The Accounting Onion

Compromising Accounting Principles: A History Lesson (and a Mea Culpa)

(I apologize to anyone who has read an earlier version of this post. Due to a problem with my blogging software, it was not sent out to subscribers. Therefore, I am re-posting it.)

First, the Mea Culpa

Over the year that I have been writing my blog, I have been fortunate to receive kind words every now and then from readers.  Writing alone, being provocative at times, and hitting the "publish" button perhaps too soon to meet a self-imposed deadline often combine to give me an uneasy feeling that I could be sitting way out on a high limb.  It was inevitable that at times I have been accused of being wrong, but never unfair -- until now.

I recently received from two readers similarly critical missives concerning some not-so-nice things I wrote about Jim Leisenring, former FASB and current IASB member. One of the commenters, identifying himself as "Guest," wrote:

"That's a pretty unfair attack on Leisenring with no appropriate context regarding the background of FAS 133. The alternative to FAS 133 was virtually no recognition of derivatives in financial statements. Is it perfect? No. Were compromises made? Absolutely. But it was better than what was there before. And it certainly doesn't indicate a pattern of Jim "capitulating to the majority." If you've ever met Jim [actually, I have], then you know he's not real concerned with what the majority thinks." (comment in brackets is mine)

After thinking about these comments for a few days and discussing it with my genious wife, I have decided that I owe an apology. When I gratuitously remarked that I was not surprised by Jim Leisenring's decision to "capitulate" on IFRS 3(R) because of his past participation in FAS 133, I crossed a line.

The Point I Was Really Trying to Make

Now that I hope I have cleared that up to the satisfaction of all, I want to address the related issue raised by Guest, which should have been the real point of my criticism.  I do not believe that compromising one's principles in crafting accounting standards in the name of incremental progress can be expected to produce a net benefit for investors.

Merely being "better than it was before" (to quote Guest) may still be far from good enough, and there is plenty of U.S. GAAP history to back that up. The table below is a partial list of standards where compromises clearly must have occurred, and serious consequences ensued:

Statement	What Gained	What Lost and Consequences
FAS 87 - pensions	Balance sheet recognition of some pension liabilities.	Timely recognition of gains and losses in pension plans. Plans were mismanaged because of FAS 87.  The toll in shareholder value destruction and lost pension benefits has been enormous.
FAS 13 - leases	On-balance sheet treatment of some leases	Most leases can still be classified as "operating." Managements have misspent vast sums over the past 30 years on financial advisers and auditors because FAS 13 invites unnecessarily complex and inefficient lease contracts.
FAS 133 - derivatives and hedge accounting	Fair valuation of derivatives	Complex and unprincipled hedge accounting rules distort values of other assets and liabilities, or permit deferral of gains and losses from holding derivatives. Managements engage in costly and inefficient accounting hedges that may not result in appropriate hedges of economic risks. The value destruction caused by Fannie Mae's misapplication of FAS 133 may be enough by itself to regard FAS 133 as having failed.
FAS 115 - marketable securities	Current values for some investments whose market value is readily determinable	Securities classified as available-for-sale or held-to maturity categories are mismanaged because ofFAS 115. The held-to-maturity category unreasonably deprives investors of current value information.
FAS 123 - stock options	Grant date present value of options granted to employees	Because of FAS 123's option for footnote disclosure without income statement recognition, excess stock options were granted to employees.
FAS 114 - loan impairment	Consistent measurement of impaired loans	Measurements are still based on historic interest rates, and the criteria for timing of loan loss recognition provide inappropriate discretion to manage earnings. As a result, investors have been deprived of accurate and timely information; management makes inefficient decisions on delinquent loans out of a desire to manage reported earnings.
FAS 141, 142 - business combinations	Elimination of pooling of interests and amortization of goodwill	Costly goodwill impairment test on a number that provides minimal information to investors. As a result, excess financial statement preparation, auditing and consulting costs are incurred.
FAS 95 - statement of cash flows	Converting inconsistent funds flow statements to more consistent cash flow statements.	The direct method of presentation is rarely used, depriving investors of information regarding actual operating receipts and disbursements.  Subsequent attempts to revise this glaring flaw in FAS 95 have failed.

What would have happened in each of these cases if those who those who gave up the fight in the name of incremental progress refused to yield the high ground?  For example, how would derivatives and non-derivative marketable securities be accounted for today if compromises had not been made ten and fifteen years ago? Fair value is still the only plausible answer. The lost momentum of compromise with closure reigns forever and a day.  In the case of FAS 133, it's been 10 years and counting.  As for lease accounting, it's been 30 years and even getting a second wind no less; the FASB has recently announced that it is limiting the scope of the project to revise lease accounting rules, which has already dragged on for far too long.  I may be able to add to my list of compromises with negative examples, and I cannot think of a single compromise that ended up as a standard making those who compromised eventually look like heroes instead of patsies.

My point is that the absence of patience and fortitude can leave its stain on accounting standards for generations.  The IASB's process leading to IFRS 3(R) tells me that the lessons of history demonstrating the futility of compromise go unheeded by the putative heirs to U.S. GAAP.

I have read from numerous sources that adoption of IFRS in the U.S. is regarded to be "inevitable." I don't know about that, but I am convinced that uneconomic mergers doing immeasurable harm to both shareholders and work forces will occur because of IFRS3(R)'s loosey-goosey business combination standards. Even more important, if the non-U.S. members of the IASB come to understand that we in the U.S. are effectively committed to allowing sausage-factory-style accounting standard setting in our capital markets, we will be doomed to a steady diet of sausage.

That's why Jim Leisenring should not have voted for IFRS 3(R). 

Toward a New Big Eight: A Deal The Big Fours Can’t Refuse

Jim Peterson, who blogs on the auditing profession, has written an excellent summary and analysis of the failure of the U.S. Treasury's Advisory Committee on the Audit Profession to recommend a solution to the Big Fours' exposure to liabilities threatening their solvency. By the way, Re:Balance is worth reading simply out of appreciation for Jim's elegant writing style. Also, check out his funky bow tie!

"Did anyone really think that the endless chatter about saving the system of privately-provided audits for large global companies would come to anything? ...
...those sincerely believing in the importance of large-company assurance are avoiding an election between two unappealing choices: Either put every effort to assure that the Big Four are insulated from the very catastrophic risks that the critics insist they must remain exposed to, or start the process of designing the new audit model that must arise after the collapse of the Big Four under the abdication of the Treasury Committee and its counterparts."

I agree with Jim that the current audit model is broken: the notion of independence is fatally flawed, and much of what passes for auditing does not create useful information for investors. Ironically, the "services" that merely provide a perfunctory rubber stamp on management's judgments may create their most significant exposures to liability. Walter Schuetze, former SEC Chief Accountant and FASB member, explained this much better than I can in a 2003 speech to the New York State Society of CPAs. The deafening silence in response to his challenge to make audits simpler and more relevant attests to the fact that political will to fight deeply entrenched interests in the current system is virtually non-existent.

But, I do not agree with Jim's characterization of the Treasury Committee's winding up as an "abdication." Knowing personally and by reputation some of the committee members, like Lynn Turner, Don Nicolaisen and Gary Previts, I would be skeptical that a good faith effort to effect real change was absent. And perhaps, the Committee has unwittingly set the stage for real change by confirming what may have already seemed obvious to many: the absence of economic incentives for the Big Four to compromise.

So, where Jim sees two alternatives, I see a third. If we can all agree that government regulators bear some responsibility for the precarious position of being exposed to a disaster should one of the Big Four goes under – they should have put the kibosh on at least two of the three big mergers when they had the chance – then other solution paths will have been opened. For example, the government could offer to share the litigation exposure from each of the Big Four’s prior audit engagements in exchange for splitting up into two completely separate firms.

The immediate effect of such an offer is that the audit firms will be presented with a "prisoner’s dilemma." They will perforce separately conclude that their best chance of riding out the storm is to cut the ropes that lashed them to the other three lifeboats. If the offer to share costs is generous enough, I’m betting we can have a New Big Eight within a year. While this may not completely obviate the need to reform the audit model, which might take another catastropher to catalyze, at least some progress will have been made.   

The cost sharing I am suggesting in exchange for a New Big Eight (apologies to BDO and Grant Thornton) could also reduce litigation costs: legitimate plaintiffs won't be stonewalled because losing a case will no longer result in a firm's demise. And the audit firms would now be able to afford to take claims of less merit to court, thereby discouraging future claims. 

There may be other lasting and significant benefits of a New Big Eight as well.  First, risks of further litigation could actually be reduced if the new firms act to exercise tighter controls. Second, audit fees could be reduced by competition, with related incentives to innovate and become more efficient.

Would there be any diseconomies of scale from split ups of the Big Four? I don't know, but I surmise nothing drastic would happen. There may be some redundancies in the need to maintain technical staffs, but that could finally provide some real incentives to simplify accounting and auditing rules (maybe that’s wishful thinking). It is also possible that exposure to catastrophic litigation became higher as firms got bigger: operations were simply too decentralized to control effectively, and/or extra-deep pockets gave incentives for plaintiffs to ask for larger amounts of compensation for damages.

I'm already lusting over the prospect of christening the new mini-behemoths.  How about PriceWater and HouseCoopers? Would Mr. Young get his first name back on the firm he founded (Arthur, for those of you too young to remember) ? Would the other Ernst be resurrected? Enough already!

The Revisions to IFRS 3: Bad Enough to Abandon Faith in IFRS?

In my previous post, I described how an SEC honcho, while speaking to the choir at an event sponsored by FEI, espoused his version of faith-based accounting; though he could not provide a single, solid reason to explain why the U.S. should adopt IFRS, he has seen the light and has become a true believer.   In contrast, reason-based accounting permits recitation of a vast litany of blasphemies against IFRS to make one a serious, if not committed, agnostic.  Today, I write of one of these latest abominations: the latest revision to IFRS 3 on the accounting for business combinations.

Goodwill and NCI:  IASB Fakes Right and Goes Left

Perhaps the most significant development in the accounting for business combinations is that FAS 141(R) now requires the same basis of measurement for assets acquired and liabilities assumed, regardless of the percentage of a company acquired (so long as control is achieved).  Therefore, if control is attained without purchasing 100% of the existing equity interests in the acquiree, non-controlling interests (NCI) must be measured at full fair value. 

As you may be aware from reading my post "What Good Comes from Goodwill Accounting?", I am not a big fan of recognizing 'goodwill' under any circumstance, so I will grant that the justification for the FASB's approach is not airtight.  Nevertheless, it was common knowledge that the FASB was given to understand that, by sticking its neck out to make these controversial changes to FAS 141(R), the IASB would follow suit. 

Instead, the IASB renegged on its promise in the worst way imaginable: they voted to allow entities a free choicebetween the partial and full fair value alternatives to goodwill and NCI measurement.  What's more, issuers can make their choice on a transaction-by-transaction basis -- kind of like going to church one week and synagouge the next.  Not even the most devoted acolyte can spin this any other way except as a significant step backwards from establishing the IASB as a credible agent of quality financial reporting and investor protection. 

And, it's not just me who is outraged.  Read the strongly-worded dissents* of Mary Barth and John Smith, two of the three Americans on the IASB.  As to the third American, Jim Leisenring, I guess I shouldn't be surprised that he capitulated to the majority.  Leisenring was the most prominent voice in support of FAS 133 (on hedge accounting) when he was on the FASB; a standard whose middle name is inconsistency.  Be that as it may, one can only imagine where the IASB will take the interests of U.S. investors when our membership, and hence our influence, on IFRS inevitably wanes. 

Mind These GAAPs, Too 

If the unprincipled and unconstrained choice of accounting treatments for goodwill and NCI aren't enough for you to abandon any faith in a high-quality convergence, consider two more of the numerous departures from U.S. GAAP; these may be even worse.

First, the devilish game of managing the timing of contingent liabilities still thrives in IFRS.  FAS 141(R) now requires that any non-contractual, contingent liability assumed in a business combination must be recognized at fair value, if the probability of occurrence is more likely than not.  IFRS allows any contingent liability to be recognized, regardless of likelihood, if it can be reliably measured. 

As I discussed in a previous post on IASB machinations of contingent liability accounting, the ubiquitous criterion of "reliable measurement" is one of those areas of "judgement" in IFRS that help management make their numbers with little chance of being challenged by auditors.  Here is how this game will be played in a business combination under IFRS 3(R):  if management thinks that goodwill won't be impaired any time soon, they will recognize contingent liabilities to the max.  The effect is to create an earnings bank of liability writedowns when unlikely events become, as anticipated, resolved without the incurrence of an actual liability.  And speaking of inconsistency, IFRS 3(R) provides that all intangible assets are to be recognized, even if their fair values cannot be measured reliably.  Where is the "principle" for that one? 

Second, FAS 141(R) requires extensive disclosures that are designed to aid analysts in determining the past and future effect of a business combination on earnings and financial position.  For example, FAS 141(R) requires the following disclosures:

• The amount of revenue and earnings of the acquiree since the date of acquisition. 
• Revenue and earnings of the combined entity for the current period as though the acquisition had been consummated as of the beginning of the period
• Revenue and earnings of the combined entity for the previous period, as if the acquisition had been consummated as of the beginning of the previous period. 

Inexplicably, IFRS does not require the third item, above.  Therefore, inferences as to earnings trends of the combined entity from historical financial statements are defeated.

The recent activities of the IASB, the high priests of IFRS, confirm that they are most definitely not the august body to which the future of U.S. financial accounting standards should be entrusted.  To those who persist in practicing faith-based accounting, put IFRS's accounting for business combinations in your pipe and smoke it.

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*Unlike statements of the FASB, IFRS publications are not freely available.  Just thought you might want to know why I didn't provide a link.

Accounting Convergence: Deconstructing the SEC's Message

John White, Director of the SECs Division of Corporation Finance, gave a speech at Financial Executives International Global Financial Reporting Convergence Conference last week (June 5, 2008). In no uncertain terms (and with apologies in advance for the bad pun), it was a whitewash for the benefit of the members of the club. I am writing this post, with the objective of waking up at least some investors to the realization that their interests are being trampled upon by the auditors they pay for, their very own executives, financial intermediaries, and sad to say, the SEC.

So, peeling off the oily-based camouflage, here is the bare bones of White's speech -- at least as I see it.

Good morning. Let's skip the formalities and get right to the point. I truly believe that the endpoint of global accounting convergence will be U.S. issuers using IFRS and that it is time to move in this direction. Even though I can't mention the real reasons in public, here are the five darn good ones we're currently pitching.

First, the SEC will have less influence over accounting standards. That's a good thing, isn't it? Even though other regulators don't ask the tough accounting questions like we do, we are going to work with them and pretend we agree. Remember Societe General? We don't, and thats what I'm talking about. Even though the U.S. representation on the IASB will shrink, I know we can count on the Chinese and Europeans to come up with reasonable answers on technical issues like disclosing related party transactions, securitizations, hedging, contingent liabilities, business combinations, and about the twenty other things that really aren't so good about IFRS -- and I don't want to discuss today. Especially not business combinations: the IASB sure screwed up IFRS 3 after we improved FAS 141R, but that probably wont happen again. And sure, the IASB has some governance issues, but we'll be able to fix that with our single seat on a committee of securities regulators from all over the world that will oversee the IASB's activities. Im sure we'll all get along just fine, and everyone will listen to us because we are from the USA.

Second, IFRS leaves a lot more room for management judgment. That's a good thing, isn't it? We believe that investors most want management to have more tools at its disposal to help them manage earnings. That will go a long way to eliminating outright fraud, because management won't have to risk going to jail to make their numbers. And besides, if managements judgment is really, really unreasonable, auditors will be there to fix things, right? (Uneasy laughter from the audience.) Don't laugh! Investors aren't the only group the SEC protects. The feelings and needs of issuers who report financial results must be considered; that's why I haven't mentioned the needs of investors without also mentioning the needs of issuers.

Third, and speaking of auditors, it is going to cost billions of dollars to implement IFRS in the U.S., and auditors, one of our favorite charities, will be raking in a big chunk of that. Despite overwhelming evidence from rigorous academic studies that these costs will provide little or no benefit to investors -- and even that U.S. GAAP is associated with better information and lower cost of capital -- we have to come up with some way to employ the next wave of accounting students, especially since our last full-emplyment initiative -- SOX 404 work -- is drying up.

Fourth, assessing a companys financial results should not depend on what country a company is from. Differences in corporate governance, laws, business norms and culture do not matter to investors, so accounting rules can be the same, and will be interpreted the same whether we're applying them to companies in China or the United States. After all, IFRS is principles-based, isnt it? (More laughs from the audience.)

Fifth, global capital markets have been growing by leaps and bounds for decades, apparently unhindered by the polyglot of accounting standards in use throughout the world. But, having a single set of accounting standards is going to become really, really important; trust me on this one.

I want to conclude by explaining what I mean by "truly believe." I'm just a politician ... whoops, I mean lawyer ... who really doesn't know much about what all you CFOs have to go through to make your numbers. Frankly, the details of the differences between IFRS and U.S. GAAP don't concern me much. I just threw in "truly" to impress upon you that I am on your side -- kind of like "no kiddng," or "I swear." In other words, even though I dont have a single good answer to any of the questions I have raised today, dont worry, because we're going through with this anyway. I truly believe that If IFRS is good for you, it's good for the SEC; and it must be good for everyone.

Thank you and good night.

XBRL at the SEC: Investors Want More Data To Go With the Better Formatting

On May 14, 2008, the SEC voted to propose its long-awaited XBRL rule, requiring companies to provide the information contained in financial statements, notes and accompanying schedules in a format amenable to interactive search and analysis. The XBRL data tag information would be presented in an exhibit to the filing, leaving the disclosure and formatting standards currently in use for all other sections of filed reports available as they are today.  For liability purposes, the new exhibit would be considered to be “furnished” instead of “filed” with the Commission.  

The proposed rule is undeniably a centerpiece of Chair Cox's tenure at the SEC.  But despite all the attention and promotion lavished upon it, the milestone rule proposal comes five years after the commencement of the voluntary XBRL filers project, and has at least three more years to go to full implementation.  And, the vision of a better future with XBRL is still foggy: despite slick demos of the types of analyses one can undertake with XBRL-formatted data, it is tough to see how much more can be done than what has already been made available with tools provided by third-party data providers. 

Garbage In, Garbage Out

Well, maybe that's unfair, but I couldn't think of a better subtitle.  What is true, however, is that the SEC has failed to recognize, or at least acknowledge, that they can influence XBRL's cost-benefit equation not just by how information is formatted in electronic filings, but how having XBRL should change what information is provided by filers.   Here are just two examples from recent history where the SEC can do much to help investors at very little cost, and for which XBRL is an ideal application.  In my humble opinion, the added information itself is worth much more to investors than mere improvements in data formatting:

Reconciling information for long-lived assets -- The SEC used to require schedules of fixed assets by categories that contained information about the events that changed their carrying amounts.  But, during the Reagan era, when the costs of compliance with disclosure requirements (especially by smaller companies) were seen to be holding back the growth of the economy, these schedules were eliminated on the dubious grounds that they were not used by investors.  In contrast, IFRS has long required a reconciliation of beginning and ending carrying amounts for each class of PP&E and intangible, showing at minimum the following: additions, disposals, effects of business combinations, revaluations, depreciation, effect of foreign exchange on translation (IAS 16 and IAS 38). 

Whatever you want to say about IFRS, this disclosure requirement is real sunlight.  If the FASB and SEC truly cared about investor protection and having capital markets that set the standard for the rest of the world, they should feel shame that these basic disclosures do not exist in our rules and regulations.   As proof of that point, it's a safe bet that if these disclosure had been required of U.S. companies, WorldCom might not have happened! (See my earlier post on the blown WorldCom audit for further explanation.) 

Unhide the hidden reserves -- A second example can be found in the SEC's abandoned proposal to require specific reconciliations of numerous "valuation and qualifying accounts" that are only vaguely specified in Rule 12-09 of Regulation S-X, and therefore, widely ignored.  The proposal was added at the end of Arthur Levitt's tenure as chairman, and was a logical extension of his battle against earnings management.  The proposed list of reconciliations are so basic and reasonable, that they bear repeating here:

• Allowance fo doubtful accounts and notes receivable
• Allowance for sales returns, discounts, and contractual allowances
• Unamortized premium or discount
• Excess of estimated costs over revenues on loss contracts
• Inventory valuation allowance
• Valuation allowance for deferred tax assets
• Liabilities for exist and employee terination costs
• Liabilities for costs of discontinued oeprations
• Liabilities for environmental remediation costs
• Contingent income and franchise tax liabilities recorded pursuant to FAS 5
• Product warranty liabilities
• Probable losses from pending litigation

I would love to have Chair Cox explain why this important and basic proposal has fallen through the cracks during his term and the terms of the other Bush appointees. 

Now that we are going to eventaully have XBRL, it is going to be even more difficult to argue that investors will not benefit significantly from these detailed disclosures -- not just by having more and better information to analyze, but to have disclosures that can deter fraud.  Sunlight is free; auditors are not.

 Too Slow

I have already given you my most important thoughts regarding XBRL, but I also think that the current plan for phase-in will take way too long.  Large Accelerated Filers (approximately 500 companies) are to provide the required exhibits beginning with the fiscal periods ending on or after December 15, 2008.  Accelerated Filers, constituting the significant majority of SEC registrants, would begin complying one year later, and all remaining filers in the third year.   

For each phase-in group, there would be a one-time, 30-day grace period for late filing of the first required exhibit containing the interactive data. Notes and schedules accompanying the financial statements during the first year may be “block tagged”, meaning that each financial statement footnote or schedule would be tagged individually as a block of text.  Beginning with their second year of compliance, filers would be required to tag the detailed disclosures within the footnotes and schedules; a second 30-day grace period would apply to the first filing in which full tagging of notes and schedules is required.

My recommendations -- Shorten the phase-in period to two years.  Require all accelerated filers to comply in the first year, and don't allow them to block tag.  Everyone else should come in during the seocnd year.  If that's seen as too strenous, I would not mind lengthening the proposed grace periods to 60 days, and allowing "smaller public companies" to block tag in their first year.

As exciting as the prospect of interactive data covering all public companies may be to investors, it sure seems as if the SEC is largely going it alone on this project.  So, perhaps the slow progress is not just the SEC's fault, but for the sake of investors, they need to crack a whip, not a wet noodle.  Only 75 companies agreed to participate in the pilot program even after the SEC offered volunteer companies expedited reviews of public offerings in exchange for joining the pilot group.  Auditors have also been unusually quiet as well.  As Jack Cieselski pointed out (as reported in CFO.com), "auditing firms should be leading the parade on the subject of providing assurance on the quality of XBRL preparation."  Instead, their unison cheerleading has been aimed at two bigger prizes: the big pile of money that will be theirs should they motivate the SEC to shove investors off a cliff by adopting IFRS, and the mother lode of liability reform to shield them when the next accounting scandal tsunami inevitably crashes onto the beach.