresponds to "wealth." I draw my inference of Mosso's true views from Chapter 5, wherein he discusses the insights to be derived from comparisons of the market value of a firm's equity to the replacement cost of its net assets – i.e., a variant of Tobin's Q ratio. Mosso's analysis clearly indicates his awareness that "wealth" embodied in productive assets like machinery is not correctly measured by the current amount for which the machinery could be sold, but for how much it would cost to replace its productive capacity. So, I find it slightly ironic that Mosso condemns the politics of standard setting, but himself seeks a political compromise with the hope of persuading proponents of fair value to embrace his WMM.

The Recognition Issues—These are an even bigger concern to me than the choice of fair value over replacement cost. Mosso contends that accounting standards can be written such that "all" assets and liabilities could be found on the balance sheet. I'll admit that the possibility is tantalizing, because it would eliminate off-balance sheet financing, and it would also transform what is now merely a "balance sheet" to a true "statement of financial position." Unfortunately, Mosso's vision is unrealistic; and here's a couple of examples to illustrate why:

• A competitor's misfortune provides an opening for an entity to introduce a new product. Such an opportunity is what is known as a "real option." An accounting definition of "asset" that would comprehend those circumstances would be far too broad to be of practical use.
• Without going into too much detail here, Mosso would require the recognition of "constructive" liabilities (even though that's not the term he uses), and for reasons I explain here, I would not support that.

Therefore, the set of assets and liabilities that would be eligible for recognition needs to be bounded in a manner that can be consistently applied and audited. For me, legal rights and obligations form natural and convenient boundaries.  It has been my position that assets and liabilities recognized should be limited to legal rights of ownership, rights of use, and rights to receive assets in the future.

A Final Thought

When a member of the guild of royal sausage makers issues a health advisory, we need to find something else to eat. David Mosso's new recipe does not perfectly suit my tastes, but it's definitely restaurant quality.

A Simple Solution To Standard Setters' "Control" Issues

In the good old days, you recognized the assets you owned. For the reasons why things eventually became a lot more complicated than that, there is plenty of blame to go around. Blame the banks and their minions of financial engineers for arcane securitization transactions that transferred legal ownership of those assets, but not much else, to work the accounting wonders that have now become closely associated with the most recent financial crisis. Blame Enron for trying the same scheme with power plants and such.  Blame lots of companies like Enron that were able to keep a lower profile. 

From the perspective of the rampant abuses that occurred, I suppose you can't find too much fault with the FASB and IASB for taking another tack for asset recognition/derecognition. But, the fact remains that "control" (notwithstanding the difficulty the boards have had in pinning down an abuse-proof definition) as a recognition criteria has problems of its own. Take, for example, lease accounting, one of the more high profile issues of the day. As in my previous post, I'm going to use some recent remarks on the topic attributed to Jim Leisenring by Simon Brown as a jump off point. Before we get to that, however, I am once more compelled to provide a few caveats.

First, I incorporate by reference the caveats as to Simon Brown's reporting of Jim Leisenring's remarks concerning "high quality accounting standards" (HQAS) . Second, I'm really glad I issued that caveat when I did. Soon after I sent that post hurtling into cyberspace, I received a credible email claiming that Brown's reports on Leisenring's remarks as regards to HQAS were inaccurate and misleading. My source claimed that Leisenring had not even referred to any discussions of the characteristics of high quality accounting standards amongst the IASB members.

Although I regret any inaccuracies that may have found their way into my commentary, I only used the information from Brown to establish the existence of an active discussion among IASB members as to what "high quality accounting standards" meant.  I do not believe that any mischaracterizations of Leisenring's remarks, although highly regrettable, should call for alterations to my own personal comments.

As to the current post, I shall with newfound trepidation once again rely on Brown's reporting of comments made by Leisenring – this time, however, concerning lease accounting. I have inquired from my sources as to whether Brown's reporting on this topic was substantially inaccurate; and so far, I have received neither a confirmation nor a denial. As is always my policy, if I should subsequently discover any inaccuracies, I will make disclosures to that effect.

What Brown Said Leisenring Said About Lease Accounting

[Leisenring said,] The boards "have no idea what they're doing collectively, including me," …. [he] said the boards have been arguing about the issue for two months. Some members have argued that lessors should derecognize the portion of the asset they gave up by right of use, which he called "extraordinary accounting." He said the [sic, their?] derecognition model would suggest that every time a hotel rents a room, for example, it should account for the loss of the part of its building that it gave up, then reverse it the next day when a guest checks out.

I Can Fix That Problem!

The hotel example is clearly what one gets by taking a "control" criteria for recognition/derecognition to its logical extreme.  I can think of no other way to fix the problem than to restore "ownership" to its rightful place as the principal criteria for asset recognition; to wit, only legal entitlement to an economic resource may trigger recognition of an (as opposed to "the") asset.

By "legal entitlement," I am referring to one of the types of circumstances: (1) ownership of an asset; (2) a right (conditional or unconditional) to receive an asset; or (3) a right (conditional or unconditional) to use an asset. But unlike any other "traditional" accounting models, I would also need to define a liability symmetrically as an obligation to a holder of (2) and (3), above.

This revised asset/liability criteria makes lease accounting very straightforward, although I want to take this opportunity to remind you that I am severely critical of the measurement aspects of its proposals as well -- they are truly terrible.  Anyway, as regards to recognition only, the lessee (i.e., hotel guest) should recognize an asset for its right to use the property being leased (i.e., hotel room); and an obligation to pay the lessor (i.e., hotel owner) in exchange. The lessor, for its part, recognizes an asset for the right to receive payments from the lessee and an obligation to provide access to the hotel room. Thus, the accounting for the hotel property itself is unaffected by the lease arrangement as no change in ownership occurred.

Does My Fix to the Leasing Problem Create Other Problems?

You may already be thinking of potential shortcomings to my "legal entitlement" approach. So far, I have thought of two – but I can easily live with them.  In fact, I vastly prefer them to the results that come out of the control approach.

First, legal entitlement could put all executory contracts on the balance sheet, not just leases, the pioneer of on-balance-sheet recognition of an executory contract.  That's because it was rightly seen by many as an essential exception to close one of the most popular off-balance sheet loopholes. Years later, a forward contract meeting the restrictive definition of a "derivative" became another form of executory contract that was put on the balance sheet (SFAS 133).

So, I suppose, that standard setters can continue to pick and choose which executory contracts to scope in or out of its rules no matter whether "control" or "legal entitlement" is the asset recognition criterion.  As for my own preferences, except for limited practicability and materiality considerations, the ancient prohibition against recognition of executory contracts has become obsolete.

Second, the "legal entitlement" criterion for liability recognition as I have stated it would not result in recognizing "contingent liabilities" such as pending lawsuits (unless, of course, the case had been adjudicated). It would also not comprehend constructive liabilities. With respect to contingent liabilities, all sorts of regulators have been trying for ages to come up with consistent accounting for contingent liabilities and the results, to be kind, have been inconsistent if not just plain ineffectual. With respect to constructive liabilities, they are merely tools for earnings management.

I'm most happy to get both contingent and constructive liabilities off the balance sheet, although disclosures of contingent and constructive liabilities have their place, and arguably should be strengthened. There is nothing wrong with expansive narrative and quantitative disclosures in notes or in MD&A.

I should also note that my criterion would comprehend contractual warranty obligations and any other similar obligation to stand ready to perform in the future.

Control as a Presentation Criteria

Finally, I should point out that the notion of "control" can still be useful, even though it has done little more than to bollix things up. For another recent example, see the infamous Repo 105 mess.) Its role would be limited to determining the presentation of financial assets. If legal entitlements over financial asset(s) convey the power to control another entity, then consolidated presentation would be appropriate. Other circumstances could also indicate that consolidated presentation is appropriate, too, such as whether an entity is a "primary beneficiary." If the investment(s) confer "joint control," then proportionate consolidation would be appropriate; but, that's certainly fodder for another blog post.

An IASB Member Unleashed

I can't cite chapter and verse for this, but experience tells me that there is a cardinal rule for IASB and FASB members that goes something like this: 'If you can't say something nice about board deliberations, then don't say anything at all.' Thus, I was surprised to read that IASB member James Leisenring recently made some more-than-bland comments in regard to the quality of the sausage spewing forth out of the IASB/FASB's high-speed grinders and packers.

But, before I continue, a caveat is in order. I was not in attendance when Leisenring made the remarks that are the subject of this post. After an arduous 15-minute search I am compelled to notify readers that my only source for his comments is a very brief news article credited to one Simon Brown and entitled, IASB Member Calls Lessor Accounting Discussions with FASB "Hopeless." The report was sent to me via email by a much-respected source, who must remain nameless. I have not even been able to discover the title of the publication in which Brown's article appeared.

According to Brown's report, Leisenring made colorful comments on three topics: leases, pensions, and a disagreement among IASB members as to what constitutes "high quality accounting standards" (which I will abbreviate to "HQAS"). As lease accounting holds a special place in my pet-peeve riddled heart, I'll have more to say about the lease accounting comments at a later time. The topic for this post will be restricted to the HQAS remark.

According to Brown:

"Leisenring also explained an interpretive disagreement he has with some IASB members regarding what is meant by 'high quality standards.' He said some consider high quality accounting standards can be standards that are unambiguous, such that a practitioner 'can't fail to comply with them.' An unambiguous standard, however, could still allow 'for implicit alternatives' to the standard, Leisenring argued. He did not offer an alternative model."

Actually, I can't say that I even know from Simon's account what Leisenring is specifically referring to. What grabbed my attention was simply that the IASB members are still trying to figure out for themselves what constitutes an HQAS, especially if it will be used as a benchmark against which to judge the results of IFFRS/GAAP convergence. I'm also surprised that the dialogue among the players seems to be: (1) strictly amongst the IASB members; and (2) apparently restricted to the compliance side of standards – as opposed to whether the numbers reported in the financial statements actually will mean anything.

Regarding the strictly intramural aspect of the discussion, I have noted previously that James Kroeker, SEC Chief Accountant has stated that the SEC would want to determine whether convergence has resulted in demonstrably higher quality accounting standards before moving further down the IFRS adoption path. Leaving aside my concern that "demonstrably higher" is neither very ambitious nor specific, the SEC's view of what HQAS means should count for something to the IASB, assuming they actually care about making a case for convergence.

Moreover, if there are some doubts as to what HQAS is, the SEC's view could have been attended to more closely at the outset of formal convergence efforts (October 2002); for surely the SEC had convergence in mind when they published their congressionally mandated (see the Sarbanes Oxley Act, Section 108(d)) report on the feasibility of "principles-based" accounting standards in August 2003. According to the SEC, the "objectives-oriented" standards they are looking for from a standard setter should possess the following qualities:

"Be based on an improved and consistently applied conceptual framework;

Clearly state the accounting objective of the standard;

Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;

Minimize exceptions from the standard;

Avoid use of percentage tests ("bright-lines") that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard."

Now, seven years later, the SEC's battle plans have been subordinated by the din and desperation of convergence wars. Are any new standards from either board "based on an improved and consistently applied conceptual framework"? Obviously not, for nary a single alteration to any conceptual framework document has occurred in the last seven years. The existing definitions for assets and liabilities are like wooden ships sent to battle against nuclear submarines.

Does each new standard, or revised standard "clearly state the accounting objective"? In a strict compliance sense, the answer could be 'yes,' but otherwise not. Take IFRS 3R on business combinations:

"The objective of this IFRS is to improve the relevance, reliability and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects. To accomplish that, this IFRS … [establishes a bunch of new rules].

Fair enough, I suppose. But, every new IFRS should "improve relevance, reliability and comparability"—so what contribution to HQAS is there from from stating what should be the objective for all accounting standards? For example, the IASB has an outstanding exposure draft proposing to continue to give companies the option to fair value financial liabilities.  "The objective of this statement is to diminish comparability and reliability by allowing companies to arbitrarily choose to measure some of their liabilities at fair value, and to measure the remainder of its liabilities according to the rules of this statement." 

As to "minimize exceptions to the standard," why did the IASB propose to exclude insurance companies from the scope of its putatively "principles-based" revenue recognition exposure draft (at earlier stages of the project, insurance was not excluded); or to exclude extractive industries from its leasing ED; or, again in IFRS 3R, and without exposing it for comment, to give acquirors the option of measuring noncontrolling interests at historic cost instead of fair value?

A High Quality Recipe -- If I May Be Allowed to Say So Myself

Up to this point, I have set aside my misgivings with the SEC's 2003 report, and especially the apparent lack of monitoring by the SEC to ensure that its recommendations were adopted.   I wanted to focus first on my misgivings with the IASB/FASB convergence project as a producer of HQAS; for taken as a whole, the last seven years have done little more than to add filler and artificial coloring to the old sausage recipes.  Now, finally, here is my very own recipe for making HQAS.

First and foremost, for there to be a higher quality accounting standard, there must be higher "earnings quality," defined as the strength of association between reported earnings and economic earnings. Higher earnings quality can, and must, be established from standard economic logic. For example, I believe that every post I have written in which I have suggested an alternative accounting standard has been based on a logical link between whatever I proposed and economic earnings. On the other hand, the Boards' leasing exposure drafts, for example, would fail this test; because, although all leases would be capitalized, the numbers put on the financial statements are arbitrarily determined.

Second, accounting should never be determined by management's intent, strategy, or even industry. An asset is an asset and a liability is a liability.

Third, do not twist perfectly clear English words into misleading terms of art. The lump left over from IFRS 3R's additions and subtractions is not "goodwill"; and multiplying an historic cost denominated in a foreign currency by a current exchange rate is not "translation." A balance sheet is not a statement of "financial position" (because of omitted economic assets and liabilities); and a statement of recognized revenues, expenses, gains is not an "income" statement. And, please don't refer to a liability or a contra-asset as a "provision" unless one is legally required to prefund a future obligation.

Fourth, if a standard must exclude certain transactions or industries from its scope, justification for a scope limitation should be based only on a comparison of the cost of producing information to its value. Why are derivatives contracts with physical settlement provisions ignored, but net-settled derivatives are recognized and measured at their fair values? Why should there be different revenue recognition rules for insurance companies than for companies that issue product warranties? I believe these are examples of political tradeoffs, as opposed to tradeoffs made with the interests of investors in mind and heart.

A recipe for high quality accounting standards doesn't have to be complicated. But, it's more like baking a cake than making sausage: if you skimp on key ingredients, it will fall flat.

Fair Value for Financial Instruments: It's Now or Never

I don't watch TV very much, except for sports – lots of sports. I nonetheless tore myself away from ESPN for thirty minutes last week when a friend strongly suggested that I watch an interview of Paul Volcker (former Fed Chairman) and William Isaac (former FDIC Chairman) on the Kudlow Report. Among other things, these gentlemen were supposed to explain why they were staunchly opposed to mark-to-market accounting for bank loans.

As expected, I didn't learn anything new from watching a superficial discussion amongst voices singing in unison. However, I did come away with a new appreciation for how much public pressure is being brought to bear on the three FASB members who boldly voted to issue proposed revisions to financial instruments accounting.  If finalized, they would require reporting nearly all financial instruments at their fair values, so it's a safe bet that the ultimate disposition of this proposal will be a watershed event in the history of U.S. accounting standards; not just for what it says about the future of fair value accounting, but for what it portends for adoption of IFRS in the U.S. This one is for all the marbles.

There are, to be sure, many aspects of the FASB's proposal to debate, but the flashpoint is whether any version of mark-to-market (MTM) accounting is appropriate for bank loans. The conventional hue and cry is that market-based valuations induce "procyclical" behavior with the ultimate effect of blunting or even defeating other economic policies. The story goes like this:

1. The market value of a bank's loan portfolio must decline during an economic downturn, even if there are no specifically identifiable problems with any individual loan. This is because the market will assign a higher probability to future bad news and impound it in the price.
2. If the decline in market value is recognized on the bank's financial statements, then regulators, whose policy it is to utilize balance sheet ratios for determining the capital adequacy of banks, will require those banks either: (a) to raise new equity capital (not an attractive option in down times), or; (b) to cut back on their lending—the more likely outcome, since equity values would be depressed.
3. If the banks were to cut back on their lending, the economic downturn would become worse.

In other words, the cornerstone argument of the anti-fair value camp goes thus: truth hurts; therefore, we must repress it.

Volcker and Issac recommend a head-buried-in-the-sand accounting standard, which allows management to disregard any possibility that a loan will not be repaid in full unless and until direct evidence to the contrary bites them in the rear end.  And, when reality can be ignored no longer, we should prefer estimates of uncollectibility produced by self-interested management (under the watchful eye of their "independent" auditor), and ignore the collective opinion of disinterested market participants.  

Here's just two of many reasons for casting one's lot with the markets.

Reason #1: Current GAAP is Procyclical, Too

One can argue just as forcefully as the MTM naysayers that the existing accounting standards are also procyclical, and that it was the flaws in the existing standards that brought us the S&L failures of twenty years ago, not just the bank failures of two years ago:

1. During periods of economic expansion, accounting rules that permit delayed recognition of loan losses encourage bankers to make inappropriately risky loans. It doesn't help that auditors are prone to accept management's head-in-the-sand versions of loan loss allowances.
2. When economic expansion ceases, banks will continue to lend to inappropriately risky candidates, and perhaps, to even riskier candidates in a desperate attempt to meet unreasonable earnings expectations. Bankers can do this with apparent impunity, because they are permitted to ignore market valuations of their existing loan portfolio.
3. When bank financing is needed to reverse the economic downturn, it won't be available, in large part because the banks have dug themselves a hole, jumped in, and can't climb out.

In other words, it is also bad economic policy to base measures of capital adequacy on fictional loan portfolio valuations, especially when that fiction is the cause of underfunding government-sponsored deposit insurance programs.

I would regularly tell my students that sound banking policy means that you only lend money to people who don't actually need it. Everybody else must seek to issue equity, thank you very much. Similarly, it may be unrealistic for policy makers to expect even healthy banks (never mind the ones in that aforementioned hole) to increase their lending during a downturn. Lacking sufficient appetite for risk on the part of potential equity investors, that leaves only the government to take up the stimulus mantle. (Yes, dear reader, I'm a Keynesian).

Current GAAP has clearly encouraged banks to make loans they shouldn't have made, and if that's not exactly what Bob Herz, FASB chair said in his testimony to Congress, it's pretty darn close:

"The fact that fair value measures have been difficult to determine for some illiquid instruments is not a cause of current problems but rather a symptom of the many problems that have contributed to the global crisis—including lax and fraudulent lending, excess leverage, the creation of complex and risky investments through securitization and derivatives, the global distribution of such investments across rapidly growing unregulated and opaque markets lacking a proper infrastructure for clearing mechanisms and price discovery, faulty ratings, and the absence of appropriate risk management and valuation processes at many financial institutions." [italics supplied]

Reason #2: Fair Value Doesn't Have to Be Procyclical

If an economic policy can be defeated by putting a truth on the balance sheet, then there is something fundamentally wrong with that economic policy. Bob Herz, FASB chair, is now calling for severing the linkages between financial reporting and bank regulations, and I've also made that suggestion here. I don't want to sound like a broken record, but there must be a better way to regulate banks than to rely on made-up balance sheet numbers.

Getting back to TV and sports, while lying sleepless and jetlagged in a Chicago hotel room a couple of days after the Volcker and Isaac show, I woke to Jimmy Kimmel's monologue. What I think happened is that I dozed off during the stupefying game seven of the NBA finals, and Kimmel followed. Here, as I paraphrase it, is perhaps as close to an accounting joke as Jimmy may ever get:

"It seems like every week, the estimate of the amount of oil spewing into the ocean from that underwater well doubles. We have to stop these estimators: they're destroying the Gulf"

Get it?

ASU 2010-19: When a Dollar of Cash Is More Than a Dollar on the Balance Sheet

If you think you can find a larger wart on the backside of US GAAP than the one I am about to describe, then give it your best shot.

Here it is in a nutshell: a careful and cynical application of the foreign currency accounting rules (either US GAAP or IFRS) could result in a $10 million bank account balance being reported on the balance sheet at $25 million. That's right: balance sheet cash isn't the cash balance. I double dare you to top that one!

As you may have guessed, the rules I am referring to are part of FAS 52, Foreign Currency Translation (now Topic 830 of the Codification), which was finalized by a 4-3 vote. They have sat there for unremarked upon for thirty years, until relatively recently as negative economic developments in Venezuela have elevated them from cream cheese on a bagel to six tons of chopped liver.

So, into the muck gingerly wades the SEC with new guidance in the form of a staff announcement at a recent meeting of the Emerging Issues Task Force. The FASB has codified that guidance with the issuance of ASU 2010-19. As you'll see, the SEC's message to investors is ambivalent, to say the least, on an issue that is as black and white as it gets.

Setting the Stage for the Big Whopper

You may wish to refer to a related post, which I wrote almost 3 years ago, and in which I described how consolidated financial statements could actually report foreign exchange gains and losses on U.S. dollars. Here's an example from that post, albeit slightly tweaked, to set the stage for the whopper to come.

Alpha Co. is based in the U.S. and presents its financial statements in U.S. dollars (USD). Beta is Alpha's Venezuelan subsidiary, and its functional currency is the local currency of Venezuela, the Bolivar (VEB). Inflation has been high in Venezuela in recent years. For this reason, Beta holds its cash balances, worth $10 million, in USD-denominated accounts. Also, as a result of the high rate of inflation, the VEB has been steadily devaluing against the USD.

For simplicity, let's assume that the cash balances I mentioned are Beta's only asset. Under normal circumstances, this is the way that consolidation of Beta with Alpha would work:

1. The USD cash balances held by Beta would be "remeasured" into VEBs; the resulting gain (because the VEB is losing value) would be reported on Beta's income statement (in VEBs).
2. Beta's VEB financial statements (including the gain on holding USDs in Venezuela) would be "translated" to dollars for the purpose of consolidating Beta's financial statements with Alpha's.
3. The effects of the "translation" process on equity would be reported in a separate "translation adjustment" category, which would not affect income.

Thus, although total owners' equity does not change from the roundtrip that the USD is taking in the accounting records — USD Þ VEB (on the sub's books) Þ USD (in the consolidated financial statements) — the gain from the outbound leg of the trip would be reported in income, but the loss from the homeward leg would bypass the income statement and only be reported in a separate component of owners' equity, i.e., the so-called "translation adjustment."

Of course, it's a ludicrous outcome buttressed by extremely flimsy logic, but I have already beaten that drum. Here comes the Whopper I've been fixin' to tell you about.

The Dual Exchange Rate Problem

Even if you absolutely detest the effect of FAS 52's remeasurement/translate procedures on reported earnings, there is the small consolation that cash (and other monetary items) are correctly stated—even after their round trip. However, this is not always the case for two reasons: (1) currency exchange controls by the country in which a foreign subsidiary is located; and (2) more bad accounting rules.

As to those currency exchange controls, they can result in multiple exchange rates. Here, for example, is how the SEC staff, in ASU 2010-19, describes the current situation in Venezuela:

"[C]urrent restrictions of foreign currency exchange in Venezuela provide that entities use the official rate of exchange to exchange funds.... As an alternative to the use of the official rate it may also be legal to utilize the parallel rate. It is possible that the parallel rate provides entities with a more liquid exchange and entities can access the parallel rate using a series of transactions via a broker."

When multiple exchange rates exist, US GAAP may permit the use of one of those exchange rates for remeasurement (per ASC 830-20-30-1, the "current rate of exchange") and another for translation (per ASC 830-30-45-6, the "dividends remittance rate"). Thus spake the SEC staff on these provisions as they apply to Venezuelan operations:

"[T]he staff has recently become aware that... certain entities may have used the parallel rate to remeasure certain US dollar denominated balances that the Venezuelan subsidiary held and then subsequently translated the Venezuelan subsidiary's assets, liabilities, and operations using the official rate. The effect of this accounting treatment resulted in reported balances in an entity's financial statements that differed from their underlying US dollar denominated values."

[For example,] assume that at a period end … a U.S. entity's Venezuelan subsidiary held $10 million of cash denominated in U.S. dollars. Further assume that at the end of the period, the parallel rate was 5 Bolivars to every 1 U.S. dollar and the official rate was 2 Bolivars to every 1 U.S. dollar. Upon the remeasurement of the U.S. denominated cash to Bolivars and the subsequent translation of the Venezuelan subsidiary's financial statements, an entity would have reported cash of $25 million for financial reporting purposes. [Italics supplied]

Finally, after 30 years of sitting on its hands, the SEC has acknowledged the insanity of using one rte for remeasurement and another for translation: among other crazy things, $10 million in cash is transformed to $25 million on the balance sheet—with a hefty income statement gain in the process (due to the declining VEB).

Unfortunately, though, the SEC's solution is to soft pedal. If you're in Venezuela, but nowhere else, kindly provide some additional disclosures. Everybody else: you can keep doing that thing you do with multiple exchange rates. To all you investors out there, take comfort in knowng that the EITF, staffed with your good friends from the Big Four, has this 30-year-old emerging issue on its agenda; they'll know how to make things right—eventually.

I expect the SEC would respond that their longstanding policy is to stay away from overriding FASB rules until the Board has had its chance to fix a problem—no matter how insane and damaging those rules may be. My response is: that's not even close to good enough.  The feeling I'm left with is that the SEC, in ASU 2010-19, is conducting the orchestra with a wet noodle instead of a baton.

To help see why I think that the SEC's response is inadequate, let's try look at the problem from an auditor's perspective; or stated another way, how an investor should have expected an auditor to have resolved these kinds of problems as they arose. Let's imagine that an issuer shows the auditor the GAAP rules that lead to an actual $10 million in cash being reported as a fictitious $25 million; and the auditor perforce concludes that the issuer adhered to the letter of those rules. The auditor knows that the client's balance sheet is materially misleading: is there nothing more to be done?

For the answer to that question, I refer to Interpretation 203-1 of the AICPA's Code of Professional Conduct, Departures from Established Accounting Principles, which states as follows:

"[I]n the establishment of accounting principles it is difficult to anticipate all of the circumstances to which such principles might be applied. This rule therefore recognizes that upon occasion there may be unusual circumstances where the literal application of pronouncements on accounting principles would have the effect of rendering financial statements misleading. In such cases, the proper accounting treatment is that which will render the financial statements not misleading." [italics supplied]

If Interpretation 203-1 is anything more than hot air, then surely it must be invoked by an auditor faced with the now-codified Venezuela fact pattern. Never happened and never will, you say? Conclusion: Interpretation 203-1 is hot air.

Surely, when looking to the FASB for accounting standards, the SEC must hold itself and the Board to a standard that meets or exceeds the minimum (albeit nominal) ethical responsibilities of CPAs. In applying those standards to ASU 2010-19, I can only conclude that once again, little more than hot air has been produced.  If a GAAP rule fails to report dollars sitting in a bank account on the balance sheet according to their bank balances, that rule must be so arbitrary that it cannot be anything but misleading.  I cringe at the fact that such a rule is referred to by people who should know better as "accounting."   

 Chief Accountant Kroeker, I challenge you to find me an uglier wart in GAAP than this one. If you won't act decisively, and with the integrity expected of all CPAs, to repair dysfunctional rules that materially misstate cash no less, then kindly explain to investors what exactly it is that you are doing.

Failed Convergence of R&D Accounting: Only Politicians and Opportunists Would Have Downplayed the Implications

Unlike BP, which eventually came to admit the actual rate at which oil has been spurting into the Louisiana Gulf, the FASB and IASB continually resist any acknowledgement that the gulf between the two financial reporting regimes will remain vast, even under their best case convergence scenario. That's why the big financial reporting news of the week is the Boards' joint announcement that their latest best case scenario is once again being reluctantly revised downward: 

"The IASB and the FASB today announced their intention to prioritise the major convergence projects to permit a sharper focus on issues and projects that they believe will bring about significant improvement and convergence between IFRSs and US GAAP."

Yes, it is true that a strict reading of the announcement only reveals that the Boards are going to be taking a little more time to finish their grand endeavor. But if an additional six months is all they will require to realize the miracle of Convergence, then why prioritize? Why not just stretch out the existing timetable?

Quite surprisingly, an answer to my questions may be found in another recent document from an unexpected source: the FASB no less. Here is what the FASB stated in its recent financial instruments and hedging exposure draft:

"The FASB's main objective is to develop accounting standards that represent an improvement to U.S. financial reporting. What may be considered an improvement in jurisdictions with less developed financial reporting systems applying International Financial Reporting Standards (IFRS) may not be considered an improvement in the United States." (page 2) 

Is this the first crack in the "convergence is inevitable" façade? Maybe so, but to those of us who have been skeptical about convergence from the outset, the faults in the real convergence foundation made themselves apparent years earlier.

For example, in my previous post I mentioned in passing that convergence of R&D accounting had been attempted in earnest and then dropped like a hot potato. In the remainder of this post, I'm going to delve into that topic more deeply because the abandonment of the R&D convergence project would have been perceived to be a convergence death knell by all but the politicians and opportunists. Moreover, a headlong rush to closure on convergence will undo all the good that was accomplished by the FASB when it steadfastly resisted changes to its R&D standard.

Why SFAS No. 2 Is Right for the US

The differences between SFAS No. 2, Accounting for Research and Development Costs, (ASC 730-10) and the provisions of IAS 38 that deal with R&D arguably constitute the clearest case for why bright line rules may be essential in a particular accounting jurisdiction, even though fuzzy rules are tolerated in another. I'll deal with the fuzzy rules of IAS 38 in a moment, but I'll start with an explanation for why he the FASB, in 1974, made a rigid and simple rule the foundation for its first substantive accounting standard.

To set the stage, around the time that SFAS 2 was promulgated there were (very generally) four kinds of R&D-intensive companies: (1 and 2) IBM and AT&T, by dominating computer hardware and telecommunications respectively, were in classes by themselves; (3) there were a few large pharmaceutical companies whose patented drugs made them hugely profitable; and (4) there were numerous smaller technology-driven companies scratching and clawing for capital and market acceptance. For the purpose of evaluating R&D accounting rules, the critical factor was this: the conventional wisdom held that only those smaller companies capable of reporting positive net income in an IPO prospectus would have any chance for a successful stock offering.

In regards to accounting standards, prior to SFAS 2, accounting for R&D was "principles-based." This meant that R&D costs were supposed to be deferred (and matched with future revenue from a project) if the expenditure created a probable future benefit. The costs of unsuccessful projects would have been immediately charged to expense.

That was the way it was supposed to work, but practice turned out to be the polar opposite of theory; virtually everyone did it wrong. Smaller companies seeking a successful IPO would capitalize all R&D expenditures, because that was the only way to report positive net income. For those other R&D intensive companies—like IBM, AT&T and big pharma—being too profitable was generally not in their best interests, in part because 'obscene' profitability would attract the attention of regulators. Thus, the big boys expensed all of their R&D, even though, because of their market power and concentration of intellectual capital, they had many successful projects.

So, the perverse situation that the FASB chose to confront was one where the R&D projects with the highest likelihood of success were being expensed, while the literally go-for-broke ventures would defer their R&D expenditures until their auditors could no longer keep themselves from snorting out loud.

The FASB tried as hard as they could to develop a set of subjective criteria that would permit deferral of some R&D costs, but it ultimately concluded that no set of qualitative or quantitative criteria would result in comparability across companies. Thus was born the rule that all R&D expenditures must go straight to the income statement.

IASC Serves Up R&D Chicken Salad

Four years later, the IASC (predecessor to the IASB) issued IAS 9 (the pertinent portions of which became IAS 38), to provide that research costs should be distinguished from development costs; and that development costs should be capitalized after the issuer met the following criteria:

• Technical feasibility;
• Intention and ability to complete an intangible asset for use or sale;
• Ultimate ability to use or sell the intangible asset;
• Ability to specify how the intangible asset will generate future economic benefits;
• The ability to reliably measure the development costs.

Thus was resurrected the fictions that: (1) management could reliably determine which costs should be deferred, and (2) that deferred development costs provide useful indicators of value. The motive, of course, was to give issuers greater flexibility to manage their earnings.

Don't Tell Anyone, but R&D Convergence Was a Complete Failure

Soon after the Boards inked their agreement to pursue convergence in 2002, they divided the work into two piles: high-priority projects for which they believed convergence could be achieved in relatively short order; and everything else. R&D was put in the first pile, apparently because the differences between US GAAP and IFRS were seen as particularly straightforward and tractable. 

Right. After about four years of back-and-forth wrangling from polar opposite points of view, the following statement was buried deep in the bowels of the FASB's website (it's long gone of course, and for all I know the only version that exists is the one I salted away for a moment such as this):

"…The Boards noted that elimination of the differences between IFRSs and US GAAP could involve consideration of fundamental issues and that those issues were part of a longer-term research project on intangibles being led by the Australian Accounting Standards Board. Nonetheless, the Boards agreed that they should explore possibilities to eliminate some IFRSs/US GAAP differences in the short-term. They instructed the staff (a) to consider the criteria for capitalisation of costs under SFAS 86 … to see if they could be used to make the criteria for internally-generated intangible assets in IAS 38 more operational and (b) to consider whether there are any aspects of US GAAP that could be moved closer to IAS 38, e.g. the requirements related to initial recognition of intangible assets acquired in transactions other than a business combination."

In other words, the FASB ran up against a brick wall erected by chicken salad chefs from Australia and who knows where else. While the R&D accounting project may have been formally suspended, it was effectively sentenced to die from inattention—and to be buried in an unmarked grave.

Depending on one's point of view, one may regard SFAS 2 as either a rules-based standard or a principles-based standard (the principal being that deferred costs per se should not be put on the balance sheet as assets). But however one views the quality of SFAS 2, the FASB clearly saw, to its significant credit, that the IASB's hazy, lazy criteria for capitalization would be a step backwards from what the FASB struggled to achieve in its earliest days; and the FASB would only accept a converged solution that constituted an improvement.

It could have even been the case that the FASB actually accepted at face value the propaganda from the opportunists that convergence was supposed to enhance comparability, and so they resisted change when comparability would, in their judgment, not be enhanced. I readily grant that I may be asking for too much, but the IASB's obstinate adherence to an R&D treatment that defeats comparability should have raised huge red flags for the FASB. If R&D accounting, which was seen as both important and low hanging fruit, could not be converged, then there might be little reason to expect that US investors would be best served by efforts to converge US GAAP and IFRS.

But now that we are supposedly on the cusp of convergence, whither R&D accounting? This crazy race to deliver something, anything, to the SEC by 2011 would completely undo the FASB's principled stance in opposition to the IASB's approach to accounting for R&D. What was formerly a high priority topic has been studiously ignored for years; for acting in any other way is to openly recognize what a charade the convergence dance has become, especially as we must endure in its final throes.

I wish I could be as sanguine as Shankar Venkataraman of Georgia Tech, who made this comment after the FASB acknowledged in their financial instruments ED that what is good for the goose may not always be good for the gander:

"This should be music to your ears, Tom. Of course, you recognize that the FASB cannot be as blunt as you are. Nonetheless, this seems to be a HUGE departure from the idea in the not-so-distant past that convergence was inevitable, no?"

Perhaps that lone acknowledgement may have signaled some shift in outlook, but there is still a long way to go before I'll concede that the FASB and I might be finally singing the same tune on convergence. I will say, however, that I never felt I was merely a member of a vocal minority (so sayeth the convergence opportunists). To the contrary, I firmly believe that the vast majority of stakeholders in the U.S. capital markets feel as I do; I'm just a lot noisier than most.