The Accounting Onion

The PCAOB is Auditing the Wrong Auditors

Did you know that:

• The Sarbanes Oxley Act requires the Public Company Accounting Oversight Board (PCAOB) to inspect audit firms with one or more public companies as clients at least once every three years, and that firms with more than 100 clients have to be inspected every year;
• There are currently more than 700 audit firms that are subject to PCAOB inspection; and
• More than half of the PCAOB's $130 million budget  and 500 employees are dedicated to inspections?

If you knew all that, you're a nerd like me.  But, here is something I didn't know until I attended a presentation by a senior PCAOB staff member recently, who included this table among his Powerpoint slides:

The first three columns aren't a big surprise, but the fourth one is a whopper: of the 750 audit firms out there, 99% of them audit an aggregate 1% of the reported revenues of public companies!  The presenter made the point that all audit firms are thoroughly inspected, so it would not be outlandish to guess that significantly more than half of the PCAOB's inspection resources (> $65 million) are protecting the public against the equivalent of a flea bite on the hindquarters of a bull (market). And, add to the PCAOB's waste of its own money, the significant costs imposed on small audit firms of submitting to PCAOB inspections.

I am certainly not against regulations to incentivize high-quality audits by all firms, but what we have here is an Economics 101 case study on the pitfalls of centralized planning happening right here in the good 'ole US of A. 

No Incentives to Right the Wrong

If you passed my trivia test, you would also know that the demand for qualified accountants and auditors has increased since SOX--and so have their salaries.  I have heard SEC staffers claim that they have trouble hiring qualified accountants for their own inspection work due to the competition provided by the PCAOB. 

What I find most irritating is that PCAOB members, each paid over $500,000, are not screaming loudly at Congress that the static burdens imposed by statute on their august organization render one of its two most important functions (the other is promulgating auditing standards) half as efficient as it could be.   Well, here's the freakonomics of it:

• The PCAOB has no incentive to control costs by reducing the number of unnecessary inspections.  The more inspections that are mandated by SOX, the larger the budget that can be justified for approval by the SEC. 
• The Board members personally benefit (albeit indirectly) from bloat. The larger the scale of PCAOB's operations, the easier it is to justify their salaries.

The Board's greatest fear should be that their inspection of the audit of a Fortune 100 company concludes without discovering a problem -- and that the audit turns out to be as big a bust as the Arthur Andersen audit of Enron.  Evidently, it doesn't register with the Board that the big bucks they get are to make sure that one thing doesn't happen. They should be doing everything in their power to make the inspection process more efficient--including lobbying Congress to craft a more sensible mandate for the PCAOB's inspections -- and by the way, puts an end to the persecution small audit firms.   

Accounting Research Slam Dunks SEC Proposal to Allow IFRS without Reconciliation to GAAP

---

Would you like your staff to learn more about
SEC reporting? 
Click here for a sample in-house training agenda!

---

Teri Lombardi Yohn, an associate professor at Indiana University, has provided Senate testimony on the SEC's proposal (Rel. No. 33-8818)to permit foreign private issuers to file their Form 20-F in accordance with International Financial Reporting Standards (IFRS) without information about differences between IFRS and U.S. GAAP (principally, reconciliations of net income and shareholders' equity).

Yohn's remarks synthesize about 25 high-quality academic research studies on the effects of (1) the IFRS - U.S. GAAP reconcialtion on investor decision making, and (2) securities regulations affecting the competitiveness U.S. capital markets.  With respect to (1), Yohn made the following observations from the research pertinent to the SEC proposal:

• Research using stock prices indicate that the reconciliation is 'value relevant.'  In other words, investors use the reconciliation in their decision making.  (Huge point!)
• U.S. investors appear to prefer U.S. GAAP over IFRS.
• Uniform standards across countries would not result in uniform implementation.
• Enforcement of accounting standards is currently not, and unlikely to be uniform.  (Nothing in other regulatory regimes compares to the vigilance of the SEC. 
• The SEC already has difficulty enforcing rigorous implementation of IFRS by 20-F filers, and would likely become less effective if it were forced to monitor IFRS reporting by foreign issuers--over whom its jurisdiction is more subject to question.
• Evidence from reconciliations indicates greater opportunities for earnings management under IFRS, as reported income is higher on average than U. S. GAAP.

With respect to the competitiveness of U.S. capital markets:

• Foreign firms cross-listed in the U.S. appear to be valued higher than their counterparts, because it improves the quality of the information provided to investors.
• SOX has not eroded the benefits of a U.S. listing, and these benefits are unique.

If Yohn is anywhere near accurate, it's a slam dunk that "the elimination of the required IFRS - U.S. GAAP reconciliation is premature ... and will cause U.S. investors to possess a significantly diminshed set of relevant information for investment-related decision making."  If it were not for the political influence of special interests (see my earlier post), we wouldn't be wasting our time debating it.      

You can access the full text of Yohn's testimony with this link to my website.  On a scale of 0 - 100, I give it a 98 (I'm a hard grader).  It is wonderful to see how loosely-connected bits of specialized accounting research can be formed into a coherent and unambiguous message pertinent to a pretty high-stakes decision.  While a critic might point out that no single point made would be regarded as incremental information in the debate, nothing can match Yohn's rigorous, evidence-based approach. My two-point deduction in score is only because the language does not promote easy digestion by the big-picture bloviators.  Not everyone can get away with talking like Alan Greenspan.

---

Would you like your staff to learn more about
SEC reporting? 
Click here for a sample in-house training agenda!

---

FAS 144: Tailor-Made to Confound Financial Analysts

It should come as no great surprise to savvy analysts that far too many accounting standards were written to benefit someone else other than investors and analysts. FAS 144 on impairment of long-lived asset is yet another example, but perhaps more than any other, it suffers by comparison to its counterpart in IFRS, IAS 36.

The principle underlying IAS 36 is quite simple, and fairly intelligent:

1. If recent events indicate that the economic benefits to be derived from an asset (or group) may be less than the booked amount ('carrying value'), go to Step 2.
2. If fair value is less than carrying amount, write the asset down to its fair value, and report a loss.  Future depreciation should be adjusted accordingly.

The principle underlying FAS 144 is also simple, but completely divorced from reality:

1. If recent events indicate that the economic benefits to be derived from an asset (or group) may be less than the booked amount ('carrying value'), go to Step 2.
2. If the undiscounted cash flows to be realized from holding the asset are less than its carrying amount, go to Step 3.
3. If fair value is less than carrying amount, write the asset down to its fair value, and report a loss.  Future depreciation should be adjusted accordingly.

Both standards start out the same, but FAS 144 inserts the extra step, in italics, above--to require comparison of the undiscounted cash flows of an asset to its carrying value. 

Old School Bean Counting

A cardinal rule of finance is that one should never sum cash flows from different points in time--without first adjusting for the time value of money.  Not adjusting for time value is the equivalent of adding apples and oranges.  So, in order to excuse what economists consider idiotic, the FASB had to hark back to abacus days and the roots of historic cost accounting. 

Pure historic cost accounting, now pretty much debunked and defunct, posited that profit for a period is the difference between revenue recognized and a fair share of historic costs.  Thus, recovery of historic costs (i.e., the ancient finance heuristic called "payback") is the measure of profitability.

To the historic cost lover, the net book value of an asset is appropriately based on historic cost unless future revenues can't be expected to recover the carrying amount.  It doesn't matter whether cost-covering revenues are scheduled for recognition in 1 year or 50 years.  But, in all fairness to ancient bean counters, cash flow timing must have been an annoying detail when having to construct spreadsheets in pencil.  But, FAS 144 is a child of the information age, so why the seemingly slavish devotion to the traditions of our beloved ancestors? 

Politics as Usual

According to FASB Chairman Herz, relevance in accounting is paramount.  Since sunk (i.e., historic costs) are irrelevant to economic decision makers, their demise as a basis of accounting must be inevitable. Yet, FAS 144 allows historic costs measures for assets to remain on the balance sheet long past their time.  To understand why the conflict between what the FASB says and what it does, one need only compare the patterns of reported net income under FAS 144 versus IAS 36.

• First, we need to realize that over the life of any asset, the total effect on net income will be the same.  So, the difference between FAS 144 and IAS 36 will manifest itself by differences in timing and classification: when asset costs are reported, and how--as either depreciation or impairment losses. 
• Second, as events impair the value of an asset, the sum of undiscounted cash flows will dip below an asset's carrying amount later than the sum of discounted cash flows.
• Therefore, IAS 36 will report impairments sooner (in a more timely fashion), more frequently, and in smaller increments than FAS 144.  Relatedly, FAS 144 will likely report more costs as impairments than depreciation. 

Coping with FAS 144

Reporting impairment costs less frequently and in larger globs, is intended to convey that they are non-recurring, and therefore, should be ignored when estimating the present value of future earnings.  Analysts need to realize that impairments recognized in FAS 144 are largely the result of events occurring in earlier periods.  However, that doesn't mean there is no important information in the number. When attempting to estimate "permanent" income, or estimating earnings trends, I recommend that the impairment charge of the current period be spread out against reported income of prior periods--but for how many periods depends on the circumstances.  For industries with long product life cycles, three years might be appropriate. 

In all cases, the question should be asked whether an impairment charge is not simply a substitute for under-depreciation in prior periods.  Also, read MD&A of prior periods thoroughly.  Impairment charges rarely occur overnight.  Did management provide adequate discussion of the events leading up to the impairment charge?

IFRS and the U.S. Auditing Profession: Not a Match Made for Investors

About 10 years ago (maybe more... the older I get, the faster time flies), I attended a conference at the SEC where an FASB board member, Michael Crooch, averred that IFRS was no better or worse than GAAP--but that GAAP was a lot more detailed.  Then, as now, the part about details was an understatement.  After all, GAAP, at 25K pages, has consistently been about ten times the size of IFRS. 

But now, and for the wrong reasons (see this post), the SEC is purported to be seriously considering whether to allow U.S. firms (not just foreign firms) to file IFRS financial statements without reconciliation to U.S. GAAP.  All of the politically-correct questions in respect to the effect on audits are being posed and discussed publicly by the PCAOB--the absence of specific guidance for certain industries in IFRS (e.g., insurance), whether technical modifications to auditing standards are necessary, IFRS training for professionals, university education for students, and even if the CPA exam should be modified.

Be we freakonomists know that these aren't the questions that really matter.  The real questions, which must certainly be the subject of closed-door discussion, relate to how changes in regulations affect audtors' incentives. Will U.S. auditors make more money by serving U.S.-based clients reporting in accordance with IFRS?  Will they be exposed to greater risk of investor lawsuits from IFRS audits?

The question of profitability is easy to answer. Less-detailed standards means fewer bells and whistles that auditors will be called upon to examine, and thus will have fewer hours to bill.  The answer to the question of audit risk is also easy if you believe, as I do, that the reason why U.S. GAAP became so detailed was not a quest for "high quality" accounting standards, but principally to protect auditors. 

The 1968 landmark case, Escott v. BarChris was a class action lawsuit against a corporation, which had publicly issued debt and subsequently declared bankruptcy, and against its auditors. Although auditors were found liable for misstatements, the case also established that auditors who met the minimum standards of their profession should not be held liable for insufficient due diligence required of them under federal securities law. 

Arguably, a legacy of the BarChris case is the incentives given to the audit industry to write detailed accounting rules and vague auditing standards liberally sprinkled with weasel worlds like "should" instead of "must." These "professional standards" were to be the armament against aggrieved investors, while simultaneously satisfying their real clients--the managers who hired "independent" auditors and paid their fees.

It is hard to know how much grief auditors were able to spare themselves, and how much incremental business they were able to secure.  Arthur Andersen, a co-captain of the cheerleading squad, is gone, and the strategy of vague audit standards combined with detailed accounting standards clearly hasn't shielded auditor's piggy banks from the havoc wreaked by client shenanigans.  Whatever the actual economic impact on auditors from their efforts to muck up accounting, it does not alter the 25K-page legacy we call Generally Accepted Accounting Principles (which are neither generally accepted, nor principles-based).

I may have once agreed with Mike Crooch's assessment of ten years ago, but I don't anymore.  I am not willing to say that IFRS is better than GAAP, but I am now willing to say that IFRS is less worse than GAAP.  That's because the devil is the details. U.S. auditors won't let go of their GAAP security blanket without a fight, and if history is a guide (most recently, SOX 404), the audit profession will still be calling the shots.

The Politics of Accounting Convergence: Who's Got the Power?

---

Would you like your staff to learn more about IFRS? 
Click here for a sample in-house training agenda!

---

The gap between U.S. GAAP (unintentional pun) and International Financial Reporting Standards is a Grand Canyon.  How could it not be so, when U.S. GAAP takes up about 25,000 pages, while IFRS is a measly 2,500? And, that doesn't tell the full story, since about half of IFRS is on only one topic, hedge accounting.  Convergence of accounting regimes could be a good thing, but we have a long way to go. 

So, the SEC's proposal to permit foreign companies to present their financial statements in accordance with IFRS sans reconciliation to U.S. GAAP could only owe its existence to political influences.  In 2006, the Committee of European Securities Regulators (CESR) announced that, unless the SEC dropped the requirement to reconcile IFRS to GAAP, they would retaliate by requiring U.S. companies listed on European exchanges to go the other way--i.e., reconcile from GAAP to IFRS.  For reasons you can well imagine, that got the attention of pro-business (as opposed to pro-investor) powers that be. 

Here is just one example why elimination of the IFRS-GAAP reconciliation would be a really terrible disservice to investors:

Companies U and I are identical in every respect, except  U applies U.S. GAAP and I applies IFRS.  Both companies have an operating unit (perhaps an oil field) whose assets have a book value of $1,000,000.  Expected cash flows from operating the oil field are $200,000 per year for five years.  The fair value of the oil field is $600,000. 

U, applying FAS 144, will not report an impairment, because the undiscounted sum of the estimated future cash flows from the asset is not less than its carrying amount.  I, applying IAS 36, will report a loss of $400,000.

Without a reconciliation to U.S. GAAP, investors would be clueless as to why U's profit differed from I's profit.  The problem would spill over into subsequent periods as depreciation expense for the assets will differ. 

There are at least two other reasons why the reconciliation should not be eliminated.  First, regulators need to be able to see whether convergence is working.  If it is, we should observe net income under IFRS literally converging with GAAP.  Second, elimination of the reconciliation may reduce incentives to converge. (Actually, given the way convergence is currently being bungled, that may not be such a bad thing.)

It may also turn out that CESR overplayed its hand.  The very last thing European companies want is for the SEC to be enforcing compliance with IFRS with the same zeal and rigor it brings to bear on U.S. GAAP.  For more on this, see this recent article from CFO.com.

Finally, although not directly related to this topic, I can't resist pointing out that FAS 144 is a deeply flawed standard, making IAS 36 far superior.  I'll explain why in a post soon to follow.

---

Would you like your staff to learn more about IFRS? 
Click here for a sample in-house training agenda!

---