The Accounting Onion

IFRS Adoption Critics: More Silent Majority than Vocal Minority

Given my public record of opposition to IFRS adoption, you might be surprised to know that I have taught courses on IFRS for over ten years, beginning in Switzerland and the UK. If anybody is interested, I will be presenting a two-day IFRS/GAAP comparison courses in Chicago and Vegas this November; and I gladly collaborate on the delivery of those courses with representatives of two Big Four firms.

I try to stay away from blatant self-promotion in the body of a blog post, but I wanted to make the point that I am not an IFRS newbie, and have thought about the problems of which I blog for years. I also strongly believe that certain aspects of IFRS are much stronger than U.S. GAAP.

The larger point, however, is that I actually do have a significant stake in IFRS adoption; yet, for reasons only a psychiatrist might be capable of explaining, I persist in my financially self-destructive rants.

Imagine you're my shrink. As I lie on your couch, I tell you that my attitudes toward IFRS adoption are rooted in my childhood. (Surprise!) Both my parents fled from Nazi Germany, but my Dad was involuntarily detoured in a Nuremberg prison and Dachau concentration camp before managing to finally extricate himself from miscreants' clutches.

After immigrating via the UK to the USA, Dad soon thereafter entered the military (he was drafted after first volunteering and being turned away). He was returned to Germany on D-Day +30 as a POW interrogator. It's a long and unique story, which late in life he wrote about in a book that I posted on line.

Obviously (I try not to use that word very much), my dad's perspectives on life were shaped by these experiences. As to their effect on me, his bitterness rarely came to the surface, except indirectly when he was motivated to speak out against some proximate injustice. Dad was non-violent in actions and manner, but his words were sharp and he didn't give a hoot what others thought of his pithiness and directness. He was only self-conscious about his thick German accent (think Henry Kissinger). Also, I'm sure that his "attitude" and accent did not help his career aspirations at AT&T. Anyway, I think that is the font of my self-destructive outspokenness.

I bring this up now, as I am about to present you with a quote from a kindred spirit, and former Big Four auditor, who shall remain nameless; his nom de email is SuperHeater, and I have no idea what that is supposed to mean, but I have a pretty good idea that his brief turn as a Big Four auditor shaped his perspectives. Here's an excerpt from one of his war stories:

"I knew I needed to leave [the Big Four firm I was working for] after about three months. I had questioned a client (politely) about how they arrived at a $90,000 bad debt reserve on an A/R balance of $10,000,000 for unsecured receivables where the aging detail showed items 500 days old. I was told by the assistant controller that the 'CFO knows our customers, and knows what invoices they'll pay.'

The in-charge senior associate told me, 'I don't care if it's adequate, I care that it's there'- so much for adequate audit evidence and professional skepticism.

The following day I was summoned to meet with the partner on the job (who happened to be the HR partner) in order to be told 'the client had a complaint,' but offered no details. As the client was a trucking company that financed their equipment and was surely trying not to violate the current asset requirement of their debt instruments I suppose that's not hard to figure out. I'd like to say that was my only eye-opening experience, but it wasn't. There were screaming 'seniors' and days when testing exceptions were explained away with 'this appears to be a one-off transaction, P/f/p' rather than expanding the test sample as indicated by the audit plan."

I don't receive many substantive comments on my posts, (roughly two per post), but they are about 95 percent supportive. (BTW, those who have chosen to express their disagreement with my points of view are invariably respectful.) Thus, I want to at least surmise that SuperHeater's sentiments (with certain colorful features omitted) are generally in the same direction as those of a large proportion of my readers. In addition, the comments about how the market for auditing staff will shift after IFRS adoption is a fresh perspective for me.

"Having spent an unpleasant year at KPMG as an older, nontraditional hire and observed their methods and now currently employed at an enterprise where Deloitte is an IT contractor, I remain convinced that the only people who think IFRS adoption (either wholesale, convergence or some other method) is desirable are the Big 4, major transnational corporations and the SEC.

Additionally, the cheerleaders' affection for IFRS has absolutely nothing to do with any intrinsic superior quality, simplicity, brevity or any other (supposed but immeasurable) attribute of IFRS; it's about the ease and profitability of the cheerleaders' enterprises. The transnationals have a similar perspective; the SEC is a study in "regulatory capture", with its bureaucrats giving speeches and missing the likes of Enron, Worldcom, Adelphia & Madoff.

However, the leader of the pack is the Big Four. Like most modern propagandists, they furiously release marketing information disguised as objective technical analysis. I personally think the IFRS' "ordained clergy" are easily identified by the use of the word "robust." We are supposed defer to the presumed expertise of Big 4 partners and senior managers about the arcana of accountancy-especially when they use nebulous language and speak with the authority of historicity with constant references to IFRS as "inevitable."

For years the Big 4 have envied their clients who outsource their production to places like India, China, and other lands, where there's plenty of high intellects looking for opportunity. As the birthrate has fallen in America, it has been harder to represent the typical associate's position as something more glamorous than the fraternity hazing it resembles. The Big 4 have copied the outsourcing on their IT side, where there's no credentialing impediments; but on the attest side – well, that's different. Sure, you can staff an office full of staff and senior associates from other countries; language barriers don't matter that much when you don't speak to the client that much. Also, we know they'll work like the dickens because they're working for permanent US residency and having family half a world away creates less desire for time off.

However, when you get to be a manager, you need to have that CPA-and the exam is hard. Harder still, when you don't speak English, let alone when you have to learn a new book of rules. Do away with GAAP, you do away with the need to comb among potential US born associates with their tender egos, high debt loads and social and esteem needs. Once we're on IFRS, the Big Four becomes a truly global enterprise; picking off bright minds from lands of less opportunity-obtaining a deep inventory of intellectual capital at distress sale prices. Perhaps at the Big Four, the "A" in CPA stands for arbitrageur. I suppose it's a losing battle, because in the end, some very deep and mercenary pockets are driving this surrender of US commercial sovereignty. Now we know why Mr. Niemeier was passed over for the CA job."

The supporters of IFRS adoption have long-dismissed detractors like myself, Charles Niemeier and SuperHeater as comprising nothing more than a "vocal minority." The tepid-to-hostile feedback on the Roadmap should have put that libel to bed, but the recent remarks of chief accountant Kroeker and SEC chair Schapiro indicate that they are willing and able to follow Christopher Cox's oft-repeated example of plowing straight through reasoning critics behind nothing more than a blast of hot air.

I'll soon be posting a link to an online survey of attitudes towards IFRS adoption. Whatever the truth is, I want it to be more clearly evident.

First Missive from the New Chief Accountant: Get Ready to Roll with IFRS

It came as no surprise that SEC Chief Accountant James Kroeker's first public foray, since Mary Schapiro deigned to remove "Acting" from his title, was to announce that the IFRS Roadmap has once again become a priority at the SEC. That should please his former employer, Deloitte, one of the Big Four IFRS Cheerleaders. To give you some indication of the goal-oriented culture from whence Kroeker came, here's a couple of examples from recent "surveys" Deloitte has been peddling.

In 2008, Deloitte asked financial professional what they thought were the benefits and costs of IFRS adoption. That sounds reasonable, but the next logical question appears to have been intentionally left off: which was whether respondents perceived that the benefits of IFRS adoption might not exceed the costs.

And, here's a sample question from a survey I received in my email this month:

In your view, what should the IASB's and FASB's approach be to convergence?

• Extend a comprehensive convergence plan over the next 5-10 years
• Achieve as much convergence as possible between now and 2011, and then focus on IFRS conversion at that point
• Wind down convergence efforts at this time, and support IFRS conversion
• Not sure

"Not sure"? What if you're "sure" or just pretty "sure"; but your answer is not one of the three that Deloitte is willing to tabulate? What if, heaven forefend, you are really "sure" that further convergence efforts would be a waste of time and money?

Answer to my questions: Should you dare opine that IFRS adoption is of no benefit, Deloitte doesn't want to have to acknowledge that gazillions of other like you perchance exist amongst the public, whose interests Deloitte has an ethical obligation to serve. These were not surveys; they were charades. They were put together to serve special interests – at the expense of the investors that Mr. Kroeker now is supposed to be working to protect.

Thus far, the text of Kroeker's remarks have yet to appear, as is customarily the case, on the SEC's website. Consequently, my comments will be based on press coverage from the following sources: CFO.com, Reuters and WebCPA.

Be Very Afraid … of a "Race to the Bottom"

Some people took IFRS adoption for dead, but Kroeker came to say that it has returned to becoming a priority at the SEC, in part because the financial crisis may have underscored its importance. It appears, for example, that without a single authority over standards, the U.S. and Europe may get caught up in a "race to the bottom" to set accounting standards most favorable to banks and to the detriment of investors.

While it is true that the EU has made its fears that lower-quality accounting standards in the U.S. will cause its banks competitive harm, more recent events don't comport with a race-to-the-bottom scenario. The FASB (as I have written here) is proposing that all loans should be fair valued. The FASB is clearing saying to the IASB, 'You can take the low road if you want, but we'll take the high road.' (By the way, there's no way that the IASB will follow the FASB's lead on this. If Sir David Tweedy so much as dreamed of requiring fair value for loans, he'd call up Charlie McCreevy the very next morning to apologize.)

Nonetheless, I do concede that, in the absence of SEC intervention, a race to the bottom is at least theoretically possible. But, for at least two pretty obvious reasons, that possibility is remote, if not downright silly to contemplate.

First, as a general matter, it is not clear that competition among jurisdictions inevitably results in a race to the bottom. As one of many possible counterexamples, consider the development of the state laws governing corporations. The Delaware laws are regarded by many to be least restrictive; however, many corporations choose to register elsewhere. There are two lessons from this that I can think of: (1) there is not necessarily one set of rules to suit all tastes; and (2) the stability and longevity of our system of corporate laws indicates that multiple law givers are preferable to giving the federal government a monopoly on that role. Thus, notwithstanding the 99 other reasons (okay, 10) I can think of, it is far from clear that granting a worldwide monopoly to the IASB is the most efficient thing to do.

Second, and this is the biggie, whatever Kroeker might fear about incentives of standard setters to debase their own coinage, his job, whether he likes it or not, is fundamentally to prevent a race to the bottom from even getting past the starting line. Various securities laws clearly state the authority of the SEC to set accounting standards for public companies. It must be said, however, that the SEC has published its policy that, for the most part, has left standard setting to the FASB. (For the rule wonks amongst you, that would be Section 101 of the codified Financial Reporting Releases.) Kroeker weakly assures us that the SEC will always be active in interpreting accounting standards adopted by SEC registrants, but the SEC historically has done much more than that – by judiciously picking its moments to pre-empt or outright reject FASB pronouncements.

Given Kroeker's own stated preference for uniformity in bank accounting and his own view of its significance in the global financial order, no opportunity could be more ripe than for the SEC to take the initiative on loan accounting. All Kroeker need simply do is to endorse the FASB's proposal to measure all loans at fair value, and counsel the IASB that they should get with the program. That oughta eliminate any fears of an accounting standards race-to-the-bottom.

But, alas, world peace is a more likely scenario; fair value for loans doesn't fly in the EU, so it surely cannot fly with Kroeker's former colleagues at Deloitte. Who wouldn't prefer to know what Kroeker's thinks about loan accounting than the Roadmap? But it's a steady diet of Roadmap that we will surely be force fed in the months to come.

Saying So Doesn't Make it So

As was sadly the case when Christopher Cox was SEC chair, I found nothing in Kroeker's remarks to indicate that he cares much about citing evidence in support of his ideology. Take these accounts:

• Reuters – "Kroeker … said … that in the more than 200 comment letters the SEC has received on the proposal, it was 'resoundingly clear' that people agree there should be a single set of global high-quality accounting standards…"
  
• WebCPA – A single set of global accounting standards is "…like motherhood and apple pie."

Given, as I reported here, that the overwhelming majority of investor responses to the Roadmap proposal want to tear it up, I don't know where he comes up with this stuff. And, don't forget about Deloitte's paranoia about even broaching the question in its "surveys." (By the way, Wayne Carnall, former PwC partner, and chief accountant of the Division of Corporation Finance had characterized the response rate as a pittance, and now Kroeker is spinning 180 degrees away from that.)

Ironically, Kroeker delivered his remarks before a meeting convened by the New York State Society of CPAs. It was there that another candidate for chief accountant, Charles Niemeier, trashed the whole notion of IFRS adoption for what it was: a full-employment act for the current chief accountants' former colleagues.

Not only were Kroeker's and Niemeier's positions as different as black and white, but the quality of their inputs and reasoning couldn't be more starkly contrasted. Niemeier's inspiration clearly sprang from a foundation of cited broad-based analyses produced by published rigorous, peer-reviewed, independent research. The source of Kroeker's remarks apparently came from nothing more than his own wishful thinking.

The Lease Accounting Proposal: What Investors Say

In this post, I'll be reviewing two comment letters submitted to the FASB in response to its Discussion Paper (DP) on lease accounting* by the Investors Technical Advisory Committee (ITAC) of the FASB, and the CFA Institute Centre for Financial Market Integrity (CFA).   My original comments are here. 

The lease accounting project is a strong test of the proposition that accounting standards are capable of cutting through the camouflage of legal form to get at the underlying economics of an arrangement. In that respect, FAS 13 has been a dismal failure, with untold amounts of shareholder value being destroyed by management machinations aiming to exploit complex accounting loopholes and bright line rules lacking no conceptual basis.

Almost any new standard will be a significant improvement over FAS 13, so one of the dangers we face is setting the bar too low. For example, since FAS 13 was promulgated over 30 years ago, the field of financial management has progressed well beyond the point where precise measurement of lease value drivers is on the frontier of our knowledge. I'm not just talking about academic theorizing, either. According to the book, Real Options: A Practitioner's Guide, economic valuation of complex lease terms was first undertaken by executives at Airbus, who needed to know the true cost of the flexibility they were writing into their leases to accommodate their customers' risk preferences. That was over twenty years ago! I'm certainly don't consider myself to be at the cutting edge of financial modeling, but give me about a week, and I should be able to write a spreadsheet to value leased assets and lease obligations that can capture 100% of a lease's complexity for more than 90% of the leases out there.

So, given the state of the art of leasing and finance, we should be expecting a lot more from the FASB than the usual medley of incremental piecemeal improvements they are proposing. We should not just expect that: (1) the assets and liabilities arising from leasing arrangements are appropriately measured on the balance sheet; but (2) that they should also be appropriately measured. As I will be describing, below, ITAC and CFA are pressing for (1), but are aiming far too low on (2). Ironically, given the prominence and reputation for integrity of ITAC and CFA groups, one thing that you can take to the bank is that their positions will be regarded as the upper bound on the concessions to investors that will make it into the final standard. Thus, the most to be had is recognition of leases on the balance sheet; but they will be reported as arbitrary numbers based on calculations that hearken back to the relative stone ages of financial management.

I'll now discuss some of the specific issues starting with the ones I have the least qualms about, and ending with the stuff that gets my goat.

Overall Approach to Lease Accounting

The DP proposes to eliminate operating lease accounting, with the exception of "non-core" and short-term leases. While both ITAC and CFA strongly support the elimination of operating lease accounting, they are both against the notion of a "non-core leases" category. Nobody would ever expect that lease capitalization would have to be applied to immaterial items; but whatever "non-core" is supposed to mean, it doesn't always correspond to "immaterial." It's a ridiculously silly notion, but I'll nonetheless award points to both groups for pointing that out—and doing it much more tactfully than I would have.

ITAC further adds that exempting short-term leases would be an open invitation to gaming, which surely must have been obvious to the FASB but somebody needed to mention it.

Scope of a Forthcoming Standard

Without calling out the FASB for the real reason that lessor accounting issues were deferred, CFA reluctantly accepts the FASB's decision to defer consideration of lessor accounting. The real reason for the limited scope goes something like this: 'We're already taking too much heat from financial institutions on loan accounting, so let's not mess with them any more than we have to.' ITAC, for my tastes, is being too conciliatory (perhaps trying to rebuild the bridges it has burned on IFRS and fair value?) when they state that they are content for now to focus on lessee accounting.

My own two cents — If there is any area in which balance sheet accounting standards can (and should be) symmetrical, leasing is it. If the FASB is serious about its commitment to an asset/liability view of recognition and measurement, then the only real revenue recognition issue in leasing is nothing more than how to present the changes in lease-related assets and liabilities on the income statement. I would not object to deferral of income statement presentation issues from the scope of the next major accounting standard on leases, but I'm disappointed that ITAC and CFA are not exhorting the FASB to get everyone's balance sheet right. Let the big boy lessors present their income statement any old way they want; and let's require detailed roll-forward disclosures of the changes in balance sheet amounts.

Measurement

Everything I have written to this point has been little more than caviling, compared to my consternation on the groups' positions regarding measurement. CFA states that discounting at the incremental borrowing rate would yield a reasonable approximation of fair value, even when there is "significant uncertainty." That's the great unsupported statement of their comment letter—probably because no support is possible.

In the years since FAS 13, alternatives to discounted cash flow (DCF) analysis have been sought and developed because one eventually had to acknowledge a truth that is exactly the opposite of what CFA claims to believe: the truth is that picking the discount rate to value contingent cash flows, and coming up with a reliable measure of the fair value** of those cash flows, is nothing more than a guessing game. Ad hoc adaptations of DCF modeling to option-ladened arrangements is so yesterday. That the FASB proposes to go back to the stone ages of financial theory is less surprising to me than learning that both CFA and ITAC are cool with it.

Here's a much more robust way to think about lease valuation. There are three categories of cash flows in leasing arrangements: (1) the unconditional rental payments to be made, (2) required payments whose amount is determined by reference to uncertain future events, and (3) optional payments. We should require that a preparer document and disaggregate the fair value of their leases by each of these components. This can only mean that options must be valued using option pricing models—i.e., nails should be driven with a hammer. Yes, not all of the cash flow elements of a lease are mutually exclusive, but modern valuation models take care of that. Disaggregation in disclosure of interrelated items is challenging, but reasonable assumptions can be made and disclosed.

As to separate measurement of options, the FASB suggests, and both CFA and ITAC don't object to, a version of DCF that truncates the expected cash flows at the "most likely lease term." Given the financial technology nearly everyone has at their disposal, it's a ludicrous suggestion. Therefore, I expect it will be embraced universally by issuers. That alone should cause CFA and ITAC to reconsider their positions.

ITAC supports the most likely lease term rule of thumb (incredibly, they elevate it to "principle" status in their comments), because it seems that everybody should be able to do it. So, not only are they proposing to pound nails with rocks instead of hammers, they don't think it's worth the effort to drive the nail flush. Who are we writing standards for? FASB ought to be thinking first of the Fortune 500, because that's the bulk of the U.S. economy. Simplistic models to accommodate smaller companies no longer make sense from a cost-benefit perspective.

CFA states that one reason they support the expected lease term approach is out of expediency: "…an acceptable alternative in the interim until the use of fair value for non-financial assets is addressed by standard setters." And when will fair value for non-financial assets be addressed by standard setters? Given the glacial pace of standard setting, and the priorities that standard setters seem to have set for themselves, I'm giving even money that we won't have a general standard on that for at least another 20 years; and 2:1 odds that it won't happen before hell freezes over.  Is that really how long the CFA is willing to wait?

The bottom line on the measurement issue is that if the FASB requires some ad hoc discounted cash flow model for measuring leases on financial statements, then one of two things are going to happen: either companies will have to measure leases twice – the approach they use for internal decision-making, and again with the FASB's stone-age approach – or companies will throw out the approach they use for internal decision making and base their decision entirely on how a lease will be portrayed in the financial statements. Neither alternative should be acceptable to CFA or ITAC.

And that brings me to my bottom line on the CFA and ITAC comment letters. Both groups are legitimately concerned about the quality of information that investors will get from a new lease accounting standard, and they evidently believe that getting leases on the balance sheet at any number is as much as they dare hope for without rocking the boat too much. However, both groups virtually ignore the potentially huge value that investors will realize if the new leasing standard leads to better decision making by managers. Assets that should be leased will be leased, and assets that should be bought will be bought. That vision can only be fully realized if lease accounting gets both recognition and measurement as right as it can be. CFA and ITAC need to hold the FASB's feet to the fire, because nobody will do it for them.

Finally, here's my message for the FASB. Elimination of operating lease accounting is a good thing; it will certainly cut into the book of business of financial engineers and lawyers who accomplish little more than helping management mwwt their financial reporting objectives by skirting the edges of arbitrary bright lines. But, if you choose to catapult lease measurement back to the stone ages, all you will accomplish is to invite those same advisors to adapt to a new game at shareholders' expense. You will not be pleased to eventually discover that, once again and forevermore, you will find yourself chasing your own tail to issue fresh interpretations of unprincipled rules, so as to put a stop to some of more egregious ploys; and worse, you will be pressured to issue new interpretations to widen some of the inherent loopholes in stone age valuation. In the process, your policy choices will surely destroy value for shareholders (although you will strenuously deny it).

Alternatively, you can craft a principled and perforce simple standard requiring economic valuation of leases. There will be some work to do in specifying the objectives of the measurement process, but you will actually be able to afford flexibility in the choice of models and parameter selection. If you do that, some managers will pay consultants, but it will be for honest advice from valuation experts; they could also eschew that advice by negotiating less complex lease terms that they can understand and value straightforwardly.  Honest advice is geared toward discovering the underlying economics of an arrangement, and it will cost a small fraction of the FAS 13-style advice. In the process of all this, your policy choices will create value for shareholders.  

But, don't just take my word for this. Credit Suisse analysts recently issued a report entitled, What if All Financial Instruments Were at Fair Value?" [I can't find it on the web, so I don't dare post a link to my own electronic copy]. In it, I discovered a refreshing message that I hope ITAC, CFA and FASB will take to heart:

"With companies paying more attention to the fair values of their financial instruments, behavior could change. The controls that would need to be put in place and the due diligence involved could force companies to better understand their assets and liabilities. If that were to result in better management, companies could be rewarded with a lower cost of capital." [emphasis supplied]

 

Shalom, and L'shana Tovah (Happy New Year!)

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*The IASB also has a DP out on the topic that is about 90% similar to the FASB's. So for simplicity, I just refer to the FASB's version from here on out.

**I am an ardent supporter of replacement cost measurements, especially for leases. For example, I haven't the slightest idea how the FASB is going to come up with an exit price concept for non-transferable leases. But, to avoid distractions from other points, I am going to presume solely for the sake of sidestepping this issue that all leases are transferable. It doesn't cause replacement cost and fair value to converge, but it gets us close enough for my purposes in this post.

A Sampling of What Lurks at the Bottom of the Goodwill Garbage Heap

I have already reported stumbling upon a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one struck me right in one of my biggest pet peeves:

"In the process of recording ... [a business combination transaction] ... they discovered, by golly, that in a $300,000,000 acquisition, $100,000,000 of assets they thought they had didn't exist. And so the company tromped in with their auditors and said, the rules say the difference between what we got and what we paid is goodwill. I simply wasn't able to accept the fact that there should be $100,000,000 goodwill on their books, which didn't exist, and we told them to write it off."

I have explained in a previous post many months ago why I think the process of measuring goodwill and periodically testing it for impairment is a shameful waste of time and money. I would be hard pressed to think of a better example than Clarence's story to back that up. But, I also want to explain why Clarence's story is more than merely an interesting anomaly.

Goodwill (I despise the term, but will use it here for the sake of clarity and with the understanding that it's meaning as a term of art bears no relation whatsoever to what regular folks think it means) arises from two sources. One source is genuine assets that have been acquired, but for various and sundry good reasons those assets are never separately recognized under GAAP. Even the management that bought those assets probably can't adequately explain to you what those assets actually are in anything but very general and vague terms. Yet, in a business combination, we recognize them all together (and mixing them in with liabilities of a similar ilk as part of the process) as 'goodwill.'

The second source of goodwill are 'mistakes.' In other words, paying a price to acquire a company greater than its value. Although the amounts of money in Clarence's story are extreme, the fact of the matter is that mistakes happen all the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down after they have proudly announced their plans to acquire another company. During my part-time career as litigation consultant, I can recall at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or those assets were worth less than they were represented to be worth by acquirees. In all of those cases I was involved in, how did a mistake get accounted for? Capitalized as goodwill, of course! No Clarence Sampson or auditor suggested they do otherwise.

I suppose that one could justify initial capitalization of mistakes as goodwill, because they are impossible to detect at the time a transaction takes place; if they could have been detected, then the purchase price presumably would have been adjusted. But, don't business combination accounting rules give one a full year to adjust the values of assets acquired and liabilities assumed? Sometimes they do, but the rules don't mention that mistakes aren't supposed to go to goodwill; so that's where they go.

But, won't impairment testing eventually catch the mistakes and chase them out of goodwill? Not usually. If it ever should happen that a mistake pops out as an impairment charge, it's usually years after the mistake has become known to management. The goodwill impairment tests allow companies to aggregate subsidiaries into 'reporting units,' which are usually large enough to allow any mistakes to be offset by goodwill from other acquisitions that have accumulated a successful enough track record over time to protect their own goodwill, plus the goodwill generated by any recent mistakes.

At least the big mistakes will get caught by the Chief Accountant, right? Ironically, I doubt whether the current chief accountant or his predecessor would have the gumption Clarence did to stand up to a registrant and its auditor like that. Unlike Clarence, who spent decades coming up through the ranks of the SEC, these guys spent their distinguished careers chest bumping their fellow Big Four partners. When an erstwhile comrade-in-arms "tromps" into the SEC as his client's Doberman Pincer, will he be welcome with the secret Big Four handshake? But to be fair, today's SEC staff may not have the technical ammunition Clarence did; the FASB's sausage factory has created a new line of business combinations rules; their literal application has come to be the generally accepted method for leveling the M&A playing field…

… as opposed to Clarence Sampson's application of common sense principles:

"And that's the kind of thing that the Commission can say - look that's just too far; you can't look at the written words and try to apply them to a situation where it just doesn't make sense. And as a matter of fact there's some language, and I'll bet you can tell me where it is, which says if it doesn't make sense, you can't do it."

Those "written words" (principles-based rules?) Clarence couldn't specifically recall are still in the cupboard (see Exchange Act Rule 12b-20, and AICPA Ethics Rule 203-1), but they haven't been taken off the shelf in a real long time.

Anyway, I hope you enjoyed Clarence's story as much as I did.

Accounting for Economic Earnings: Inflation-Adjusted Replacement Cost

I am going to cap off the topic of loan accounting, which occupied my last three posts (here, here and here), with a 'proof' and further explanation of my solution to the simple problem I introduced in the first post of the series. I am doing this because some of you have asked me to explain my numbers further. Questions may also still remain regarding how the effects of inflation can be incorporated into a double-entry system of accounts. The answer is, of course, that they can, but there are a few new tricks that some might have not seen before. How exciting… new debits and credits!!

Kidding aside, even this simple example contains some mind-expanding elements for both professionals and advanced students.

For your convenience, this is a repetition of the problem statement:

• On December 31, 20x0, Lender Company invested $10,000 in a bond issued on that date with the same face amount $10,000. To keep things really simple for now (and to defer discussing differences between replacement cost and fair value), there are no transaction costs.
• The terms of the bond provide for two payments: $1,000 on December 31, 20x1, and $11,000 on December 31, 20x2. Both payments were made in full.
• Lender Company had only one other asset on December 31, 20x0: cash in the amount of $1,000. It had incurred no liabilities, and engaged in no transactions, except those related to the bond, through December 31, 20x2.
• As a rudimentary, yet sufficient, substitute for real-world measurements of inflation, we will blissfully imagine that there is only one consumption good in the world: beer. As of December 31, 20x0, a keg of beer cost $100. Immediately after the two payments on the bond, the price per keg rose to $110 and $121, respectively. (It would be perfectly legitimate to remove the dollar signs on the keg prices, and imagine that they are values of the Consumer Price Index.)

No matter, which basis of accounting you choose, the December 31, 20x0 balance sheet for Lender Company, stated in units of purchasing power as of that date will be as follows: 

I will now provide you with the T-account entries to derive the balances that are used to prepare the December 31, 20x1 financial statements, stated in units of purchasing power on that date:

 

Here are the explanations (I abbreviate "units of purchasing power" as "UP"):

And, here are the financial statements at the end of the first year:

Notice that the beginning balance sheet has been restated to reflect units of purchasing power as of 12/31/x1 (i.e., multiplied by 110/100)  even though the date of the balance sheet is one year earlier.

Finally, here are the T-accounts, explanations and financial statements as of the end of the second year:

Notice once again the treatment of the comparative periods:  20x0 has been inflated for two years (i.e., multipled by 121/100), and 20x1 for one year (i.e., multiplied by 121/110). 

To close, I'd like to remind you that reliable reporting of the effects of inflation on an entity can materially affect the financial statements, even when the inflation rate is pretty low. But, unfortunately, comprehensive inflation-adjusted replacement cost got an undeservedly bad rap when it was required by FAS 33 on a disclosure basis only. Among other things, very few accountants and analysts took the time to understand the numbers, because the patchwork implementation of some admittedly sticky issues were overly accomodating to issuers; and as a result, did not result in high-quality information.

I am hoping that inflation-adjusted replacement cost can at least begin a comeback as the FASB seeks to improve loan accounting. One thing they should know: substantial progress is possible even if inflation accounting and replacement cost measurements are not applied to all assets and liabilities. But, loan accounting, especially because interest rates are inextricably linked to expected inflation, would be a very good place to start. The implementation issues are much less problematic than, for example, hedge accounting.