The Accounting Onion

FAS 157: Fair Value Has left the Station--But Is It on the Wrong Track?

The CFA Institute recently published a monograph entitled A Comprehensive Business Model: Financial Reporting for Investors, calling for a "...broader, more comprehensive business reporting that provides sufficient information to investors that is needed to understand the wealth-generating [emphasis supplied] activities of a company and the results of those activities."  One of their key recommendations is that fair value measurements be applied to all assets and liabilities, since "fair value information is the most relevant [emphasis supplied] information for financial decision making." 

I have been waiting for the right opportunity to take a poke at FAS 157 -- a rules-based standard masquerading as principles-based -- and this report by a venerated investor group makes the time right.  My opening is widened further by the following quotation in the report from an FASB publication:

". . . The objectives [of accounting], therefore, focus on matters of wealth. Investors and creditors seek to maximize their wealth (within the parameter of the risks that they are willing to bear). Likewise, business entities also seek to maximize their wealth. It follows, then, that information about the wealth of those entities and the changes in it is relevant to investors and creditors that are seeking to maximize their wealth by investing in or lending to those entities. [As quoted from The FASB Report, No. 263-D (28 December 2004), pp. 1 - 2; emphasis and comments in brackets supplied by yours truly.]

The authors of the monograph are all pretty savvy and clearly share my interest in providing high-quality reports to investors. Yet, I wonder if they realize that fair value, as defined in FAS 157, is not consistent with the objective of measuring wealth and changes in wealth?  The purpose of this post is to describe and illustrate the inconsistency I believe they have missed.

The Economic Principles and a Simple Example to Illustrate Their Proper Application by Accountants

To begin, here are the two basic economic principles I will bring to bear: (1) “Wealth” is command over goods and services; (2) “Income” is the maximum amount of consumption that could take place during a period without changing wealth during the period. 

Imagine a world in which there is only one consumption good -- beer. Ignatz Schicker brews beer for his personal consumption and for sale:

• The accounting period is two days long.
• Beginning of the period (BOP): Schicker had in his possession 1 keg of beer and $72. He estimated that it would cost him $12 per keg to brew more beer (i.e., ‘replacement cost’ or ‘entry price’), and that he could sell beer (‘fair value’, or ‘exit price’) for $20.
• Day One: Schicker produces 5 kegs of beer for $12 per keg. He sells 2 kegs and drinks 1 keg.
• Day Two: The replacement cost and selling prices of beer increase to $16 and $25, respectively.

Applying the basic economic principles, we can straightforwardly calculate Schicker's economic income for the period as follows:

This is our benchmark ($4.00 of income) against which we can compare the results of applying various approaches that an accountant could take.  There are many approaches to choose from, but these three are sufficient to make my point:

1. Current GAAP. For our purposes it could be described as historic cost without adjusting for inflation in the cost of beer (so-called ‘nominal dollars’).
2. The approach endorsed by the CFA Institute, which could be described as ‘Fair Value, Nominal Dollars.’
3. Economic-principles-based accounting, which is based on replacement costs—adjusted for inflation of the cost of beer (so-called ‘constant units of purchasing power’ [C$]).

My spreadsheet with the underlying calculations displayed below is available here.

And the winner is... replacement cost! That approach is the only one that accurately reports, in accordance with generally accepted economic principles (pun intended), earnings and wealth.

Message to CFA Institute: you are right to push for a comprehensive basis of measurement based on current prices; but, fair value (and FAS 157) is not the answer. Replacement cost is more relevant, more reliable, and even less complex than FAS 157.

Less complex, you ask?  Isn't that a current focus of the SEC? 

Here are just a couple of examples where replacement cost is much simpler to apply than SFAS 157:

• Virtually every transaction is burdened by transaction and transportation costs. Both of these costs are a component of an asset’s replacement cost. But under FAS 157, transaction costs are excluded as a component of fair value, thereby creating practical difficulties of having to develop separate estimates. FAS 157 also creates the anomaly of recognizing expenses before the first dollar of benefit from the asset can be realized.
• Since replacement cost measures economic utility (so says ARB 43, Chapter 4), the unit of account must be the asset grouping that minimizes total replacement costs. Concerns such as the controversy over blockage factors in FAS 157 would not be relevant.
• The invented concept of 'principal market' in FAS 157 would not be relevant. Replacement cost as a measure of economic utility dictates that the least costly way to obtain the asset is reported.
• Perhaps most important, estimating the present value of future cash flows might only rarely become appropriate for measuring replacement cost. 

Moreover, the concept of replacement cost is not new to the accounting regulators:

• Inventory impairment (ARB 43, Chapter 4), the familiar lower-of-cost-or-market rule (LOCOM), is based on replacement cost. In essence, the rule provides that inventory should be measured at current replacement cost, if it is less than historic cost. All kinds of complex impairment tests have been promulgated subsequent to the inventory impairment standard; and so much has changed about accounting in the last fifty years that it’s difficult to name many things that have remained the same. LOCOM for inventory is one of the few stalwarts, because there exists no good reason to abandon or modify its replacement-cost-based principles.
• For a time beginning in the mid-70’s, the SEC required (Accounting Series Release No. 190) disclosures of cost of goods sold, depreciation, inventory and property, plant, and equipment on the basis of replacement cost. SFAS 33, since superseded, required supplemental financial statements prepared on a ‘current cost’ (an attribute that is similar to replacement cost), constant dollar basis.

Wrapping Up

As is my wont, I have used a very simple example to make the points that (1) replacement cost accounting is principles-based and therefore, FAS 157 must be rules-based; and (2) FAS 157 is needlessly complex (a common characteristic of rules-based standards).  But simplicity doesn’t change the fact that the underlying principles of replacement cost accounting are correct, even if, by adding richness to the example, implementation may not be perfect.  Above all, keep in mind that application of FAS 157 cannot result, except by happenstance, in economic measures of wealth or changes in wealth.

Finally, I have to ask myself (and I hope you do this same), why the focus by the FASB is on fair value instead of replacement cost? I think the answer, as usual, has little to do with the informational needs, but the incentives of preparers to influence accounting standards towards new "principles" that permit them to manipulate their income. To see how easy this can be under a full fair value regime, look closely at the operating income numbers in the fair value column. All Ignatz Schicker (or GM for that matter) has to do to generate accounting earnings is to produce beer (or cars). Actual sales to third parties is not directly relevant. Think about it.

Accounting Convergence Scoreboard: Issuers 1, Investors 0

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

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As I feared in earlier posts (here, here and here), but naively hoped against, the Republican-dominated SEC has carried the water for Big Business and anti-regulation ideology by eliminating the IFRS-to-U.S. GAAP reconciliation requirement.  Investor advocates and other thoughtful people who are passionate about accounting are frustrated.  I know this with near certainty, because I have taken a sample of two of these people: myself and Pat Hopkins, an accounting professor at Indiana University.  Here is what Pat had to say in our private correspondence, which he has graciously allowed me to post:

"Notwithstanding the diligent, thoughtful effort of Teri [Yohn, whose congressional testimony yours truly wrote about here], Jack Ciesielski and others, the politicized and pandering SEC demonstrated that it is far cry from the investor-oriented organization run by Arthur Levitt a decade ago.  All we have to do is refer to the gleeful statement reported at CFO.com and attributed to cheerleader-in-chief, Christopher Cox, “the SEC's decision could put a shine on the image of the United States in the global capital markets system, improve capital-raising opportunities for companies, and provide better comparability of financial statements for investors.”  Of course, glossing up the capital markets and improving capital-raising for individual companies sounds more like something a promoter does; it certainly is not in the SEC’s mandate.  And, of course, the last statement [about improving comparability] is logically false." [emphasis supplied]

The American Accounting Association (the national organization of academic accountants) has a committee that regularly comments on financial reporting policy.  Here is an excerpt from their letter to the SEC, opposing the elimination of the IFRS-to-GAAP reconciliation requirement:

"If IFRS is so transparent for these foreign-private issuers, then we should be willing, today, to allow every company in the US to immediately adopt IFRS. We are not willing to do so for many very good reasons..."

Granted, the SEC has drawn a line -- for now -- at not accepting local versions of IFRS without reconciliation, but that's a red herring.  When I was searching for the announcing press release on the SEC website, I thought for a moment that I might be looking at the wrong one when I first read the headline: "SEC Takes Action to Improve Consistency of Disclosure to U.S. Investors in Foreign Companies."  Chutzpah.  A more accurate headline would have been, "SEC Takes Action to Increase Opacity of Financial Statements Filed by Foreign Private Issuers." 

Here's hoping that investors get another turn at bat during the next presidential administration.

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

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Big Bath Accounting is Alive and Well at Merrill Lynch, Citigroup and GM

In yesterday's post, I wrote about Merrill's big bath charge.  Two other recent news items confirm that not much as changed since Arthur Levitt declared war on earnings management games almost 10 years ago: the big bath accounting charge still lives on.  Merrill's gets a seven on my proprietary 10-point chutzpah scale, which is pretty tame compared to these two examples of financial reporting gone mad.

Citigroup -- 9.0 on the Chutzpah Scale

The Citigroup press release of November 5th doesn't necessarily raise questions about the appropriate size of its writedown (yet), but the timing is so ham-handed it's not even a bit funny.  Citigroup is saying that the entire writedown to be taken in the fourth quarter of between $8 and $11 billion is entirely due to events that took place this past October.   Here's a trenchant snippet from Jonathan Weil's recent Bloomberg column:

"It's as if we're supposed to believe that all this stuff at Citigroup happened after September [the last month of its third quarter] ended, notwithstanding the $8.4 billion of bad subprime mortgage stuff at Merrill Lynch & Co. that happened before September ended. [Hey SEC, a smoking gun!] And we're also supposed to believe Citigroup's brass didn't have a clue any sooner." [emphasis supplied]

Even granting that the accounting may be apporpriate (a big stretch), the SEC should be looking at the adequacy of MD&A in earlier periods for both Citigroup and Merrill. As Lynn Turner pointed out in an email I received from him, Regulation S-K, Item 303 and numerous Commission interpretations (most notably, Financial Reporting Release No. 36) are anything but subtle in their exhortations to management that they owe investors an informative, forward-looking discussion of uncertainties that are reasonably likely to affect future earnings, liquidity and financing.  I haven't looked myself yet, but I'm betting there is hardly a breath of discussion of the fomenting sub-prime meltdown in the third-quarter 10-Q of either one of these pillars of financial strength and probity.

General Motors -- The Winner with a Perfect 10

General Motors announced on November 6th that it will establish a $39 billion valuation allowance on the deferred tax assets arising from net loss carryforwards of prior years.  I suspect a big bath for two reasons.  First, $39 billion is a huge allowance to emerge in one quarter, especially if zero was the answer in the prior quarter. Are we to believe that everything went to hell in three months?  Again, what did MD&A say? Second, I'm ever watchful of the big bath motive to take a charge that is more than necessary in one period for the purpose of goosing earnings in future periods.  I hope I don't insult your intelligence when I point out that $39 billion is a staggering amount.

But, IF (ha ha) the accounting is right, it means that it is now literally a coin flip whether GM will be able to generate enough future taxable income from the right sources to realize in tax deductions the newly reduced book value of the net deferred tax asset.  But that's not what GM writes in the press release.  I was taught that murdering your parents and pleading for mercy from the court because you're an orphan is the ultimate act of chutzpah, but this statement from the press release comes awfully close to establishing a new benchmark:

"...the establishment of a valuation allowance does not reflect a change in the company's view of its long-term automotive financial outlook... GM continues to believe that its new product introductions, combined with the new GM-UAW labor agreement,once fully implemented, will significantly improve GM's competitive position in the U.S. and better position the company to utilize tax benefits in the U.S. and Canada in the future."

Huh?  If that's what you believe, then why was it necessary to write down the value of the deferred tax asset?  Where in FAS 109, the applicable accounting standard does it say that you are supposed to ignore evidence?  Answer:  it doesn't!!

Message to SEC Chair Christopher Cox:  your reputation will sink to shill status if you don't act quickly to reign in the blatant financial reporting shenanigans being perpetrated on the investing public by these icons of the U.S. economy.  I suggest your read the SEC's enforcement action against Sony (AAER 1062), which resulted in landmark fines and remedies, and then ask yourself whether these cases are any different.

 

"Big Bath" Accounting at Merrill Lynch: Give Me that Old Time Conservatism

In a story whose main subject was increasing auditor vigilance, the Associated Press wrote as follows on November 2, 2007:

"Merrill Lynch last week reported a bigger-than-expected $8.4 billion in writedowns.... On Oct. 5, the investment bank had initially said it would take $4.5 billion in writedowns when it announced earnings later in the month.

Merrill executives said they got that much bigger number by deciding to go with a valuation at the more "conservative" end of the range they had established weeks before. Company officials cited their more "conservative" approach 12 times during a conference call with analysts, according to a transcript provided by Thomson Financial StreetEvents.

That sounds like the company's managers found some religion when it came time to account for such losses, surely preached to them by their auditors." [emphasis supplied]

Sorry, but it looks more like a big bath to me, and the auditors are falling down on the job to let them get away with it.  The nefarious thinking behind big-bath writedowns is that if you have to take a loss, and analysts know its coming, then by all means make it a big one. If analysts perceive the whole tubful to be non-recurring, score chutzpah points for you.  And, award yourself more points if the inevitable writebacks can be recycled to earnings under the radar -- thereby lumped together with other 'permanent earnings' in valuation rubrics.

"Conservative," My Tuchas

What really irks me is the way Merrill apparently believes they have legitimized their big bath by a virtuous appeal to the conservative approach taken in measuring their losses.  In fact, conservatism was officially repudiated by the FASB 27 years ago: 

"Conservatism in financial reporting should no longer connote deliberate, consistent understatement of net assets and profits.  The Board emphasizes that point because conservatism has long been identified with the idea that deliberate understatement is a virtue.  That notion became deeply ingrained and is still in evidence despite efforts over the past 40 years to change it." [Statement of Financial Accounting Concepts No. 2, para. 93, emphasis supplied]

I think that Isaac Hunt, when he was an SEC Commissioner, stated the obvious as well as it could be stated in a 1999 speech when commenting on Staff Accounting Bulletin 100, which was issued with the objective of curbing big bath accounting shenanigans:

"...balance sheet amounts must reflect management's best [i.e., not conservative] judgement -- i.e., be reliably and appropriately based." [pp. 3-4; emphasis supplied]

For the auditors' sake, I'm hoping that the "conservative" spin was conjured up solely for the entertainment of the conference call audience, and not also for the purpose of persuading the auditors.  Not to beat a dead horse, but according to the FASB, conservatism died sometime during the Truman administration.  If the auditors actually bought into the conservative hokum, the AP's story is more about auditor capitulation, or incompetence, than about their newfound vigilance. 

Here's hoping and expecting that the SEC staff will review Merrill Lynch's 10-Q, and give a close look at their mark-to-model calculations leading to the big bath.  Based on the AP's reporting, it may well be that Merrill has unwittingly already made a strong case for draining some of the suds from the tub.