The Accounting Onion

Making Myself Clearer on the Topic of Liabilities and Equity

I made a conscious decision to eschew formulas in my recent post on the difficulty the FASB has had in creating a standard that results in a reasonable classification of liabilities and equity.  An exchange of emails with Accounting Onion reader David Harper now makes me think that my approach wasn't as clear as it could have been -- especially since David is the founder and principle contributor to www.bionicturtle.com, a popular financial training website.  He is also the author of the financial statements tutorial on investopedia.com.  So, if it ain't clear to him, I've got some explainin' to do.

Following David's comments, I'm going to organize this supplement to my original analysis into two parts: classification and measurement.

Classification of Liabilities and Equities: Past versus Future

The accounting model, according to the FASB’s conceptual framework, looks like this:

Assets – Liabilities = Owners’ Equity

The variables on the left side are defined independently, so therefore, owners’ equity is supposed to be strictly defined as assets minus liabilities.  However, the reality that emerged over time through actual financial reporting standards looks like this:

Assets – Liabilities – Other Stuff = Owners’ Equity

Until recently, “other stuff” consisted of:

• Deferred taxes (reclassified as a liabilities in FAS 109)
• Minority interest in consolidated subsidiaries (relcassified as owners' equity in FAS 141R
• Equity financial instruments subject to mandatory redemption (only some reclassified as liabilities in FAS 150). 

This “other stuff” was part of the motivation to come up with better classification rules for liabilities and owners' equity.  As I described in my earlier post, the attempt to base standards on an indepdent definition for liabilities ran into a lot of political resistance that did little but create high-paying jobs for financial engineers and super-specialized accountants in the national offices of the Big Four auditing firms.  That’s why the FASB is proposing to turn the model on its ear, if you will, so that it looks like this:

Assets – Owners’ Equity = Liabilities

At the same time, the definition of owners’ equity will admit initial recognition of only the most common of common stock, plus retained earnings.

What About Measurement of Liabilities and Equities

Now that owners' equity has been moved to the left-hand side, will the approach to its measurement change?  No.  For measurement purposes, owners' equity is still the residual, as in my first equation, above.  So, we'll actually employ two formulations of the relationship among basic balance sheet elements: one for classification (i.e., initial recognition), and another for measurement. 

David realized that this dual approach might be a possibility, and I think it may have been a source of his confusion.  It certainly seems strange, but that is what is being proposed.  And, I support it.  That's because the FASB has utterly and shamefully failed to reign in 30 years of chaos.  I generally am predisposed to support incremental changes, but in this case, the FASB has little choice but to throw everything out and start again from scratch.

David, thanks again for your comments, and I hope this clarifies some aspects of my earlier post for all.

Liabilities and Equity: FASB Turns Accounting on Its Ear

I am happy to report that the FASB's recently issued Preliminary Views document entitled Financial Instruments with Characteristics of Equity fills me with cautious optimism that, at long last, the FASB may actually be able to create a principles-based accounting standard. 

The Games Companies Play on the Right-Hand Side of the Balance Sheet

In the halcyon days of the 1970s when accounting was purportedly more "principles-based", a popular scheme of companies was to create financial instruments that were owners' equity in name only.  The objective was to report cash expenditures as dividends associated with a variant of preferred stock, instead of income-reducing interest expense associated with debt.

In recent years, particularly since FAS 133 has required fair value accounting for all derivatives within its scope, new games were invented. One of my favorite schemes exploited a loophole in EITF 00-19 involving written put options.  To qualify as owners' equity (thereby avoiding fair valuation with gains and losses to earnings), a company issuing the put options on their own stock had to retain the ability to settle in cash or stock. Solely because of the favorable accounting treatment for this weird arrangement, companies rushed to make sizable bets that their stock price wouldn't go down in exchange for a modest premium for writing the put option. (Would they make the same bet on the stock of another company?  Nope.  That's because they wouldn't get the same sweet accounting treatment.)  It so happens that this particular trick was ill-timed, as stock prices sank with the bursting of the dot-com bubble.  Many companies ended up losing hundreds of times the amount of the premium -- with nary a blip on the income statement, or a whisper to shareholders about the evaporation of cash or share dilution until judgment day was nye upon them.

A Thirty Years Accounting War

The FASB's project on distinguishing liabilities from equities may not have begun officially until 1986, but the SEC teed it up seven years earlier in Accounting Series Release No. 268.  Abuses of the supposedly fuzzy border between liabilities and equity had been rampant for years, and the SEC felt they couldn't wait any longer for the FASB to take some kind of stand -- any stand.

Out of admirably restrained deference to the FASB, whom they exhorted to do the heavily lifting via a project that would be concluded within a reasonable time, new SEC rules (Reg. S-X, Rule 5-02.28) addressed only one particular abuse, so-called "redeemable preferred stock."  But, I can't help wondering what ASR 268 would have looked like if: (1) the SEC had even an inkling that after almost thirty years, the most fundamental principles would still be unresolved, and ASR 268, which was intended to be temporary, is still needed; and (2) the rules produced thus far would be an unintelligible and inconsistent hash of 60 separate pronouncements. 

At the risk of oversimplification (and to be charitable), the underlying problem that the FASB had been grappling with all this time boils down to, believe it or not, a constraint inherent in the Fundamental Accounting Equation.  If you have an equation with three variables (assets, liabilities, owners' equity), only two of the variables can be defined independently and the third variable must be defined in terms of the other two.  Thus far, the FASB's approach has been to attempt to establish independent definitions for assets and liabilities -- and to define owners' equity by default as assets minus liabilities. 

The asset/liability approach, which has been enshrined in the FASB's Conceptual Framework, seems reasonable; but, they have failed to follow up with coherent rules, largely due to political forces that eroded the will to adhere to this simple constraint.  By defining some kinds of equity independent of assets and liabilities (certain derivatives in a company's own stock, for example), the inevitable result is a soupy right-hand side of the balance sheet, ripe for creative engineering of financial instruments to achieve a desirable accounting result. 

Peace in Our Time?

I was a doctoral student at the time ASR 268 was issued, when one of my professors, the late John Shank, explained to us that enterprising managers will always be looking to create transactions (and value for themselves) by devising transactions that are consistent with accounting rules, while completely inconsistent with their intent and spirit.  John's maxim goes a long way toward explaining how this sorry state I have been describing has come to pass.

But, as I started to tell you, I am now filled with hope -- a rare and heady feeling for me when it comes to the future of financial reporting! The title of the preliminary views documents indicates right from the start that a fundamental shift in approach is contemplated.  Henceforth, assets and owners' equity would be independently defined -- and liabilities would be equal to assets minus owners' equity.  The approach, if adopted, should work, if owners' equity can be defined to be strictly limited to common stock plus retained earnings. 

Thus, everything else on the right-hand side will be reported as liabilities. Much of the fun and profit will be taken out of financial engineering for an illusory accounting result, and may actually focus managers on figuring out how to make real money.  Here are some examples of implementation issues that are likely to raise hackles:

• Stock options granted to employees would be classified as liabilities.  Because they are derivatives, they would fall within the scope of FAS 133 and fair valued, with changes in value going to earnings.  In effect, we would be shifting from grant-date valuation to exercise-date valuation.
• FASB clearly intends to value all financial instruments that are not owners' equity at fair value, so shifting financial instruments like preferred stock from equity to liabilities will add even more volatility to earnings.
• Minority interest has just recently been reclassified to owners' equity and renamed non-controlling interests.  Will that position be reversed?

As always, regulated business will cry foul and insist that accounting standards must serve them, too. And now, for the sake of accounting convergence, we're supposed to care about banks in Europe as well?  On the bright side, this may be the time and place where the FASB finally understands that the needs of regulators and even regulated companies should not hinder them from serving the needs of investors.  ... Perhaps I'm getting too hopeful. 

Is this going to take another 30 years?  Should it take even more than one year?

 

If You Think GAAP is Opague, Try SEC Staff Interpretations!

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The securities laws give the SEC broad power to create regulations to implement the pertinent statutes.  The political appointees of the Commission, in turn, allow their staff to publish "interpretations" of the regulations.  These have accumulated to a mountain of technical detail dispersed over obscure documents that only an expert can hope to find, much less divine the need for. 

One wonders whether the system (such as it is) exists to protect investors, or to secure employment for Commission staff after they leave the SEC?  Companies who must comply with the SEC's disclosure rules pay a premium to SEC alumni who came to know the arcana first hand; and have street cred with the SEC staff by dint of their own contributions to the mountain when they themselves were SEC staff members.

A Recent Example to Illustrate the Point

By way of background:

• SFAS 159 permits a company to account for financial assets at fair value, including investments that otherwise would be accounted for under the equity method (per APB 18).
• Regulation S-X (the principle SEC regulation governing the form and content of financial statements in reports to the SEC), Rule 3-09 requires a company to provide separate financial statements of individual investees accounted for under the equity method, if the investee meets any one of the three quantitative tests of significance set forth in Rule 1-02(w) at the 20% level.
• Rule 4-08(g) requires supplementary disclosures regarding the assets, liabilities (i.e., a highly condensed balance sheet), revenues and expenses (i.e., a highly condensed income statement) of all such investments in the aggregate if the Rule 1-02(w) significance test is met at the 10% level. 
• APB 18 has similar disclosure requirements as Rule 4-08(g), but it lacks a specific significance test.  Moreover, the free election of SFAS 159 would obviate the APB disclosure requirements, since the investment would no longer be within the scope of APB 18.   

The two questions recently addressed by the SEC staff were: (1) whether the Reg. S-X disclosure rules still apply for investments elected to be accounted for at fair value under SFAS 159 that would otherwise be accounted for using the equity method; and (2) how significance should be determined (i.e., how Rule 1-02(w) should be applied) when the fair value option is elected. 

The staff's answer to the first question is “yes.” If an investment is eligible to be accounted for under the equity method as set forth in APB 18, then Rules 3-09 and 4-08(g) apply by "analogy."  In other words the rule clearly states that the disclosure rules don't apply to investments measured at fair value, but the staff is telling you to apply them anyway.  The Staff’s position on significance is that the ‘income test’ (one of three tests of significance) should be based on the change in the fair value reflected in the investor’s income statement—instead of the investor’s equity in the earnings of the investee as if the equity method had been applied. Again, the rule, as written, doesn't give you a clue as to what you're supposed to do--just do what the staff is telling you to do.

These SEC discloure rules, as written, were good rules, because they balanced abusive off-balance sheet accounting practices afforded by APB 18 (you can view my post on the equity method of accounting here).  Also, the questions the staff adressed are important, given recent developments in GAAP.  But, my point is this: if a disclosure rule should be updated, why doesn't the SEC simply vote to modify the rule for all to know and plainly see? In fact, the only place you will find the Staff's position is in an obscure AICPA publication -- you can't even find it on the SEC's website. 

Coincidentally, a recent GAO report to be released tomorrow -- you can read what Gretchen Morgenson has to say about it here -- has found significant problems with the SEC's antiquated methods of policing insider trading violations.  I find it ironic that the SEC's approach to updating many of its own rules also benefits a class of 'insiders' -- current and future SEC alumni.   

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Is IFRS Compatible with U.S.-Style Corporate Governance?

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I just finished reading a brief, highly readable and interesting article by a Columbia Law School professor, John C. Coffee, Jr., entitled A Theory of Corporate Scandals: Why the U.S. and Europe Differ.*  The purpose of this post is to piggyback on his framework to also provide an explanation for the difference in basic approaches between U.S. GAAP and IFRS; and most importantly, why political pressure to trash U.S. GAAP and adopt IFRS should be resisted. 

How and Why, According to Coffee, U.S. and European Scandals Differ

Coffee's thesis is that corporate governance of majority-owned corporations (predominant in Europe) should be fundamentally different than corporate governance of corporations that lack a controlling shareholder group (predominant in the U.S.). It's not necessarily because there are fewer incentives to rip off other shareholders, but the feasible means to do so will differ.

Scandals in Europe involving majority-owned corporations usually do not feature an accounting manipulation. First, financial reporting is less important to the majority owners because they rarely sell shares; and if they do, they usually receive a control premium that is uncorrelated with recent earnings (and generally larger than control premia in U.S. transactions).  Second, fraud is more easily accomplished by misappropriation of the private benefits of control: authorization of related-party transactions at advantageous prices, below-market tender offers, are prime examples.  Any trading that takes place between minority owners has less to do with recent earnings reports, and more to do with an assessment of how minority shareholders will be treated by controlling interests. 

In dispersed-ownership corporations, managers do not possess private benefits of control.  Moreover, a significant portion of manager's compensation may be in the form of stock options or other forms of equity.  Therefore, stock price can have a significant effect on a manager's compensation, providing them with strong incentives to manipulate accounting earnings.

The Implications for Accounting

Professor Coffee's thesis is that differences in ownership patterns have important implications for the selection of gatekeepers: auditors, analysts, independent directors, etc.  His observations and recommendations are interesting, but I want to advance a related thesis, namely that different ownership patterns call for different types of accounting regimes. 

It stands to reason that accounting should be difficult to manipulate, if it can be used to rip off shareholders.  Thus, the evolution of U.S. GAAP can be seen as a response to the need for specific rules that minimized the role of management judgment because of their strong self-interest in the reported earnings and financial position.  This has occurred in part because U.S. gatekeepers have shown themselves to often lack sufficient resolve or power to prevent management from under-reserving, overvaluing, or just plain ole making up numbers.  U.S. managers effectively control the "independent" directors and auditors; and prior to Regulation FD, analysts bartered glowing assessment in exchange for tidbits inside information.  Without empowered gatekeepers to prevent accounting fraud, we have had to place our hopes on very inflexible accounting rules, and sheriffs like the SEC and private attorneys to catch the cases where management has attempted to surreptitiously cross the bright line.

Thus, it should be self-evident that IFRS-style accounting, replete with gray areas, would be a gift to U.S. managers.  Outright fraud would be replaced by more subtle means of "earnings management," rendering the SEC and private attorneys much less potent. Is it any wonder why U.S. corporations and their auditors are practically begging to have IFRS available to them? 

In short, it would be a grave mistake to adopt IFRS in the U.S. simply because it seems to work well elsewhere.  As corporate ownership patterns in Europe change, it may well be that IFRS may evolve to look more like U.S. GAAP.  Only after that occurs may it make more sense to have a single worldwide financial reporting regime.      

Imagine if Enron Had Applied IFRS

One of the scapegoats of the Enron scandal was "rules-based"  U.S. GAAP. The libel was that Andrew Fastow was a mad genius, capable of walking an accounting tightrope by creating complex special-purpose entities (SPEs).  But, GAAP wasn't the culprit in the Enron scandal. Frustrated Fastow was only able to get the accounting treatment he needed past the auditors by hiding from them side agreements that unwound critical provisions requiring the new investors to have a sufficient amount of capital at risk in the SPEs. 

The enduring legacy of the libel is the erroneous conventional wisdom that GAAP is responsible for Enron; and what's more, Enron et. al. might not have happened if our financial reporting system were more like IFRS.  More likely, if IFRS had been the basis of accounting for Enron instead of GAAP, it might have taken longer to discover the fraud, or to pin the blame for the fraud where it belonged.

Neither GAAP nor IFRS are principles-based, but GAAP certainly has more rules and bright lines.  At least there seems to be some method to the madness, but it would be nice if more of the rules were based on sound principles. 

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*There are two versions of this paper.  The working paper is available at no charge from the Social Sciences Research Network electronic library at http://ssrn.com/abstract=694581.  The published version is in Oxford Review of Economic Policy, Vol. 21, No. 2 (2005).

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From Chaos to Principles: Can Financial Accounting be Fundamentally Transformed?

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After posting my commentary on FAS 157, which took more time to put together than I'm willing to admit, I resumed reading The End of Poverty, by the Jeffrey Sachs. I just finished the chapters about his experiences in helping Poland and Bolivia end hyperinflation and transform their economies.  Of lessons learned from these experiences, he writes:

“…I learned once again about the importance of a basic guiding concept for broad-based economic transformation, a concept powerful enough to frame the great debates in a society and give guidance to millions of individuals about the changes ahead.” (p. 129). 

I found this statement to be particularly apropos to the place we find ourselves post Enron and SOX, and on the cusp of plunging into IFRS.  A broad-based transformation of accounting is very much needed, but the changes thus far in reaction to the calamities of five years ago bear little relation to Sachs' recipe for successful transformation.  Where is the ennunciation of basic principles that can transform accounting from a patchwork of compromises created only to pacify special interests--and ripe for abuse?

Principles-based accounting is the only acceptable answer, but neither the SEC, FASB nor the IASB appear to be particularly motivated to do much more than pay lip service to the mere idea of principles, much less set them down on paper. 

Ah, well, it's only accounting.  At least they're not the ones in charge of finding a cure for poverty.

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