The Accounting Onion

IASB: The Rules of Arithmetic Are Suspended Indefinitely

"The London Symphony played Beethoven last evening, and Beethoven lost." That quotation, which my father attributed to George Bernard Shaw, leapt into my mind as I read Marie Leone's CFO.com report of remarks made by Thomas Jones, vice chairman of the IASB:

"… in general, he [Jones] and other IASB members support fair value accounting for financial instruments, but 'don't believe in fair value for the factory or production machinery.' Jones observed that leaving aside the issue of mark-to-market accounting in an illiquid market, 'I think that fair value does capture reality.' The only thing historical cost captures regarding financial instruments is an 'accurate' but 'meaningless' number, he opined." [italics supplied]

Principles-based accounting didn't just lose, it was assassinated. "O, pardon me, thou bleeding piece of earth, that I am meek and gentle with these butchers!" (The Bard's Mark Antony to Caesar's corpse.)

It appears that Jones' position (and that of the other board members Marie Leone reported him to have spoken for) is that fair value measurements should be restricted to financial instruments that can be sold in a liquid market. If fair value has such limited application, and historic costs are meaningless, then perhaps neither one of these measurement attributes belongs in a principles-based system of financial reporting. Of course, as many of you may realize from reading previous posts, I believe I know which attribute does belong: replacement cost.

Mr. Jones evidently is of the opinion that fair values for "factory or production machinery" yield illusory measures of profitability – and I agree. To make the larger point as simply as possible, let's consider the implication of fair value on inventory. One does not simply make a profit by producing inventory; it has to be sold. That's because real wealth is "command" over goods and services, and no one can be commanded to buy what you produce. Perhaps somebody can be convinced to buy a car from GM (although it appears to be getting harder by the day), but having a car in inventory in no way represents command over anything – except for that car in inventory. (By the way, nobody can be commanded to buy your junk financial instruments from you either.)

The sense of the word "command" in economics is that every owner of an asset has their price; offer a high enough price, and at least in theory, anything that is legally salable is available for sale. That's why replacement cost of all of the assets at one's disposal is the economist's standard choice for measuring wealth.

Replacement cost as the attribute of an asset to measure also resolves both of the problems I have with Jones' positions. First, no number reported for an asset will be "meaningless." Replacement costs of financial instruments and producing assets is the money equivalent of already owning a resource instead of having to expend cash to acquire or produce it.

Second, the problem of illiquid markets for financial instruments goes away. A financial instrument is fundamentally a stream of risky cash flows. It is always possible to estimate how much it would cost to acquire the financial asset, and circumstances will dictate the most reliable method for making that estimate. The illiquid markets caveat is nothing more than code for "I can't find someone to buy my junk asset for the price I want to sell it."

I learned to write my name on my first day of elementary school. On day two, I learned that one plus one only makes two when we add two like things. Does anyone else see a problem with ceding accounting standards to a single group whose putative leadership sees no future for accounting except for one that violates the most basic rule of numbers and logic we all learned by the first grade?

G-20 Conference Provides Cover for the SEC to Issue Its IFRS Roadmap

The trustees of the IASC Foundation (the oversight body of the IASB) have continued to blithely plug IFRS as if it were just an innocent bystander in the global financial crisis. Just days before the G-20 economic conference, the IASC Foundation sent a letter to President Bush, urging that the G-20 recognize that IASB should be the one to lead the "efforts to improve financial reporting … to ensure a globally coordinated approach." Of course, the trustees conveniently neglected to mention that it has long been the IASB's function to establish high quality financial reporting – lest anyone should closely examine its ongoing and recent neglect of investor interests, political machinations and prevarications.

In any case, the strategy seems to have paid off for the IASB, in large part because the G-20 utterly failed to develop any semblance of a strategy for resuscitating the global economy. The G-20's parting statement was a scant 12 pages; one page of introduction and recriminations, one page vaguely enumerating "actions to be taken" (don't you love the passive voice?), and 10 pages of proposed regulatory reforms to prevent bad stuff from ever happening again:

"Regulation is first and foremost the responsibility of national regulators who constitute the first line of defense against market instability. However, our financial markets are global in scope, therefore, intensified international cooperation among regulators and strengthening of international standards, where necessary, and their consistent implementation is necessary to protect against adverse cross-border, regional and global developments affecting international financial stability. Regulators must ensure that their actions support market discipline, avoid potentially adverse impacts on other countries, including regulatory arbitrage, and support competition, dynamism and innovation in the marketplace. Financial institutions must also bear their responsibility for the turmoil and should do their part to overcome it including by recognizing losses, improving disclosure and strengthening their governance and risk management practices." (para. 8)

In other words, competition among nations to attract capital shall be henceforth streng verboten; and if financial institutions don't suddenly get some religion, then … something.

Fluff and kerfuffle. If the U.S. hasn't learned its lesson from the harm already wrought by the absence of sensible capital markets regulation and accounting rules, then no amount of pledged international coordination, cooperation or centralization can save us from another financial tsunami. Why can't each nation, especially the U.S., be entrusted to act in their own best interests – to diagnose and correct its own policies, and provide a progress report one year hence?

Focusing on financial reporting regulations, the IASB has not been, and never will be the maker and keeper of high quality accounting standards. There is no reason to think that the U.S. can't go faster and further on its own. Nobody would let me, of course, but it wouldn't take me more than a week to accomplish 80% of the job. Here are a few of the changes that can get us well on the way to high-quality, investor-oriented accounting standards.

• Do away with the held-to-maturity and available-for-sale investment categories (which the IASB still fiddles with as Rome burns). Financial institutions will no longer have any incentive to hold onto underwater investments solely because they can defer loss recognition. The concept of an "other than temporary" decline in market value is squishier and even sleazier than "pornography."
• All financial assets and liabilities should be measured at fair value (or current replacement cost) with changes to earnings. CFO.com recently reported that the Basel Committee is thinking about adjusting capital adequacy requirements to take into account fair value measurements. All I can say is that it's about time! Accounting standard setters have been kowtowing to financial regulators and banks since time immemorial, and in the process compromising the quality of accounting information provided to investors. Let the bank regulators adjust to fair value, and if they need any other measurements to effectively monitor bank capital, let them be required in addition to, and not in place of, fair value.
• Do away with anything else in owners' equity except for the accumulated net proceeds from common stock issuances and earnings that were not paid out as dividends. Managers will no longer waste their time and shareholder money conjuring up complex financial instruments that do nothing except evade fair valuation for entity-issued instruments.
• Do away with interest cost capitalization. Every investor wants to evaluate operating profitability separately from financing decisions.

Now, ask yourself why the SEC couldn't make these simple changes in very short order. Instead of a simple and straightforward approach to fixing GAAP, the G-20 conference provided the needed cover for the SEC to finally unveil its proposed rule, Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, and the IASB scored a coup.

I'll take the above four bullet points over that 165-page albatross any day, and especially as a more appropriate and timely response to our financial crisis.

Amended IAS 39: Exploding the Myth of an Independent IASB

Although the FASB's record as accounting standard setter is far from spotless, I can't think of a single action taken where the quality of information provided to investors unambiguously diminished. That's what makes the IASB's amendments to IAS 39 so remarkable: the august body that is supposed to take over the FASB's role as principle standard setter for the U.S., the putative adherent to principles, the preacher of "true and fair view," just took a huge step down a very steep slippery slope.

By way of background, IAS 39, Financial Instruments: Recognition and Measurement, requires financial assets to be classified in one of the following categories, which determine how a particular financial asset is recognized and measured in the financial statements:

• Financial assets at fair value through profit or loss (FVTPL);
• Available-for-sale financial assets (AFS) – fair value through other comprehensive income;
• Loans and receivables (L&R) – measurements based on contracted-for amounts;
• Held-to-maturity investments (HTM) – measurements based on investment cost.

These categories are more or less the same as U.S. GAAP, so I should start by observing that everyone's accounting for financial assets could easily be a lot simpler all around: all financial assets should be measured at fair value (or preferably replacement cost) through profit or loss. The exceptions to FVTPL for equity and debt securities are the FASB's invention in SFAS 115, the original fair value standards.  Such a political compromise was made necessary to get the buy-in of issuers (who funded the FASB) fearful of the havoc that mark-to-market accounting of even some investments would wreak on their earnings (and presumably, executive compensation).

The IASB's press release announcing the IAS 39 amendments reminds me of the politician (everything reminds me of politics on this day) who will say anything with a straight face, no matter how false, just so long as it can possibly win votes:

"In responding to the crisis, the IASB notes the concern expressed by EU leaders and finance ministers through the ECOFIN Council to ensure that 'European financial institutions are not disadvantaged vis-à-vis their international [read U.S.] competitors in terms of accounting rules and of their interpretation.' The amendments today address the desire to reduce differences between IFRSs and US GAAP in a manner that produces high quality financial information for investors across the global capital markets." [emphasis supplied]

Taking these two sentences together, it appears that the IASB must have performed a miracle. Somehow, it has allayed concerns of the European financial institutions, while in the process, has come up with a new accounting treatment that still "produces high quality financial information for investors." I admit they didn't actually say that the quality of financial information has increased by their actions, but a diminishment in quality is the unambiguous and unprecedented result. In stark contrast to the press release propaganda, there is not even a whiff of consideration of investor needs in the document amending IAS 39; nowhere is the word "investor" to be found.

I don't have to deal here with all the ins and outs of the amendments to make my point; just two examples will suffice. First, loans (think mortgages) and receivables that were heretofore measured at fair value may be transferred to the HTM category. As explained above, this is a place where fair value measurement takes an indefinite leave of absence. Today, fair value; tomorrow, who knows.

Second, the effective date of the IAS 39 amendments is retroactive to July 1, 2008, i.e., before the proverbial you-know-what hit the fan. While permitting loan reclassification to HTM may be said by some to undo any "disadvantage" because the same accounting was already permitted in U.S. GAAP (though more narrowly than IAS 39 now permits), even an undergraduate student will immediately understand that the European banks are being given a mulligan. With the unprecedented benefit of hindsight, issuers will cherry pick financial assets with accumulated gains since July 1 to remain in AFS, and the loss securities will be transferred to HTM as of July 1. In other words, the accounting will look like the crash in value didn't happen—in fact, winners count and losers don't. That's not leveling the playing field, it's picking up your marbles and going home. Will any auditor in Europe challenge a client's statement of intent and ability to hold a toxic loan for the "foreseeable future," whatever the heck that means? Vive le Société Générale!

As to any "disadvantage" that may have existed prior to the IAS 39 amendments, the IASB is mute as to what it is, why it is, or how it works.  I have never understood the argument that real competition in business should be presumed to be affected by financial reporting. Take business combinations, for example. In order to eliminate pooling of interests accounting, the FASB had to overcome the objections of its constituents who argued (whether they believed it or not) that recognition and amortization of goodwill would put U.S. companies at a competitive disadvantage when making acquisitions of other companies. When I was at the SEC for just one year, at least one registrant per week would spend shareholders' good money machinating and politicking to get to the point where the SEC staff wouldn't object to pooling of interests accounting for an acquisition. One of Abe Briloff's most famous essays was about how MacDonald's Corp. (I think it was in More Debits Than Credits) would systematically pay far too much of its own stock to underperforming franchisees to reacquire their restaurants (if that's what you would call a MacDonald's), while qualifying for pooling of interests accounting. There was even one case where politicians must have leaned on the SEC to look the other way when AT&T used pooling of interests to account for its acquisition of NCR. AT&T overpaid, of course.

The point is, as I have made repeatedly before, that bad accounting, especially when lobbied for by management, begets decision making that may be good for management in the short-run, but will eventually destroy (lots of) shareholder value. The amendments to IAS 39 will be no exception. Will the toxic loans on the books of financial institutions be managed with a desired accounting result in mind? You betcha (more election blues)! Auf wiedersehen, shareholder value.

The distinctive feature of this story, however, is the blatant pandering to issuers by the IASB, without any pretense of due process and nary a flinch of concern for having robbed investors of current information at a time when they need it the most. If there ever was any notion of an independent IASB, it has now vanished.