The Accounting Onion

Merrily We Roll Along -- Forward and Up

It took seven years for the FASB and IASB to publish its "preliminary views" exposure draft (ED) on the fundamental issues addressed by the Boards' joint financial statement presentation project. And just recently, the FASB staff has posted a ten-page tabular summary of their "tentative decisions as of December 2009."

My own views, which I have expressed in four previous points (see the list, below) are neither "preliminary" nor "tentative." Granted, I am not bound by due process constraints, but eight years and counting has been far too long to wait for closure on a project that will have absolutely nothing to say about recognition or measurement. As my previous posts will indicate, I have also been extremely frustrated by some of the puff-pastry notions contained in the DP—and that are still on the table in some form or another:

First, there is no investor value created from allowing management to determine how a transaction is classified on the financial statements. Yes, every business is different, but there are still only two principles-based categories of transactions/events in which an enterprise may engage: 'financial' and 'non-financial.'

Even rudimentary delineation of the non-financial category into 'operating' and 'investing' activities has proven futile, and should be abandoned. For example, is the acquisition of inventory an investing or operating activity? Is purchasing one new machine to replace a worn-out machine on the factory floor arrayed with 1000 machines an investing or an operating decision? At best, even the operating/investing dichotomy it is too subjective to be audited, and at bottom, it is a distinction without a substantive difference.

Even allowing that there are some informative ways to further delineate ongoing operating activities, affording management the latitude to make those determinations is a loser before the opening bell is rung. Accounting standards should require a principled separation of financing from non-financing, but that would challenge the sacred cow of interest cost capitalization—so it ain't gonna happen.

Second, no investor value can possibly be created simply by re-arranging the financial statement deck chairs, even in the name of a newly coined "cohesiveness principle." Disaggregation is where it's at, and in that regard there does happen to be a role for that idea; as I am about to explain, however, it appears to not a role envisaged by the Boards.

A Promising New Direction

Having gotten that off my chest, I do very much want this latest missive to be seen in a positive and constructive light. To wit, there is one new piece of information, to be found in the very last item of that ten-page table that knocked my socks off. It's somewhat lengthy, but worth repeating:

"Replace the proposed reconciliation … [of cash flows to comprehensive income] with an analysis of the changes in balances of all significant asset and liability line items. Each line item analysis should distinguish the following components:

a. Changes due to cash inflows and cash outflows

b. Changes resulting from noncash (accrual) transactions that are repetitive and routine in nature (for example, credit sales, wages, material purchases)

c. Changes resulting from noncash transactions or events that are nonroutine or nonrepetitive in nature (for example, acquisition or disposition of a business)

d. Changes resulting from accounting allocations (for example, depreciation)

e. Changes resulting from accounting provisions/reserves (for example, bad debts, obsolete inventory)

f. Changes resulting from remeasurements

Present information about remeasurements in the financial statements.

• FASB: require disaggregation of remeasurements on the face of the statement of comprehensive income (SCI) in a columnar format. Those two columns should be labelled total comprehensive income and remeasurements.

• IASB: require presentation of remeasurements in the notes to financial statements.

Modify the definition of a remeasurement. The working definition of remeasurement is: an amount recognised in comprehensive income that reflects the effects of a change in the carrying amount of an asset or liability to a current price or value (or to an estimate of a current price or value). A current price or value includes the following measurement attributes: fair value, fair value less costs to sell, value in use and net realisable value. [bold italics supplied; dates omitted]"

This is pretty big news, AND IT COULD BE HUGE! However, I'm afraid the devil will be in the implementation details. That's why I'm going to spell it out for the Boards in simple terms: what is actually needed, why it's needed, and how to do it.

The What — The Boards enunciated in their original exposure draft an objective that financial statements should be presented in a manner that "presents a cohesive financial picture of an entity's activities." I'm not exactly sure what they mean by "cohesive" even after looking up that term in a few dictionaries.  Nonetheless, as a metaphor to financial reporting, the term resonates as regards the relationship between financial statement notes and the financial statements themselves. "Cohesiveness" should mean that the financial statements hold together, in a coherent or cohesive manner, the quantitative information in the notes. Stated even more plainly, every balance sheet line item should be "rolled forward", and each line item in the 'flow financial statements' (e.g., income statement, statement of cash flows, statement of changes in shareholders' equity) can be found to be the sum of line items in those balance sheet item roll forwards. That's what I mean by HUGE.

The Why — As I have already stated, disaggregation is where it's at. With XBRL around the corner, analysts will most certainly be competing with each other to create the sexiest non-GAAP measures of financial performance they can by plucking a little tagged something from here, and combining it with a little tagged something from there. If you're a sports fan, you are probably aware of all the new and interesting baseball stats created by imaginative analysts—once they were able to get their hands on the underlying data.

The statistics revolution in financial reporting should make the baseball stats revolution look like—well, what it is—a mere game. To pick just two of hundreds of possibilities an analyst should be able to identify each component of a foreign currency translation adjustment, and decide whether to accept it as presented, or to make one's own pro forma adjustments. Or, if you don't like capitalized interest, an analyst should be able to reverse every stinking dollar of it.

A more subtle, but equally important reason for comprehensive roll forwards is that it will be a huge enhancement to external controls over financial reporting (and along with that, something for an auditor to really audit). Much has been said and written about the importance of internal controls over financial reporting, but a financial regulator's basic responsibility is not merely to mandate internal controls, but to impose substantive external controls. Any control expert should tell you that if you can't roll forward a balance sheet account, you can't hardly test its accuracy. If everyone should be doing their roll forwards internally, and they are quite obviously an efficient form of disclosure, then what is keeping regulators from mandating them? (The sad answer to this question shall be provided anon.)

The How — The extract I have provided from that ten-page table leaves a lot of implementation questions unanswered; and admittedly, it's only a summary of what the Boards may be thinking. The area of greatest concern to the Boards appears to be the level of detail to be provided in the roll forwards.

Once again, that new-fangled "cohesiveness principle" makes the answer to their dilemma straightforward: the Boards need merely to specify that the line-item detail of the roll forwards must be sufficient to allow "roll ups" to each of the lines in the flow statements. For example, if the FASB wants to separately identify "remeasurements" (more on that unfortunate term later) on the statement of comprehensive income, then the remeasurement components in a balance sheet line item roll forward must perforce be set forth.

I am compelled to add as an aside, though, that if the board is struggling to define "remeasurement," they should first acknowledge that the term is already spoken for in another part of GAAP. ASC 830-10-45-1 (within the Foreign Currency Matters topic) identifies remeasurement as a process by which the books of record of an entity are converted to its "functional currency." Contrary to the Boards' proposed new definition, what is currently regarded as remeasurement does not necessarily result in "current prices" or "current values." So, if new terminology is indeed required, which I recognize is likely the case, I would humbly suggest a couple of terms that convey the objective more straightforwardly: like "revaluaton" or "valuation adjustment."

Alas, the "Why Not"

The sad reality is that issuers will balk severely and senselessly at comprehensive roll forwards. And, who knows whether the toes-in-water approach now suggested by the Boards will prevail, or perhaps ultimately drive a wedge between them? I'm betting that the FASB will insist on something at least close to the sensible approach that they have finally put forward.  Meanwhile, the EU will threaten to ditch the IASB unless they get back with the a la carte chicken-salad-for-issuers program they have ordered.

As for yours truly, I don't believe issuers who will claim that balance sheet roll forwards (much less a direct cash flow statement) are a bridge too far – and neither should any reasonably intelligent undergraduate accounting major. If consolidated income statements already articulate to consolidated balance sheets, then why can't the components of those statements articulate? The simple answer is that they should – and they must.

Simple can be beautiful; that's why I like accounting. Comprehensive roll forwards that permit comprehensive roll ups would not solve every single problem that exists in regard to financial statement presentation.  But, by comparison to every other concept or objective offered up by the Boards during the past eight years and counting of this project, everything else is weak tea.
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*Those four posts are as follows:

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

Financial Statement Presentation: The Sequel

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Financial Statement Presentation: Will Issuers or Investors Prevail?

Goodwill Impairment: I Love a Charade

I have written about initial recognition of goodwill on numerous occasions. I suppose it might be less bothersome if goodwill had the good grace to sit and stay like a good dog on the balance sheet at its opening 'value'; but alas, such is not the case. Not even close.

Goodwill impairment tests chew up good money, and as I am about to describe, they screw up the accounting for just about everything else. Even in the best of circumstances (by which I mean that goodwill could actually be something more than a garbage can for overpayments, mis-measurements and measurement exceptions) the goodwill impairment test is a ludicrous charade.

To Illustrate

Let's start with a simple set of made-up facts, albeit loosely based on a real situation as described to me. The teller of the tale attended a business combinations workshop that I had recently led:

Acquiror Company purchased 100% of the outstanding shares of Target, a consulting company for $1,000. None of Target's liabilities were assumed; the only asset eligible for recognition other than goodwill was a customer-related intangible, with a fair value of $400 million and an expected economic life of 8 years. Therefore, goodwill was initially "measured" (the FASB's misleading term, not mine) at $600 million (=$1,000-$400). Why such a high amount for goodwill? Acquiror viewed Target's assembled workforce to be its most valuable asset, which may not be recognized separately under GAAP (or IFRS).

One-year later, negative events associated with the recession significantly diminished Target's prospects. Principally, the value of the previously recognized customer related intangibles declined significantly; however, their remaining expected economic life still has seven years to run. (The remaining expected economic life of the asset is not particularly relevant to my analysis to follow, but there it is, anyway.)

U.S. GAAP requires that the customer-related intangible be tested for impairment before the goodwill is tested. To make a long story mercifully short, one first assigns the current carrying amount to the smallest cash-generating unit (CGU) for which cash flows can be reasonably attributed. Acquiror determines the CGU to be Target itself, and then determines the expected undiscounted cash flows to be just slightly greater than $350 million (which is the carrying amount of the CGU. Thus, no impairment of the customer-related intangible is recognized, even though its value is surely far below the carrying amount.

Now, it's on to the goodwill; and for the FAS 142 cognoscenti among you, we shall stipulate that Target constitutes a "reporting unit." Cutting to the chase again, GAAP requires that the current fair value of Target be compared to its carrying amount. Let's say that the fair value of Target is determined to be $300 million. Since that's less than Target's carrying amount of $950 million (=$350 + $600), Acquiror must launch itself through the gauntlet of the goodwill impairment test, known as "Step 2."

Step 2 requires Acquiror to pretend that it purchased Target today for its fair value, and to figure out what goodwill would be recorded at today, should that impossible fantasy somehow be the reality. So, let's see: assuming a purchase price of $300 million and a fair value for the customer related intangible of $200 million, the "implied fair value of goodwill" (another fabricated and misleading term to add to one's collection) comes to $100 million.

Thus, a "goodwill impairment" of $500 million (=$600 - $100) must be recorded, even though everyone and their brothers and sisters all know that it is the customer-related intangible that is deep underwater. Acquiror's management knows that the customer-related intangible is worth $200 million less than the amount reported on the consolidated financial statements, but investors don't know that. All they see is a writedown to goodwill; which everyone and their brothers and sisters dismiss as merely the result of an arbitrary recalculation of an arbitrary calculation.

So now you know why issuers don't complain too much about goodwill impairment accounting, even though the charade by which it is calculated can be a gigantic pain in the tuchas. It's just one more line of defense for hiding information about real impairments on any kind of long-lived asset other than goodwill that you can imagine. Nothing actually re-measured, only goodwill actually lost.

Is IFRS Any Better?

No. It's worse and with no prospects of improvement anywhere close to being on the horizon. Unless management elects to separately estimate the "recoverable amount" (higher of net fair value and "value in use"), then all of the goodwill and customer-related intangibles carrying amounts are thrown into the CGU bucket. If the CGU's fair value is less than its total carrying amount, then you will always write down goodwill before you touch any of the other long-lived assets.

Although in this case the GAAP and IFRS answer would be identical, the difference is that under GAAP there is at least some chance that non-goodwill assets would be stated at a more realistic value for them. Moreover, the SEC has demonstrated its awareness of the anomaly and willingness to hold a registrant's feet to the fire. For example, here is one case of an SEC comment letter to a company expressing its incredulity that goodwill was written down while miraculously preserving the carrying amounts of its non-goodwill assets:

Taking into consideration the circumstances that caused you to recognize an impairment charge on the Birmingham market goodwill, tell us whether you first tested your long-lived assets … If you did test your long-lived assets for impairment, explain to us in why an impairment charge was not recognized. If you have not tested your long-lived assets for impairment explain to us why not. Please also tell us how you group your long-lived assets for purposes of testing your long-lived assets for impairment …. [Letter from the SEC to Cox Radio, Inc., dated July 17, 2006]

Don't Worry, Be Happy

Small wonder that goodwill and long-lived asset impairment is not on the rush-rush 2011 convergence agenda, or even anytime thereafter. The financial crisis has clearly demonstrated, asset impairment accounting is a sacred cow that may only be approached in circumstances involving extreme unction. Not very long ago, it was hard enough for the FASB to push through any sort of consistent impairment standard for long-lived assets. Now, with the EU already threatening to jump ship on financial instrument impairment, the only choice the Boards have is to pretend that the shortcomings of impairment standards are not a high priority, not to mention the gaping inconsistencies within and between IFRS and GAAP.

I love a charade.

The FASB's Mission Incomprehensible

I had believed that one of the few positives that would come out of the wave of accounting scandals that broke at the beginning of the just-completed decade would be a general awareness of the critical role that financial reporting and its regulation plays in the functioning of large economies. There certainly seems to be more in-depth coverage in business periodicals, but little else. For example, I was appalled at how little coverage my hometown paper, the Arizona Republic gave to the SEC investigation of Phoenix-based Apollo Group's revenue recognition policies.

But, the NYT's Paul Krugman soothed my feelings more than a little in his last column of 2009 (which incidentally was at the top of the Times' 'most emailed' list for about a week:

"For as the decade began, there was an overwhelming sense of economic triumphalism in America's business and political establishments, a belief that we — more than anyone else in the world — knew what we were doing.

Let me quote from a speech that Lawrence Summers, then deputy Treasury secretary (and now the Obama administration's top economist), gave in 1999. 'If you ask why the American financial system succeeds,' he said, 'at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles: it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities.' And he went on to declare that there is 'an ongoing process that really is what makes our capital market work and work as stably as it does.'

So here's what Mr. Summers — and, to be fair, just about everyone in a policy-making position at the time — believed in 1999: America has honest corporate accounting; this lets investors make good decisions, and also forces management to behave responsibly; and the result is a stable, well-functioning financial system.

What percentage of all this turned out to be true? Zero." [my emphasis]

And this assessment comes from a guy who has repeatedly displayed a soft spot for financial regulation. Considering the sheer size of diversity of Krugman's audience, it is a devastating indictment that should make the FASB's ears ring.

It All Begins with a Mission Statement

My dear wife, Jane, had a long and distinguished career as an information systems consultant; and her engagements usually began with an in-depth examination of the client's mission statement. Thusly is writ the first sentence of the FASB's:

"The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information. …"

 

Jane has very patiently explained to me on multiple occasions the purpose of a mission statement, and what it should say about an organization. I have to confess, however, that my mind doesn't work on that level. But, I did absorb enough to know that one's mission should be clearly stated and universally understood.

I have studied accounting intensely for more than thirty years, and I don't understand the FASB's mission statement. The only substantive indication I can glean from it is a clear intent to be unclear, thereby rendering the processes in place for setting accounting standards as muddled as the standards themselves. Aside from just being able to state that one does indeed have a mission statement, its only apparent use to the FASB is as a sort of blank check to throw a bone whenever it wants to whomever it wants.

Of course, methinks it should be quite easy to write a sensible and comprehensible mission statement. I offer this one, which I threw together in about 15 minutes, just to kickoff the rest of this conversation with myself.

The mission of the FASB is to establish and revise standards of financial accounting and reporting that significantly improve the usefulness of financial statement information to current and potential investors. Recognizing that significant improvements are urgently needed in numerous aspects of accounting and financial reporting, the Board is to continually evaluate the pace of change, and whether its short- and long-term goals are appropriate considering the current informational needs of investors.

The Board also gives due consideration to the feedback from non-investor stakeholders – principally auditors, preparers, attorneys and other finance professionals – to the extent that such feedback provides relevant information regarding cost and feasibility of a proposed change to standards. However, the evaluation of a proposed standard's effect on relevance and reliability, is to be made independent of feedback from non-investor stakeholders.

Now, that's a mission statement I hope Jane would be proud to read. It's a clear a set of marching orders that identifies the organization's 'customers', what to produce, and how to produce it.

Convergence: Mission Impossible

Convergence with IFRS could be the clearest and most timely example of how a true mission statement would direct the FASB goals and processes; there should be general agreement that standards production efforts over the past decade have been focused on attaining convergence with International Financial Reporting Standards. Yet, convergence is neither a necessary nor a sufficient condition for producing significant improvements to the quality of accounting and financial reporting.  As such, according to my own view of what the FASB's mission should be, it is a non-core activity. Indeed, a decade's worth of "zero," as Paul Krugman would have it, must perforce lead one to conclude that convergence has been a prime sourcesof standards production inefficiencies.

I could cite any number of examples of counterproductive behavior resulting from convergence fixation, not the least of which would be the current idiotic "debate" over fair value for financial instruments. But I cannot possibly do any better than Dennis Beresford, erstwhile FASB chair, in a recent posting to the AECM listserv (frequented by about 700 academics and other interesting people):

"But what I find most interesting about the recent decision for the Boards to start meeting every month and to complete the converge plan by 2011 is that these are projects that have begged for a solution for decades in some cases and now they will supposedly be finished in two years. The consolidation project, for example, was added to the FASB's agenda in 1982 and the Board has never been able to operationalize a definition of 'control.' But somehow the joint efforts of FASB and IASB will now solve that issue in 24 months, including all of the normal due process.

 

And the IASB has just issued an exposure draft on financial instruments impairment and other issues. One 'feature' of that ED is that loan losses will be accounted for using an expected loss model rather than the incurred loss model we have in SFAS 5. This means that companies will have to predict future losses over the lives of loans and not just record what has already happened. Some of the old timers on this list may recall that one of the main reasons the FASB issued SFAS 5 was to eliminate the practice of accruing "catastrophe losses" in advance. In other words, casualty insurance companies that previously priced policies and accrued for a portion of expected future losses for floods, hurricanes, etc. could no longer do so. The new IASB exposure draft deals with with [sic] loan collections and not casualty losses but the principle is the same and applying it would move us back to the pre-SFAS 5 accounting. Is that progress? More importantly, is that something that is capable of being accomplished before the end of 2011?" [italics supplied by me]

Here we have yet another devastating indictment of the process that has dominated standard setting for the past decade. Some convergence has been achieved, but far short of a reasonable goal, even if one were to believe that convergence, in and of itself, were a valid goal to embrace. Just one implication of Denny's comments is that the legacy of the FASB's fixation on convergence could be the entire world ending up with German-style hidden reserves all over again. (I can't resist pointing out that I am writing this while on a plane heading to Frankfurt!)

Convergence has been the tail wagging the dog of high quality accounting standards. The FASB could be much better by starting 2010 with a reconsideration of its mission statement, instead of a head-over-heels run to a finish line – precisely situated at the edge of a cliff.