The Accounting Onion

Securitization Accounting and Grand Theft Auto

Many books and articles have been written to describe the mishaps that led to the Great Recession of 2008, but few have done so while putting the role of accounting standards and auditing in context. I reported back in January 2010 that Paul Krugman at least was cognizant enough of accounting to acknowledge that we do not presently have honest financial reporting standards that let investors make good decisions and that "… forces management to behave responsibly." But, other than changing the name on the sausage packaging from GAAP to IFRS, detailed suggestions for achieving fundamental change have been exceeding rare.

NC State accounting professor Paul Williams also drew inspiration from Krugman's column and the financial crisis for a brief paper entitled The Wrong Metaphor, which I recently heard him present to the Public Interest Section of the American Accounting Association. Much as I have (but certainly with some important differences that you should read for yourself), Williams has come to the conclusion that a paradigm shift is needed for accounting to re-assume its proper role in society. I wish we could have much more from Williams reagrding what he thinks should be changed and how to make change happen.

A recent paper by S.P. Kothari and Rebecca Lester of MIT, The Role of Accounting in the Financial Crisis: Lessons for the Future, is very strong in its description of flawed accounting and its potential role in the past crisis. These are some of the basic messages:

• The accounting rules provided originators of subprime mortgages (SFAS 140) the opportunity to record economically specious gains on securitization transactions.
• The accounting rules also permitted regulated financial institutions that invested in financial instruments created out of subprime mortgages (MBOs and CDOs) to delay recognition of likely losses; which, in turn, distorted measures of capital adequacy.
• Estimation errors, most significantly estimates of fair value, committed by issuers of financial statements and their auditors exacerbated the accounting misstatements inherent in the accounting rules.

Although, like Williams, the Kothari/Lester did not provide much in the way of "lessons for the future," I would still highly recommend it. Accounting students could, and should, read it if only for its lucid examples and explanations of the arcane and flawed accounting rules that are applicable to securitizations.

The purpose of this post is to distill the analysis of Kothari/Lester so as to further discuss "lessons for the future." Before I do that, however, I want to tell you about an email correspondence I had with S.P. Kothari after I read their paper. Since I was preparing my own remarks for academics on the topic of IFRS adoption and the future of U.S. accounting, I asked him whether he thought it more or less likely that promulgation of more appropriate fair value or securitization standards would occur if the SEC continues to pursue convergence with IFRS. This was the response:

"…I think convergence will harm promulgation of more appropriate standards because a converged standard setting body would become a monopoly that would be pulled in all different directions by its constituencies."

Clearly, whatever the "lessons for the future" may be, adoption of IFRS is not one that he had in mind.

 

Securitization Accounting as Grand Theft Auto (not the video game)?

The process of securitization reminds me of large-scale car theft ring.* To obscure the link to the illegal 'acquisition' of cars, much like subprime mortgage loans, the cars are almost immediately chopped up into parts and re-sold. As a business model, stealing cars works only because the cost of obtaining a car is low; but let's ignore that for the moment and assume that someone actually establishes a legit buy/chop auto parts business – in other words, cars are bought for full price and chopped up for the sale of parts. Here is a representative sent of journal entries:

Day One – buy a car:

Dr. Car (at cost)                               30,000
      Cr. Cash                                                   30,000

Days Subsequent – chop up the car and sell its parts:

Dr. Cash (from sale of parts)            25,000
Dr. Engine (at estimated fair value)   7,000
     Cr. Gain on sale of parts                            2,000
     Cr. Car**                                                    30,000

I readily acknowledge that second entry does not comport with current GAAP.  I am using to illustrate securitization accounting in the context of a highly simplified example.  Having stated that, however, I don't see any reason (although others might) that the accounting for a chopped car should be different than the accounting for a chopped subprime mortgage.  I can't abide mixed-attribute accounting systems, and believe that college-educated professionals should not be adding apples and oranges, much less elevating the error with misleading names like "statement of financial position."

If you can set aside any cavils you might have with respect to my violation of current GAAP, please answer this question for me:  Would you invest in a business whose financial statements were based on journal entries like these? They sure do look legitimate, but common economic sense would dictate that the second journal entry must overstate the real profit on the resale transactions. First, as Kothari and Lester observe in the securitization context, "how is it possible that the sale of an asset originally recorded at one value could generate income and higher asset balances upon merely transferring this asset to another entity?" I suppose one could say that butchering a chicken should add value such that the sum of the parts is greater than the whole chicken. But that's because there's only one way to one way to obtain chicken parts – first, you gotta grow a chicken. However, one doesn't have to manufacture a car just to obtain a spark plug; or to originate a subprime mortgage loan just to create contracts containing a particular pattern of future cash flows.

The second reason indicating that the second journal entry is misleading is that the flawed business model would not be able to earn an economic profit over a full cash-out-cash-in cycle (i.e., buy car Þ chop Þ sell Þ reimburse for defects under warranty). If the engine could actually be sold for $7,000 (and generating an overall profit of at least $2,000), then I'll be a monkey's uncle!

The Lessons for the Future

In order to determine whether a better accounting is feasible, we need to be able to identify the sources of overstated income. With respect to both the car parts example and securitizations, overstated income could be the result of any of the following:

1. Kothari/Lester do not refer to this explicitly, but the most subtle and important aspect of the problem, in my view, is the unavoidable change in the 'unit of account' from the original asset (e.g., car, subprime loan) to the retained portions (e.g., engine; or in the case of securitizations, a servicing asset, and the right to residual cash flows). For example, erroneous accounting will occur because the values of the components of the car will not exactly sum to the pre-chopped value of the car itself; it doesn't matter how one chooses to measure value.
2. The appropriateness of the basis of measurement for the retained assets: such as historic cost, fair value or replacement cost.
3. Given a basis of measurement, biased measurement of the assets retained (which auditors fail to correct). Kothari/Lester surmise that this is the most significant source of overstated income.
4. Unrecognized or understated liabilities (e.g., a warranty obligation on the car parts, or a written put option for underperforming loans).

As to mitigating these sources, I have provided my two cents on #3, the biased estimate problem in a number of posts, the latest of which is here. Regulators have tried over and over again to make incremental improvements to auditing standards, with no perceived help in increasing the public's confidence that auditors can play a significant role in averting a large-scale financial crisis. It is time to abandon any notion that: management can provide unbiased estimates of value; and/or that auditors are intellectually capable or even inclined to provide a independent and knowledgeable assessments of management's estimates.

Therefore, when financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – i.e., neither management, nor the auditor. The auditor's role should be limited to:

• Verification of the components of financial statements that can be verified.
• Verification of the inputs to current valuations that can be objectively measured, and hence, verified.
• Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

As to #2, above, the conventional wisdom is that historic cost accounting is fact-based, objective, understandable, and even verifiable. We have learned the hard way that this is a fiction; however historic cost accounting has been practiced. To get to a point where financial reporting can be freed from perverse incentives for management to produce biased estimates, standard setters must dedicate themselves to the establishment of accounting standards that yield financial statements capable of being audited and understood by auditors, investors, credit rating agencies and the like. Securitization/loan accounting standards clearly indicate that historic cost "principles" when applied to financial instruments create nothing but a big mess.

Saving the worst for last, the unit of account issue (#1, above) may defy a principles-based solution, but I still want to take a stab at it. Referring to the sample journal entries, the higher the values assigned to the assets retained, the higher will be the reported gain. This suggests, once again, replacement cost is the most appropriate basis of accounting, for it would require measurement based on the least costly way to replace the asset subject to being measured. For the car example, the business model indicates that the most economical way for the entity to acquire an engine would be to buy a car, chop it up, and sell all of its parts except for the engine. Thus, the marginal cost of an engine might be essentially zero – and the result would essentially eliminate the gain recognized in the second journal entry. Indeed, the loss recognized in the second journal entry by this logic would be the telltale sign of a flawed business model.

The same logic used to measure the replacement cost of the engine could easily apply to securitization assets such as servicing rights and residual interests, and leads to an analogous question: Did the subprime loan origination/securitization business model only work, or appear to work, because of favorable accounting treatment? These are questions worthy of further research, but if the accounting for securitizations had been more reasonable, we would already have reasonable answers.

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*Kothar/Lester address both the accounting for securitizations by the originators of subprime loans and the subsequent accounting by investors in the financial instruments created by securitization. I am only looking at the former in this post.

**I am assuming that costs of chopping the car are negligible or are expensed in a journal entry not displayed. Capitalization of these destruction costs would affect the form of the journal entries, but it would not affect my conclusions.

Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False (Part Three of Three)

Click here for Part One of this Three-Part Series.

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False Claim # 6:    Costs of conversion to IFRS can be spread out over a long transition period.

All I can do here is to point out the obvious: merely spreading out the costs doesn't lessen them, nor lessen opportunity costs. What cost spreading does, however, is unduly prolong the time until financial reporting will reach a stable environment. If proponents of IFRS adoption are still playing that misleading comparability card as a primary benefit of IFRS adoption, then they should also explain why prolonging the transition, and the resulting lack of comparability, benefits investors.

Especially in light of the feedback the SEC has already received and the current economic climate, what is the benefit for a small public company of incurring the transition costs to IFRS? These companies could care less about how they stack up against the financial statements of a foreign company, and neither could their banker or venture capitalist.

We know from the European and Canadian experiences that transition costs were not trivial – to say the least – and it put a lot of shareholders' money into the pockets of auditors. If any member of Congress that voted for the Jumpstart our Business Startups (JOBS) Act believes that companies with $1 billion in sales or less have been unduly burdened in their capital raising by SEC rules, then they should act now to prohibit the SEC and FASB from changing accounting standards primarily for the sake of convergence with IFRS.

 

False Claim #7:    The U.S. will not experience any loss of sovereignty over its ability to set accounting standards.

There could be mechanisms to assure that the U.S. will always be heard, but the absolute very best the U.S. can expect is to have a significant influence over IASB decision making. That's a far cry from sovereignty; and frankly, any efforts to minimize this issue are disingenuous.

Added to the fact that the EU will continue to do its level best to control all aspects of the IASB, there are other formidable forces that may be working to mitigate the U.S. voice in IFRS. Let's take one case that has recently been in the news – India. From reading an interview with India's Chairman of its National Advisory Committee on Accounting Standards, the mindset of India's accounting establishment reminds me more of the reserve-oriented income statement smoothing approach developed by the Germans. The interview mentions four (of a total of 65) major carve-outs from IFRS; but one in particular, on deferral of gains and losses on foreign currency-denominated debt, best reflects the great divide that still exists after years of negotiations with the IASB. Indian issuers, who rely on foreign debt more heavily than their U.S. or European counterparts, are unwilling to tolerate the income statement volatility of FX gains and losses on that debt. Hence, an exception to IFRS in India permits an issuer to spread any foreign exchange gain or loss over the life of the loan.

This is just one of many examples of an irreconcilable difference in financial reporting mindsets. It is inconceivable that such differences can be bridged by a single set of global accounting standards. It's just not realistic to expect that the U.S. will be the winner in every case when there is a difference in mindset, regulatory, political or legal circumstance; or not even in the majority of cases.

Indeed, history suggests that the U.S. will lose most of these battles. The numerous failed convergence projects alone attest to how many battles the U.S. stands to lose if it incorporates IFRS into U.S. GAAP. None of these issues – R&D, inventories, pensions, borrowing costs, business combinations, impairment of long-lived assets, financial instruments, hedge accounting, to name the ones that quickly come to mind – are trivial. For, if any of these, or any of the other differences between U.S. GAAP and IFRS were small differences, surely they would have been converged by now.

It is not unreasonable to expect, even, that a country like India might form a coalition with other countries against the U.S. Here's just one scenario: India makes a deal with the EU, and together they push a new standard that permits the deferral of unhedged foreign exchange gains and losses on foreign currency denominated debt. How will condorsement work? Will we carve out that particular deferral option? If so, the goal of comparability would be irretrievably lost.

I should add that what we are seeing now in the United Nations is not all that different from my hypothetical. It seems that numerous smaller nations have learned to use the United Nations to advance agendas that are making citizens of wealthier nations question their own willingness to continue belonging to and funding these efforts. Thus far we do not have a similar problem arising with the uniting of smaller nations to dominate standard setting in the IASB. However, once the U.S., Japan, India, and China become committed to IFRS, smaller nations could begin to rise up in the IASB. Their incentives would come from the fact that international accounting standards are not necessarily neutral when it comes to global capital flows and economic development.

 

False Claim #8: Bad things will happen to the rest of the world if the U.S. does not adopt IFRS

Harvey Goldschmid speculates that, without IFRS adoption, the so-called coalition of IFRS members would break apart. However, history strongly suggests otherwise. As I have already mentioned, much of IASB's growth was driven by the desire to insulate Europe and other jurisdictions with less developed standards, like China, from the influence of U.S. GAAP. So, maybe the only thing that could possibly break up the IASB would be for the U.S. to join it.

The IASB was created in 1973. It was reconstituted in 2001. In all those years, it has not been the sole creator of accounting standards. Yet it has grown and done well. Without the U.S. in the coalition, the IASB will continue to have the degrees of freedom events have shown that it needs to do what it takes to bring everyone currently in the coalition even closer together. That will mean giving the EU the financial instruments and hedge accounting standards it wants, giving India the foreign exchange standards it wants, and giving China the watered down related party disclosure standards that it wants – and so on and so forth, and all in the form of free choices that are in opposition to the goal of comparability and the mindset of U.S. GAAP. None of that would be possible if the U.S were to adopt IFRS.

I find it difficult to imagine that the U.S. could ultimately justify subsequent endorsement of the IASB's standards from the numerous failed convergence projects without significant modification – and what if the EU likes those standards just the way they are now? Just recently, for example, the Financial Times reported that there was a "real risk" that the European Commission would reject the IASB's new consolidation and joint venture accounting rules, developed jointly with the FASB, and which were due to become effective for 2013. Indeed, it is entirely possible that, as the EU has threatened before, they could cut their support for the IASB, establish aggressive new carve-outs, or even promulgate its own standards.

 

False Claim # 9: Bad things will happen in the U.S. if the U.S. does not adopt IFRS

Mr. Goldschmid also predicts that if the coalition does not break apart, it will leave the U.S. to fend for itself when it comes to accounting standards. According to Mr. Goldschmid, this is would be the worst of all possible worlds.

Again, history would suggest otherwise; and moreover, if it did occur, many believe that it would be a good thing, not a bad thing. As the AAA's Financial Accounting Standards Committee concluded, standards competition is desirable, and monopolies can have dire consequences. I find it extremely ironic that individuals and organizations such as the AICPA that normally speak out for free markets for goods and services somehow think that granting a monopoly on accounting standards is preferable to accounting standards produced in a competitive environment. Even if, and this is certainly not true at present, IFRS could be regarded as higher quality at some point, granting IFRS a monopoly would risk stagnancy – and in place of innovation toward higher quality accounting standards, we could be racing to the bottom. It is a great understatement to say that there is still plenty of room for improvement in both IFRS and U.S. GAAP, and a monopoly would virtually assure that not enough of that improvement would happen.

And, perhaps the monopoly effect explains the many failures to progress on convergence in the past ten years. If one were to accept that execution of the convergence projects and the results of that work to-date are the most important factors for the SEC to consider when deciding the future status of IFRS in the U.S., one would have no choice but to conclude that continuation by whatever means – condorsement or anything else – will be a monumental waste of time. That should also make it apparent that the FASB's time would have been much better spent on efforts to improve the quality of U.S. GAAP, instead of on convergence with IFRS.

It's hard not to be amazed at how much time has been devoted since 2002 to debating accounting issues and to see how so little of the convergence objectives have actually been accomplished.

Going back just two years to the time of the SEC's February 24, 2010 Statement on IFRS, the FASB and IASB had nearly a dozen joint projects planned for completion by both boards by mid-2011. The Commission was hopeful that at least some of those projects would be completed by now; but even IFRS adoption skeptics (like me!) could not have imagined that we would actually be further from convergence today than we were back in February 2010. Progress has been made toward partial convergence of some trivial matters – like the way that the components of dirty surplus (so-called "other comprehensive income") are presented, and the IASB has finally agreed to adopt the FASB's fair value measurement standards for the few items that are measured at fair value. But, almost everything else seems to be heading in reverse.

The US could lose its seat at the IFRS table, as Harvey Goldschmid warns, but this doesn't mean it will lose its voice. Even before convergence projects began, it was obvious that IFRS owed its form, and a great deal of its substance, to U.S. GAAP. It is very clear that IFRS wouldn't be what it is today without U.S. GAAP to serve at least as a point of reference, and whatever U.S. accounting standards will become in the future, they will always make the rest of the world at least stop and think – if not do.

 

False Claim #10: All nations have the same goals for financial statements.

I suppose that one could take the position that although there may be differences in objectives for financial statements, they are not enough to abandon efforts to establish a single set of accounting standards suitable for use by companies worldwide. Yet, who could in all seriousness state that the financial reporting objectives of the SEC and Chinese regulators are anywhere near the same?

Even more significant at the present time, the history of the EU's efforts to monitor and steer the IASB clearly indicate its regulators believe that a legitimate role for accounting standards is to support the agendas of politicians and key industrial powers. It is undeniable that when it comes to bank accounting, EU regulators clearly see nothing wrong with investor protection taking a back seat. I know the Greek bond problem remains extremely serious, but I have to admit that it amused me last fall to see heads of state Angela Merkel and Nicolas Sarkozy arguing on television, for all to see, over an accounting issue: the size of the balance sheet haircut that banks should take on their Greek bonds. Surely, their constituencies must have been asking themselves, 'what are they talking about'?

If IFRS were high quality, as Messrs. Hoogervorst and Goldschmid claim, then politicians wouldn't have to get involved in accounting debates, and could instead turn their attention to the real problems. The EU could continue to muddle along using the same approach to financial problem solving long after the Greek bond crisis is behind it. But, that doesn't mean the SEC has to muddle along with them. By adopting IFRS, the SEC will essentially be telling U.S. investors that it is willing to tolerate insurmountable barriers – such as the EU's obdurateness – to high-quality, investor-purposed accounting standards.

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So, here today we sit with the awareness that IFRS adoption is still laden with many problems and issues. There is seemingly overwhelming opposition to IFRS adoption, but many fear that the decision to proceed with some form of condorsement is soon at hand.

I would like to thank the following people who have provided comments on drafts of my speeches, and on which this series of posts is based: former SEC Chief Accountants Walter Schuetze and Lynn Turner; Gaylen Hansen; my colleagues, Jim Noel and Ray Stephens; and Bob Jensen, retired professor and current lifeblood of the AECM listserv.

I can only speak for myself, but I am confident that everyone whom I have just named all agree with me on this: for the sake of investor protection and the public interest, the SEC should have long ago made a U-turn on its Roadmap to IFRS adoption.

Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False (Part Two of Three)

Click here for Part One of this Three-Part Series.

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False Claim #2: A move to IFRS would restore the public trust in accounting standards.

I'm going to present three examples – one from 2007 and two from 2011 – that directly challenge this claim.

The 2007 case is one of my pet peeves. It has to do with the revisions to IAS 23, Borrowing Costs, ostensibly to further convergence of US GAAP and IFRS. I say "ostensibly" because there are still significant differences between IFRS and its U.S. GAAP counterpart. The bottom line is that IFRS rules still give management more latitude to manage earnings than the corresponding U.S. guidance.

Be that as it may, I'm am very confident that if you were trained in accounting or finance, one of the basic principles you were taught is that asset acquisition decisions are separate from the decision of how to finance them. And, prior to the 2007 revisions to IAS 23, that was the IASB's principled position as well.

Under IAS 23, prior to the 2007 amendments, two accounting treatments were permitted for self-constructed assets: the treatment designated as the "benchmark" treatment was to expense borrowing costs; but the "allowed alternative" permitted rules-based capitalization: a senseless alternative, unless one values opportunities to manipulate earnings.

Incredibly, the IASB in 2007, the supposed principles-based system of accounting, blithely rejected the sound and long-ago-established principles it had embraced earlier, by requiring the capitalization of interest on self-constructed assets. In other words, it threw out the principles-based benchmark and now permits only the management-friendly erstwhile allowed alternative. There can be no basis, other than politics, for this change, but that did not seem to bother all but two of the IASB's members. This is what was stated in the basis for conclusions of the revised standard:

1. Eliminating a difference between IFRS and GAAP is always progress. (In other words, two wrongs can make a right.)
2. Allowing only one method will enhance comparability. (This is not true, because companies with different financing policies will generate non-comparable results from business operations. It is more accurate to state the irony that the IASB's rules-based standard actually defeats comparability since initial asset values and subsequent depreciation charges will depend on the timing and type of financing employed.)
3. It will improve financial reporting (for reasons unstated).
4. This reason is so ludicrous and outrageous that I have to quote it verbatim:

   "The Board further noted that both IAS 23 and SFAS 34 Capitalization of Interest Cost were developed some years ago. Consequently, neither set of specific provisions may be regarded as being of a clearly higher quality than the other. [Nonsensical] Therefore, the Board concluded that it should not spend time and resources considering aspects of IAS 23 beyond the choice between capitalisation and immediate recognition as an expense." [bold italics supplied]

I chose this example because it demonstrates that the IASB cannot be trusted to adhere to its own due process policies, or to provide a legitimate basis for conclusions. Yes, the FASB is also susceptible to pressure, but the way that the IASB went about revision to IAS 23 was untrustworthy and made a mockery of its own "due process" policies.

There can be little question that big-issuer interests drove the revisions to IAS 23; both investors and smaller issuers were cast aside without so much as a nod to the real reasons for the adoption of a rules-based accounting standard. Any issuers that formerly elected the benchmark treatment were forced to change their accounting to a lower quality and costlier-to-implement alternative. The unavoidable conclusion is that the IASB caused significant wealth destruction, and it continues today under the guise of "convergence" of accounting for borrowing costs, even though it has no hope of enhancing comparability.

The second example is the IASB's revisions to its pension accounting standards, which incidentally were not undertaken as part of any convergence project – and I shudder to think that the FASB might actually be called upon to incorporate these changes into U.S. GAAP. I wrote a rather lengthy description of the revisions to IAS 19, Employee Benefits, in my blog this past October, and the bottom line is the same as for the first example: the revisions foster more income smoothing and earnings management; they indicate that the IASB cannot be trusted to tell the truth or to put investors' priorities first. Again, and just a few months ago, to accommodate special interests, the IASB shows its willingness to promulgate accounting standards that surely result in shareholder value destruction.

My third example is the secret letter sent by Mr. Hoogervorst to the European Securities and Markets Authority this past August, in which he expressed concern at the inappropriately high valuations produced by specific EU banks on their holdings of Greek sovereign bonds classified as 'available for sale.' Setting aside the accounting implications of that letter, and there are many, the subsequent revelation that the letter was kept secret – until the IASB was forced to make it public once news of its existence was leaked to the Financial Times – raises trust issues that can be directly traced to the current head of the IASB.

Hans Hoogervorst, as a former regulator, surely knew that sunlight would have been the best disinfectant, yet he chose secrecy. The numbers in financial statements are cyphers, and pronouncements of accounting standards are the principal means by which they are de-encrypted. If one is not concerned that investors fully understand the basis under which the financial statements were prepared, then one might have no qualms about withholding part of the de-encryption key. Evidently, the IASB wanted to be certain that European regulators fully understood the financial statements, and for the regulators to have that knowledge without letting investors in on the secret. It leaves a strong impression, to say the least, that EU regulators are currently the IASB's primary constituency.

False Claim #3:    U.S. GAAP is not superior to IFRS

Mr. Hoogervorst stated that quality of the actual accounting standards should be the most important consideration for the SEC as it formulates its IFRS policies, but he is "not convinced by the arguments that one set of standards is clearly superior to the other."

Moreover, he stated that "academic studies have concluded that both IFRSs and US GAAP are high quality standards." A vaguely-worded footnote to that statement reads as follows:

American Accounting Association Financial Accounting Standards Committee, 2008 ‐ Karim Jamal

That footnote leads me to believe that Mr. Hoogervorst was referring to a paper published in Accounting Horizons [Vol. 22, No. 2, 2008, pp. 241-248] by the AAA's Financial Accounting Standards Committee.

Let's take a closer look at that paper. That committee did indeed cite evidence from academic research that IFRS and U.S. GAAP were substantially similar; but, crucially, it added that it had no basis to state that either set of standards were "high quality." Furthermore, that same committee stated in a subsequent comment letter to the SEC that high quality depends on a number of factors that are specific to each environment: legal systems, securities enforcement, taxation and incentives of preparers, for example.

Taken as a whole, the paper from which Mr. Hoogervorst took one supportive nugget out of context clearly would not provide academic support for IFRS adoption in the U.S. Rather, I took the committee's remarks as an endorsement of a standard setting system that supported where standard setters were in competition with each other. And indeed, in the comment letter I mentioned, the Committee stated:

[A]cademic research indicates that using a single set of uniform accounting standards will not lead to the production of comparable and consistent financial reports that are desirable to regulators [citation omitted]. The promise that adoption of IFRS will deliver comparability and consistency in accounting reports is false and misleading. [bolding and italics supplied]

There are two more quick points I want to make about what academic research has to say about the relative merits of IFRS versus GAAP. In the same issue of Accounting Horizons, another AAA committee of academics, the Financial Accounting and Reporting Section of the Financial Reporting Policy Committee, took the opposite position on the relative attributes of the IFRS versus U.S. GAAP: empirical evidence suggested that analysts actually preferred working with GAAP financial statements instead of IFRS. Consequently, the elimination of the SEC requirement to provide reconciliations of differences between IFRS and U.S. GAAP was premature.

But, whatever these papers stated at the time they were published, time has elapsed, and both IFRS and GAAP have changed. Has IFRS been improved? The SEC needs to acknowledge that IFRS has taken a number of steps in the wrong direction: to name just a few, there are the borrowing costs and pension accounting issues that I already mentioned; there is also the free choice in accounting for non-controlling interests, and most recently, there is the proposed hedge accounting revisions that would broaden and liberalize the application of hedge accounting. I wonder if a single investor has called for any of these changes that will permit preparers to further manipulate earnings?

False Claim #4: IFRS is already widely adopted elsewhere

The IASB has been successful in achieving various degrees of acceptance of IFRS in many jurisdictions, and notwithstanding one significant carve-out, the EU should be regarded as the IASB's greatest success. But, if proponents of IFRS adoption are claiming that the U.S. should be following the EU to IFRS, the reasons why the EU adopted IFRS must be examined – for they are as different from legitimate regulatory goals for the U.S. as north is from south.

The impetus for IFRS adoption in the EU has its roots in events that were triggered by the NYSE listing of Daimler-Benz in 1993. At that time, German GAAP was known for the availability of so-called "hidden reserves," which permitted a high degree of non-transparent income smoothing. The SEC was under significant pressure to waive the reconciliation to GAAP requirement, but the SEC held firm; and the financial results reported by Daimler backed them up. For its latest reporting period disclosed in its initial registration statement, Daimler showed a small profit under German GAAP, but a significant loss under US GAAP. The difference was due to Daimler releasing reserves that were accrued in prior periods under German GAAP.

For similar reasons, the Daimler-Benz listing incited a debate in Germany about whether its own accounting standards were adequate. In 1998, German law was changed to allow listed companies a choice between German GAAP, IFRS or US GAAP. The end result was that many companies switched away from German GAAP, and about half of those switchers picked US GAAP.

Just as today, where the EU fears that the US could end up with too much influence on the IASB, the US GAAP switchers seem to have caused great concern throughout Europe; both governments and large banks feared the loss of their power to establish accounting standards, and especially feared inflexible standards that were rigorously interpreted and zealously enforced by the SEC. Stated bluntly, there was great concern that US GAAP could take over Europe; so, in 2002, the European Commission acted swiftly and decisively to mandate IFRS for all listed companies in the EU.

My point is that the SEC is now being urged to give up its prerogative to set accounting standards for U.S. issuers – not for the greater good as is generally thought, but solely because members of the EU feared their own loss of sovereignty. Without adoption of IFRS by the EU, we wouldn't be discussing whether the US should be adopting IFRS in any manner, shape or form; and anybody who doesn't think that the EU won't push back hard if it finds that the U.S. is limiting the EU's ability to influence, if not control, the IASB is kidding herself.

If the shoe were on the other foot – in other words, if the U.S. were part of the IFRS coalition along with the rest of the world – would the EU be inclined to join the coalition if it couldn't control the outcomes? Of course not.

False Claim #5: Even though IFRS may not be consistently applied elsewhere, the SEC can enforce compliance with IFRS as it sees fit.

It's hard to imagine that SEC enforcement of IFRS can take place without SEC-quality enforcement in the EU at a minimum. More likely, one of two scenarios will come to pass: SEC enforcement will raise the quality of IFRS worldwide, or the SEC will be pressured to join in a race to the bottom. I fear, and would expect, the race to the bottom scenario.

Here's an example of how the race to the bottom could take place: a questionable interpretation of IFRS is the basis of a loan loss allowance methodology adopted by, say, a French bank; and that treatment is approved by its French auditors and regulators. The race to the bottom begins when SEC registrants facing similar facts and circumstances argue to the SEC that if they were forced to comply with the SEC's stricter interpretation of IFRS, then they would be placed at an economic disadvantage – it could create competitive pressures, or perhaps affect compliance with banking regulations.

Consequently, even though the SEC may find no merit in the registrant's position, it might have to yield to pressure from registrants and sacrifice investor protections. The pressure could also come from an outside source: Congress, lobbyists for special interest groups, other foreign governments, and maybe even the United Nations. Even if the SEC manages to keep the high ground, the scenario is not pleasant to contemplate, and arises from the fundamental problem of a single set of global accounting standards: the present and likely future reality is that one size doesn't fit all. The relatively low degree of detail in IFRS also creates opportunities for this type of race to the bottom scenario to occur, and the higher detail present in U.S. GAAP may explain why it rarely occurs in the U.S.

I think there is also a technical problem that has not yet been the subject of much discussion and could easily start that race to the bottom rolling. If the SEC were to implement the so-called 'condorsement' approach, U.S. GAAP would continue to survive with IFRS rules incorporated into it. Ignoring whether such an approach is actually practicable or even feasible, U.S. GAAP provides that when an authoritative source does not specify an accounting treatment, an issuer would eventually be allowed to adopt a "practice that is widely recognized and prevalent either generally or in the industry." U.S. registrants could validly claim that they are permitted to adopt industry practices that developed globally among any critical mass of IFRS issuers, and not just in the U.S.

 CLICK HERE FOR PART THREE OF THIS ESSAY.

Stock Compensation, Tax Law, Financial Reporting and Facebook's IPO

Last August, I wrote a post in which I expressed my dismay that Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio) are trying to make tax law based on the premise that FASB rules for stock options are caviar -- when the stark reality is that they are chopped liver (or worse). The senators are oblivious to the fact that the evils they decry lie in the financial reporting rules (hewn from decades of political wrangling, grandstanding and backroom dealing), and not the income tax rules; and worse, their proposal to reduce the deductions available to corporations while keeping the same taxable income for the individual who would exercise options has no precedent in tax policy, logic or fairness.

This current post is in response to Senator Levin's recent speech on the Senate floor in which he pressed the same dubious points. But, the really interesting part are the circumstances he relates regarding Facebook's upcoming initial public offering of its shares:

"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.

Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see Footnote.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …

Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades." [italics supplied]

To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.

When the Levin and Sherrod approach to taxation is compared to other forms of compensation to executives, rank and file employees, vendors and lenders, it makes no sense whatsoever. If the senators want to make stock options more costly to corporations than other forms of compensation, then so be it – but they should just come out and say so, and explain why it's a good idea.

But, most of what I have just written reprises my earlier post (and if you want even more background on the depressing politicis of the accounting question, see Jon Weil's article, here.) I'm covering this topic anew because Levin's Facebook IPO story raises some other interesting questions with implications for financial reporting.

My first question is this: If U.S. GAAP for stock compensation expense were based on the value realized upon exercise, just like the tax rules, how would that have affected Facebook's financial statements?

The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.

Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?

My inclination is to say "no," but I can only speculate. So, I all answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?

If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.

Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.

But, methinks that Facebook would still be Facebook.

* * * * * *

Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.

 

 

An Accounting Parable for Our Time

As told to me by a faculty member at Ohio State, who heard it in a presentation by Eugene Flegm, former general auditor for General Motors:

Some years after the end of World War II, GM was negotiating a new contract with the United Auto Workers. The labor union proposed that GM should pay an additional amount per hour to its unionized employees, which the UAW would take and invest in a pension fund. Pension payments to retirees would eventually become the full responsibility of the UAW.

The CEO of GM consulted with his economist, who advised that the proposal was a good deal for GM: the expected cost of funding the pensions would remain the same, but the risk of funding unanticipated losses would be borne entirely by the union.

The CEO next consulted with his accountant, who informed him that current profits would suffer if the union's offer were accepted: the additional wages called for would be reflected in expense immediately. On the other hand, if GM were to keep the responsibility (and risk) of paying the pensions, recognition of the associated expense under extant GAAP would be delayed for decades – until retirees were actually paid.

The CEO chose to disregard the economist's advice and to decline the UAW's offer.

Postscript: Following similar decisions of subsequent CEOs and questionable funding decisions, GM's underfunded liability for retirement benefits grew to $50 billion as of December 31, 2008. In December 2008, under President Bush, GM received $13 billion of TARP funding, and another $39 billion under the Obama administration.

 

The 'Moral of the Story'

This tale of GM wealth destruction is just one of many that can be told that begins with a bad accounting rule. It's a relatively dated story, but if the first twelve years of this millennium are any indication, the problem of perverse accounting incentives has been getting much worse – despite the putative best efforts of standard setters to enhance financial reporting "quality."

Either the problem is seen by accounting standard setters to be in the "not my job" category, or if they are sensitive to it at all, then history suggests they are going about it the wrong way. That's just one reason why convergence hasn't been worth a hill of beans, and any forthcoming statement from the SEC about continuing on with IFRS adoption in one form or another is dross. I'll have more to say about that at the end of this post.

The wrong way that the Boards have been pursuing is predicated on the explicit assumption in their respective conceptual frameworks that the fundamental purpose for financial statements is to provide information to help interested parties value an entity. But, a major problem with this approach is that it doesn't provide any consistent answer as to how the recorded assets and liabilities of the entity should be valued. Instead, the approach is used as a justification for the kinds of accounting that managers can manage.

To illustrate, one of the most recent contributions to the valuation perspective for accounting standards is a new book by Columbia professor Stephen Penman, Accounting for Value. In many respects it is an excellent book and I highly recommend it; however, I take exception with his line of reasoning that rejects current values as the basis for asset and liability measurement.

Without wishing to oversimplify, there are two sources of equity value from Penman's perspective: things that we know; and things we can only speculate about. If accounting restricts itself to measuring things we know (such as the historic cost of land), then the amount of speculative value in the current stock price can be deduced from the difference between it and the book value per share. Penman argues that speculation should be left to investors, for if accountants were to engage in too much speculation, then it will be difficult to avoid paying a market price that could over value a company.

I do have questions about Penman's analytics that lead to a conclusion that historic cost accounting is to be preferred to current value accounting; but, if valuation is not the primary objective for financial statements, then it doesn't matter whether he is right or not. My intent is solely to point out that a rigorous defense of historic cost accounting depends on whether one maintains that it is appropriate to prepare financial statements under the presumption that valuation analysts are the primary user group. My position is that to determine that this assumption is inappropriate, it should be sufficient to have enough stories like GM, where transaction-based financial statements clearly caused massive value destruction. Based on my own experience and study, I would estimate that there are thousands of examples out there just like it – albeit few that are as overtly laden with societal consequences.

The right way to select a basis of measurement should begin with the assumption that financial statements exist to guard the interests of investors in an entity. Indeed, I would think that this "stewardship" function was the original intent of double-entry accounting in the first place. It entails a high level of accountability from managers to owners for the manner in which business was conducted. Normally, this should mean that managers have an obligation to utilize the (net) assets of a business in a manner that appropriately balances risk with return on the owners' investment.

Of course, neither stewardship nor any other financial reporting system is foolproof. But, if accounting has any hope of bringing perverse incentives to manipulate financial statements down to a tolerable level, the implication of a stewardship perspective is that accounting must focus, to the extent practicable, on measuring the effect of managerial decisions on wealth and changes in wealth.

While some argue that estimating current values injects too much subjective judgment into accounting, I suggest that no matter what system of accounting is proposed, judgment is an unavoidable reality; and therefore, quibbling about which approach to valuation requires larger doses of judgment is largely irrelevant. A stewardship role for accounting also implies that it is not "management's view" that should count, for that would be circular logic indeed. The only view that should matter is the view of a disinterested economist, taking into consideration current business conditions.

Getting back to that annoying IFRS question, which most of us wish would just go away, the SEC's Chief Accountant, James Kroeker, spread the word last week that he will be preparing a proposal to the Commission for moving forward on IFRS. I don't know what will happen here, particularly since not a single Commissioner has delivered a major speech on accounting standard setting – despite the fact that it is one of the most critical regulatory functions within the SEC's purview. If any of the five sitting Commissioners has a reasonably complete understanding of accounting standards and policy, I haven't seen it demonstrated.

Obviously, I'm not going to go into all of the reasons why the SEC should finally move away from IFRS in this blog post, but I do hope the Commissioners will ask themselves this one question:

If accounting standards can either create or eliminate perverse incentives for the managers of public companies – with potentially profound consequences for the U.S. economy – how can we set a goal of convergence with standards that cater to "management's view" instead of a goal of reflecting economic reality?

Accounting without Rules -- or Principles

Ted's Accounting Question

My friend, Ted (not his real name), is the ex-treasurer of a very large public company where he acquired extensive experience in solving accounting problems. He departed a few years ago to run a business that he and his brother had purchased. Business had been humming along nicely until the economy took a dive.

Ted recently came to me with a question about the accounting for a renegotiated payable to a long-time supplier, ABC Printing. While the negotiations were underway, Ted discovered that recent prices being charged by ABC were much higher than he could have obtained elsewhere. Eventually, the parties agreed to the following terms (more or less): (1) reduce the amount currently owed by 40%; (2) the remainder of the trade payable would be converted to a non-interest bearing note payable with equal monthly payments over the next three years; and (3) ABC would continue to be the exclusive printer for Ted's company for the next three years -- at a 5% discount to prevailing market prices, so long as new billings were paid within 30 days of their invoice dates.

Solely for the sake of discussion, let's assume the following additional facts:

• The change to the terms of the payable would result in a $90,000 write-down, such that the remaining balance of the payable would represent the discounted present value – or equivalently, the fair value – of the 36 monthly payments over the next three years.
• The amortization schedule for the note payable results in changes to its balance that correspond to changes in its current value.
• The current value of the future purchases at discounted prices is $114,000.

Based on our collective knowledge (i.e., winging it without any formal research), Ted and I identified two potentially permissible accounting treatments:

Treatment #1 – Reduce the payable by $90,000; record a gain of $90,000; no recognition of the purchase commitment.

Treatment #2 – Reduce the payable by $90,000; record a deferred gain of $90,000; no recognition of the purchase commitment. In subsequent periods, amortize the deferred gain to income over the term of the purchase agreement.

Ted tells me that his former employer had engaged in similar deals, and it had accounted for them along the lines of Treatment #2 because it produced a smoother stream of earnings. That comes as no surprise, but it would seem to me that an auditor could find Treatment #2 to be inappropriate (even though it is more "conservative") because the deferred gain does not meet the conceptual definition of a liability, and there is no specific rule that permits it. So much for principles.

Moreover, whichever of these two treatments is elected, the parties will be able to manipulate the accounting results to their preferences by manipulating the monetary parameters of the agreement – i.e., the amount of the payable forgiveness and the amount of the discount on future purchases are interdependent. Consequently, should the executive compensation packages for either company have an earnings-based component, it's easy to see how the absence of neither rules nor principles creates perverse incentives for management that end up destroying value for shareholders. The only form of accounting that would prevent such value destruction would entail recognition of all of the assets and liabilities – including the purchase agreement – and measurement at their current values.

This is Also an Interesting Revenue Recognition Problem

I chose to blog about my conversation with Ted because the accounting issues for ABC Printing (the supplier) is even more interesting than the accounting for Ted's company. Mostly, it's a good example for thinking about how the exposure draft, Revenue Recognition (Topic 605): Revenue from Contracts with Customers, would fail to provide answers to many issues that are sure to arise if finalized in its present form.

Before considering the exposure draft, however, let's start with existing accounting standards; because ABC has an opportunity to manage its earnings in two respects. First, the writeoff of the receivable from Ted's company might not have an impact on current earnings if ABC can conclude that the allowance for bad debts is sufficient to absorb it without a charge to bad debt expense. Second, if ABC was concerned with maintaining its future profit margins, then they might be willing (and could "afford") to grant a larger forgiveness of their current receivable in order to minimize the amount of the discount on future sales in order to keep Ted's business.

None of this weirdness would be corrected by, or particularly affect the accounting under the exposure draft, without my adding one more twist to the problem: let's assume that a portion of the re-negotiated amount owed by Ted would be payable in a lump sum at the inception of the new arrangement. The exposure draft would require separate accounting for the forgiveness of the indebtedness (a financial instruments contract) and the contract to supply goods; yet, it is impossible to determine whether the lump sum payment is a partial settlement of the receivable or a prepayment for future goods. To the extent that it is seen as a prepayment, then the resulting "performance obligation" would be accounted for like a deferred gain.

It would seem that this is an issue that the FASB could resolve before finalizing the exposure draft, but my sense is that it is only one of many gaping holes in the standard. Again, the only principles-based way of accounting for this transaction would involve recognition of all assets and liabilities, and measurement at current values, as follows (for ABC):

Reduce the receivable by $90,000 and any cash received at the inception of the new arrangement; recognize a purchase agreement liability of $114,000 (to be netted against the receivable); record a gain/loss to balance the journal entry. In subsequent periods, recognize changes to the current values of the purchase agreement and receivable directly in earnings.

In addition to providing the most complete picture of the legal rights and obligations created, there would be need for highly stylized and vague accounting standards like the revenue recognition exposure draft, and no perverse incentives to manage earnings via exploitation of the gaps in GAAP.

What I Mean by "Replacement Cost" is not Literally Replacement Cost

I get a lot of questions – and yes, some criticism – of my support for measurement of assets and liabilities at "replacement cost" (with comparative periods adjusted for the effects of inflation). My views are derived in large part from three conclusions. First, replacement cost measures are the only possible way for accounting to reflect wealth invested by shareholders in an enterprise; and consequently, changes in invested wealth. In a post and working paper that are already more than four years old, I demonstrated the truth of this proposition using a simple example.

The second conclusion is derived from the first: namely, that principles-based accounting must be primarily concerned with measurement of wealth and changes in wealth. I can think of no other principle that is more fundamental to accounting – and no way to be faithful to that principle without replacement costs. Financial reporting under complex and inconsistent rules, without principles to bind them, has been a losing proposition.

Third, I go back to the maxim that accounting affects decision making; or, "what gets measured gets done." If management is supposed to maximize wealth, then accounting must endeavor to measure the effects of management decisions on wealth. I have tried to say this in different ways over the years, but Walter Schuetze nailed it for me this weekend over lunch in San Antonio:

"Accounting cannot stop management from doing dumb things. But, we can report it as soon as possible so the world can see the results."

The FASB has succeeded in ignoring this self-evident maxim throughout its entire history. In doing so, it has enabled a national tragedy at many levels: obscene levels of compensation awarded to management, impairment of U.S. competitiveness, mass disruptions of financial markets, shareholder value destruction – not to mention the chaos and misery inflicted on honest, hardworking and capable individuals.

"Replacement Cost" in the Real World

However, I don't deny that there are a lot of implementation issues that should be addressed. Perhaps the most persistent and fundamental criticism of replacement cost measures is the lack of relevance when there is little or no prospect that the existing assets will be replaced with identical, or even similar, assets. A commonly invoked scenario is when an existing asset lacks some of the desirable characteristics of later versions that are available to be purchased – say, an aging airliner.

The conceptualization of "replacement cost" that I advocate can handle this situation simply and reasonably. To begin, let's set aside the airliner for a moment and consider inventory held for sale. For such assets, there is already a replacement-cost-based accounting treatment in U.S. GAAP (though not in IFRS), which has stood without challenge for more than 60 years.

Every accounting major will be familiar with U.S. GAAP measurement of inventories at its lower of cost or "market." For the sake of compactness, but without loss of generality, here is the essence of the protocol:

"A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost … the difference shall be recognized as a loss of the current period.

… [market] provides a practical means of measuring utility.

As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. … [However] … replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility." [Accounting Standards Codification 330-10-35-1 through 4 (emphasis supplied)]

In essence, a measure of the utility of inventory (i.e., wealth invested) should be capped by the amount it could be sold for, less incremental costs of disposal. This is because it is hard to imagine a situation where replacement would be economically justified if, once replaced, the inventory could not be sold for more than its replacement cost.

Having established the concept in existing US GAAP, let's turn back to the problem of the aging airplane. Following similar logic as for inventory, the owner should first determine whether there is an active market for airplanes of similar vintage and features. If so, then the replacement cost can be objectively based on recent transactions. But if there is no active market, then my operationalization of "replacement cost" would cap the reported amount at what could be received from sale (under current conditions), less estimated out-of-pocket costs.

Thus, there is no need to determine whether inventory is "obsolete", or even how management intends to use and/or dispose of the asset. Moreover, the resulting measure of "market," "current cost," "replacement cost," or whatever it may be called happens to be conservative because it is likely that the utility of the investment to shareholder interests is greater. This logic is buttressed by the fact that the airplane is still owned as of the balance sheet date, providing some indication that greater utility was expected from use rather than sale.

Simple Solutions to Contentious Problems of the Day

I know we are a long way from applying replacement cost or market to airplanes, but I want to conclude by pointing out that the concept of replacement cost provides for very different solutions to a number of current controversial accounting topics. Below are two very different examples.

Leases – Speaking of airplanes, many operators access them via non-transferable leases. When the right to use an asset is not transferable, "fair value" (i.e., exit price) makes no sense whatsoever; and neither does the crude and arbitrary calculations for leased assets and liabilities that the FASB and IASB are currently proposing.

The only relevant measurement attribute of non-transferable rights and obligations arising from lease contracts is replacement cost. In fact, if you believe that non-transferable rights should be recognized as assets, I can think of no better example to show why replacement cost is preferable to fair value as a comprehensive basis of measurement.

Going concern evaluations – Just yesterday, after years of rumination, the FASB announced that it has decided it will not issue a standard that would require management to disclose its going concern evaluation (instead of auditors), even though IFRS requires it of management. If all assets and liabilities were measured under the concept of replacement cost that I have described here, this would be a non issue.

A Practical Way Forward

Although I am for comprehensive use of "replacement cost" measurements, I don't want to be seen as rigidly ideological. As the forgoing example illustrates, there are plenty of ways to significantly improve GAAP without full adoption of replacement cost measurements. By far, the most important are those inflation adjustments I mentioned in passing at the top of this posting.

In that regard, I'll leave you with two closing thoughts: (1) a bank has not earned a profit on a loan of $10,000 when it collects a total of $10,001 over the five-year term; and (2) inflation-adjusted historic costs do a pretty good job of surrogating for actual replacement costs in most circumstances.

IFRS Convergence: Let's Play 'Chief Accountant for a Day'!

When I was at the SEC (1992 – 93), one of the senior staff members whom I admired greatly for his competence and integrity was Robert Bayless, the Chief Accountant for the Division of Corporation Finance. ("Corp Fin" is the branch of the SEC that reviews and comments on financial statement filings.) Sometime after I had left the Commission and the position of "Chief Accountant to the Commission" had opened up, it was rumored that Bayless would be in line for the promotion. But, the chatter quickly died down after Bayless was supposed to have responded, "Why would I want to drink battery acid?"

The point of my story is that the Accounting Establishment can always make life miserable for the Chief Accountant to the Commission – especially one who, like Bayless, would have made investor protection his sole priority. I thought of him recently as I read James Kroeker's (the current Chief Accountant to the Commission) remarks at the AICPA's annual conference on SEC and PCAOB developments. Mr. Kroeker did concede that the planned imminent policy statement from the SEC on International Financial Reporting Standards could not possibly happen for at least several months. But, in all other respects, he once again demonstrated his abilities and willingness to be the implacable Chief Spinmeister for the Accounting Establishment. If nothing else, it's a way to keep battery acid out of one's diet.

Rather than criticize Kroeker point by point, I'd like to imagine that I could take his place as Chief Accountant for one day – the day of that speech. This is what I would have said:

Good morning. It's an honor and a privilege to be the Chief Accountant to the Commission for a day.

Let me begin with a discussion of the current state of the IASB/FASB convergence agenda. If I were to start with the premise that execution of the convergence projects and the results of that work are important as the staff considers the issue of incorporation of IFRS, I would have no choice but to conclude that further efforts at convergence will be a monumental waste of time. Moreover, it is clear to me that the time and efforts of this office and the FASB over the past 10 years could have been much better spent on efforts to improve the quality of U.S. GAAP, instead of on convergence with IFRS.

As all of you certainly are well aware, the work of the two Boards on convergence has been at the top of their respective agendas since 2002. It's hard not to be amazed at how many hours have been spent debating accounting issues over those ten years while so little has actually been accomplished. I am stunned that the SEC staff has not given more direction and constructive criticism to both Boards. But, as my kids would say, "I'm not gonna lie. It is what it is." (I hate both of those expressions!)

Let's go back just a little bit to see how bad things have become. At the time of the February 24, 2010 Commission Statement on IFRS, the FASB and IASB had nearly a dozen joint projects planned for completion by both boards by mid-2011. The SEC was hopeful that at least some of those projects would be completed by now, and even IFRS adoption skeptics, like me, could not have imagined that we would actually be further from convergence today than we were back in February 2010. Progress has been made toward partial convergence of some trivial matters – like the way that components of dirty surplus (so-called "other comprehensive income") are formatted, and the IASB has finally agreed to adopt the FASB's fair value measurement standards for the few items that are measured at fair value. But, everything else seems to be heading in reverse.

We have come to the point where the SEC is placing all of its hopes for any indication of significant progress toward convergence on the revenue recognition and leasing projects. However, the best that can be said of these projects is that two watered-down standards could become finalized by the end of 2012. I do not consider this to be progress, as I believe that the FASB would have been capable of creating higher quality standards without being forced to collaborate with the IASB. We do have our politics here in the U.S., but recent years have shown that it is nothing compared to the political pressures exerted on the IASB by its many "stakeholders."

The major project that seems most likely to be finalized in 2012 is revenue recognition. In the revised exposure draft issued just last month, the Boards have abandoned any semblance of a principled position on the asset/liability view – supposedly one of the prime reasons the project was begun almost 10 years ago. If finalized as currently proposed, all sorts of deferred costs will populate the balance sheet. 

Overall, I think it is fair to say that this project has devolved into a desperate quest to somehow quell criticisms by preserving current practice while at the same time replacing the rules from 200 separate pronouncements and interpretations with one cohesive document. The unsurprising result is a draft standard that is so vague and lacking in robust illustrative examples, I wouldn't be surprised that we will soon have 200 new interpretations to deal with before an effective date finally comes to pass – which I expect to be no earlier than January 2017.

I should also mention that the prospects for a high-quality lease accounting standard are even more dismal. The Boards are being pushed to whittle down recognition of lease obligations to some crudely calculated minimum amount that lessees might grudgingly accept. Lessor accounting, after years of vacillation and improvisation, is still in flux.

Ironically, if my predecessors had been completely honest with the public, they would have admitted long ago that the greatest progress made on convergence has been to point out where convergence has no chance of succeeding in our lifetimes.

Take financial instruments. Please. Given the 2008 financial crisis, the impending implosion of bank balance sheets in Europe and the recent embarrassment in the U.S. of MF Global, this is the one area where the Boards could provide an immediate service to investors. Yet, the SEC stood idly by as one FASB Chairman was fired by the Financial Accounting Foundation for daring to insist that convergence result in high quality financial instrument standards, and while the FAF stacked the Board with three more reliable IFRS shills. But, it seems that nothing less than a return to post-WWI hidden-reserve accounting will satisfy the German and French bureaucrats. (At least we can thank the current members of the FASB for resisting at least that much.)

Even as the SEC's arguments for continuing with convergence have been pounded to dust by the vast majority of SEC registrants and independent-thinking investors, the staff has been blithely proceeding (albeit at a snail's pace) with its work program – exploring whether and, if so, how the Commission could or should proceed with a decision to incorporate IFRS for U.S. issuers. In truth, the scope of that work plan is woefully inadequate. I have absolutely no idea how the staff will produce a rigorous analysis of the costs and benefits of incorporating IFRS into U.S. GAAP that meets the standards set by a recent court ruling against the SEC.

My skepticism in this regard is further reinforced by the two progress reports that the staff has recently issued in the form of Staff Papers. The first is a comparison of the differences between U.S. GAAP and IFRS. Although revenue recognition, leasing, and financial instruments were excluded, it's amazing how many significant differences still exist! First, there are all of those convergence projects that have been abandoned or indefinitely postponed; second, there are the significant differences that remain from projects that the staff is counting as converged; and third, there are the differences that are so fundamental, the boards didn't even bother to put them on any convergence agenda.

Yet, it appears that the staff has attempted to downplay the sheer impossibility of bridging these differences, mainly by providing a document that no Commissioner would find any reason to actually read, except perhaps as a natural and highly effective cure for insomnia. The bulk of the report is a turgid regurgitation of differences between IFRS and U.S. GAAP that could have easily been lifted from a pamphlet written by any one of the Big Four. The staff also made sure to leave out any summary, takeaways, or any indication whatsoever of the dim prospects for, and herculean efforts that convergence will continue to entail. If the authors' intention was to provide no new information or guidance, then they succeeded admirably – and they should also be quite ashamed of themselves for the dismal quality of their work.

The second Staff Paper is an analysis of the use of IFRS in practice by the subset of Global Fortune 500 companies that claimed to comply with IFRS in their financial statements. This paper was actually well done (and it should be noted that it was not written under the direct supervision of the Chief Accountant to the Commission). The number of apparent departures from IFRS noted, and the inconsistent ways that IFRS has been interpreted by the largest companies, should explode the myth that worldwide adoption of IFRS will result in more comparable financial statements. The unavoidable conclusion is that even if a single set of global accounting standards were possible, the paper leaves no reason to believe that effective global enforcement would occur. A single set of standards without a single, consistent and rigorous enforcement mechanism will fail to deliver on the promise of comparability.

In summary, as I reflect on the negative feedback from the July Roundtable and these two staff papers, I see absolutely no reason to continue consideration of IFRS adoption in any manner shape or form. But, I'm only the Chief Accountant for today, and James Kroeker returns tomorrow. You should expect that he will continue to display his singular talents to spin convergence whilst the SEC's project spins ever more rapidly out of control (or down the toilet, if you will).

Thank you for listening. If only the Commission would do the same for once.

 

 

What Should "Investor Protection" Mean to Accounting Standards Setters?

If you were to ask a financial regulator what 'investor protection' means in the context of accounting standards, the textbook response will have something to do with ensuring that investors have enough information to make informed investment and voting decisions.* Indeed, that's what also has been taken as gospel since 1978 when the FASB published its Statement of Financial Accounting Concepts No. 1:

"[F]inancial reporting should provide information to help investors, creditors, and others assess the amounts, timing and uncertainty of prospective net cash inflows to the related enterprise." (¶ 37)

I believe this has been the guiding philosophy of standard setting ever since. It is time to recognize that it is a failed philosophy.

Informativeness is in the Eyes of the Lobbyist with the Most Juice

First, to rank accounting alternatives on the dimensions of their 'informativeness' is deceptively difficult, if not just downright impossible. That's why FASB "due process" takes forever, and is more about politics than reasoned thinking. But, even if the goal of enhancing informativeness were the correct goal for regulators, what can be said about the progress toward informativeness that has been made over the ensuing one-third of a century? Not a whole heck of a lot.

Lawrence Summers gave a speech in 1999, when he was deputy Treasury secretary, which contained this remark about financial reporting:

"If you ask why the American financial system succeeds, 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." (source: a 2009 NYT column by Paul Krugman)

I am resurrecting those remarks from an earlier post because they demonstrate how central financial accounting is to the functioning of our economy; and conversely, the vast destruction that can occur when accounting doesn't work as it should. Perhaps, from Summers' perspective in 1999, accounting standards were more or less okay, even though he ignores the S&L debacle and the role played by inadequate loan accounting standards. But from the perspective of 2011, after all that has befallen us in the ensuing 12 years, surely he would have to recognize that accounting has become more a part of the problem than holding out much promise for being a part of the solution. (For a more contemporaneous viewpoint, I suggest you read Floyd Norris's recent column on the utter mess and disgrace that is the accounting for financial instruments.)

Some would say that the mission of the FASB has been to institute improvements to accounting standards, and on a case-by-case basis, there is no disputing that some improvements have been made. But, despite all the new rules and complexities, it's still much too easy to smooth income, and to obfuscate or just plain hide important information about risks and uncertainties. All in the name of informativeness, U.S. GAAP (more so, IFRS) gifts issuers with free choices (explicitly or often implicitly) among accounting treatments, and the privilege to make highly subjective and self-serving estimates. Nowadays, few are surprised at how powerless or unwilling, auditors are to stop issuers from making two plus two seem like something other than four. (Indeed, an important lesson here is that audit reform may not be possible without accounting standards reform.)

Accounting Standards as Weapons of Financial Destruction

Second, there is an aspect of reality that goes essentially unacknowledged in the FASB, SEC or IASB literatures: financial statements issued for public consumption routinely double as convenient, albeit very dangerous, management control systems.

For example, the attainment of a pre-determined amount of earnings under U.S. GAAP can be a surrogate for achieving underlying economic goals. This may ostensibly be the case because of the difficulty in measuring achievement of real targets. I say "ostensibly," because I'm not confident that enough corporate board members sufficiently appreciate the tradeoffs involved; in particular, the difference between reported net income and real profitability. Even granting a genuine willingness on the part of board members to exercise due care, they seem to be too easily won over to the point of view that game-conducive earnings-based compensation is the most effective way to achieve congruency between management's preferences and shareholder value maximization.

In short, "what gets measured gets done." Yet, by fixating on informativeness, the FASB has succeeded in ignoring this self-evident maxim throughout its entire history. And in doing so, the FASB (with the SEC standing idly by) has enabled a national tragedy at many levels: obscene levels of compensation awarded to management, impairment of U.S. competitiveness, mass disruptions of financial markets, shareholder value destruction – not to mention the chaos and misery inflicted on honest, hardworking and capable individuals.

Give Accounting Back to Shareholders

We desperately need to figure out how to make accounting part of the solution instead of a big, big part of the problem.

To start, we need to shift the primary emphasis of accounting standard setting from informativeness to 'stewardship' and 'external control.' By stewardship, I mean economic reality: the identification and valid measurement of the net resources that management has been entrusted to invest and utilize; whether management is taking the appropriate level of risk; and whether management has generated a satisfactory return to shareholders. External control is an outcome of a focus on stewardship in financial reporting, and by stewardship I am referring to the need to explicitly recognize that accounting standards have had, and will continue to have a profound impact on corporate decision making. (Pardon the digression, but this consideration by itself should be sufficient reason to stop all the IASB adoption nonsense.)

Granted, no set of rules can result in an accounting for all of the assets and obligations of an enterprise; and by extension, no set of internal and external controls can be expected to put a complete halt to shareholder value destruction through accounting-based managerial decision making. But, the least regulators can do is to endeavor to recognize a reasonable set of an entity's assets and liabilities, and to measure them in sensible economic terms. For a start, we should be using constant units of purchasing power instead of nominal currency units in comparisons. Even in times of merely low inflation, It is not true that a bank earns an economic profit when it ultimately collects $1,001 on a 10-year $1000 loan; yet, that's the way that bankers appear to think, largely because accounting rules permit them to act like it's okay to think in such naïve terms. And, just like Floyd Norris points out, we don't need about a dozen different free choices and all the subjectivity involved in accounting for stocks, bonds and loans.

* * * * *

My reading of history is more critical than Lawrence Summers'. It tells me that tight regulation of financial markets is necessary, because bad things happen when managers could end up being rewarded for decisions that destroy shareholder value. But, focusing on stewardship and external control does not mean that informativeness gets thrown out the window. In fact, I think the resulting financial statements would be more informative than those prepared in compliance with today's U.S. GAAP or IFRS. If done right, they should also be more auditable, but that's a topic for another post.

If investor protection were a horse, then when it comes to accounting standards the SEC and FASB have spent far too much time looking at the wrong end. (Don't ask me where I think the IASB has been looking!)

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*And also to prevent misleading disclosures, but that's not central to what I am thinking about here.

The IASB's Revisions to Pension Accounting Rules are Based on a Preposterous Premise

Last June, the IASB issued revisions to IAS 19, Employee Benefits. The accompanying press release would have us believe that the five-year project resulting in incremental changes to the accounting for pension costs are a significant improvement; unfortunately, they are just one small step forward followed by a giant step backward.*

The small step forward is the elimination of the alternative approaches for dealing with actuarial gains and losses – i.e., differences between the expected change to the net pension liability (after taking into account contributions and payouts) and the actual changes. The older version of IAS 19 permits a free choice among no less than three treatments:

1. Similar to U.S. GAAP (which is also highly deficient in this regard), amortization of 'excess' cumulative gains/losses;
2. Immediate recognition of the excess cumulative gains/losses; or
3. As per UK accounting standards, immediate recognition of the total gains/losses for each period in other comprehensive income (OCI), without recycling.

The giant step backward is, of course, the new treatment, which gifts issuers with a new set of tools for managing earnings. Under the new accounting, only management's (biased) forecast of the change to the net pension liability is included in net income, and the actuarial gains and losses go to OCI – without recycling.

It's easy to see what is going to happen after companies adopt IAS 19. First, a manager can rest comfortably in the knowledge that, even if the sky falls on the company's pension plan, it won't affect hitting any of their earnings targets – and their earnings-based bonuses – ever. All variability will be forever sequestered in accumulated OCI (AOCI).

Second, and relatedly, management will be much less concerned with actual pension cash flows, especially those cash flows that won't take place until long after current management has departed. A limitation on the amount of income from pension plan assets** could mean that management will care less how those assets are invested; and the plans themselves will become more liberal in ways that wouldn't exist if the total change in the present value of cash flows were fully reflected in net income.

Third, estimates of the future costs that actually find their way into net income will be inappropriately low. Will 'independent' auditors feel any compunction to correct management's naturally occurring bias? I'm not betting on it, and especially not without mandatory audit firm rotation.

OCI Has Become the IASB's Kitchen Sink

The new pension accounting treatment is apparently based on a preposterous premise: that net income for a period is supposed to reflect "the underlying financial performance of the core business" or "an entity's day-to-day operations."

I say preposterous because, although it is certainly an appealing thought, it is perforce not possible for net income to reflect "underlying financial performance" or "an entity's day-to-day operations." To take just a few examples:

• Gains/losses from dispositions of PP&E, as well as impairment charges, largely reflect events that occurred in prior periods. Would the IASB suggest that these items, too, be thrown into the kitchen sink of OCI? Of course not.
• Some events are recognized in net income only after their cash flow effect meets a measurement threshold, like "probable" or "capable of reliable measurement." These terms make me gag, but again, this means that much of the amount recognized in the current period is due to events that occurred in prior periods.
• Some items in accumulated OCI, such as translation adjustments from prior periods, are recycled from AOCI to net income in the current period when certain criteria are met. Yet again, this is a conflation of current and prior period events.

For each of these, and more, IFRS would permit additional line items; and additional subtotals may also be added to the income statement, in order to assist the user in assessing performance for the period. The same could apply to pension costs: if actuarial gain/loss components merit separate disclosure, nothing should prevent a company from separately captioning them within the income statement; and quantitative disclosures as notes accompanied by explanatory paragraphs would also do the trick.

But, none of these treatments would have accomplished the political objective of the IASB, which was to gift managers a new tool for managing their reported net income.

Another Standard for No Good (Stated) Reason

I say apparently based on a preposterous premise because my source for the above quotations is from that little press release I mentioned earlier. The official standard is devoid of any remotely similar language or any other reasonably detailed discourse answering the 'why' questions that must be integral to the "basis for conclusions" of any new standard. This is not new, by the way. See my post on the revisions made to IAS 23, Borrowing Costs.

If you want to see the problem for yourself, go to paragraphs BC3 – BC11 of the revised standard. While actual words are there to be read and understood, they amount to little more than boilerplate, addressing 'what' and 'when' types of questions.**

The unavoidable conclusion is that there is no defensible logic to the new accounting treatment for pension costs. More generally, OCI has become the kitchen sink in which to toss anything that management feels would despoil its precious 'bottom line.'

SEC, Are You Paying Attention?

Whether or not one supports the actual revisions, there can be no denying that a section of an accounting standard labeled "Basis for Conclusions" creates an expectation that the IASB will explain why the accounting treatment chosen is the best among a reasonable set of alternatives. To be as generous as possible, the IASB's explanations are vague and misleading. But, to be brutally honest, the IASB has made a mockery of due process on this and any other occasion where it suits its political agenda.

If the SEC is still thinking about looking to the IASB as its principle accounting standards setter, with the FASB following in lockstep in a so-called "condorsement" role, this is just one more indication of the folly of that strategy. As much as it has tried, the SEC cannot blithely presume that IASB-promulgated standards are high quality, but only that a final standard ultimately emerged out of a five-year political football match. 

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*On September 9, 2011, Patricia Walters started a discussion of the revisions to IAS 19 on the AECM listserv. Some of the comments to that thread have influenced my own views.

**The new standard also creates a new approach for measuring the expected return on plan assets, which I completely disagree with (see paragraph 125). I may discuss this in a later post.

***To be fair, there is this statement further down in the document (paragraph BC88):

"The Board noted that although changes included in the remeasurements component [i.e., the actuarial gains/losses] may [italics supplied] provide more information about the uncertainty and risk of future cash flows, they provide less information about the likely amount and timing of those cash flows."

I think this is inadequate for reasons that are self evident. Substitute "does not" for the weasel word, "may", in the above quote, and you have a much more realistic assessment.

A Much Needed Accounting Lesson for Two Senators

Nothing good comes from bad accounting, and many of the bad things that happen are easy to predict: excess bonuses to management, negative NPV investments, underfunding of pension plans, etcetera, etcetera, etcetera. Yet, the instance I'm writing about in this post has a special flavor.

Savvy managers may know that the accounting rules they are exploiting fall far short of good, but others, in stark contrast to their status in society and evident sophistication in other matters, take the solemn pronouncements of the FASB for gospel. Recently, two U.S. senators have apparently forgotten or are oblivious to the fact that the making of financial reporting standards is more like the production of sausage than the engraving of the Ten Commandments by Moses on Mt. Sinai. Consequently, they have introduced a bill to model the tax deduction for stock-based compensation after the low-grade pork in a tube known to the accounting cognoscenti as Codification Topic 718 (formerly SFAS 123R).

The senators in question are Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio). A couple of weeks ago, they introduced a bill to eliminate the so-called 'excess tax benefit' from issuing stock options to employees. The two senators note that the amount of expense reported for financial reporting purposes (for example, in SEC filings) is quite often less than the amount of the tax deduction taken per the tax return, and they seem to think that the so-called 'excess tax deduction' amounts to a government giveaway to corporations. If financial reporting measures stock-based compensation 'right' (and it surely does not), then by their logic it's wrong to receive a deduction that's greater than the expense reported for financial reporting purposes.

Bless their little hearts, but Levin and Brown (and surely other senators) are oblivious to the reality that the accounting evils lie in the financial reporting rules, and not the income tax rules. It is the financial reporting rules that are fraught with inconsistencies, for they were designed to systematically understate the cost of compensating employees.

The Economic Measure of Stock Compensation Cost

I'll be the first to admit that, when it comes to taxes, I'm sort of a babe in the woods myself. But, the complexity that is misleading the senators does not lie in the tax rules. The tax rules in this respect are simple, and a review of the fundamentals ought to be sufficient to set the stage for my accounting lesson to them.

There are two kinds of deductible expenses for tax purposes. The first type is the cost of productive resources that are consumed; examples include depreciation of productive assets, rent of productive assets, costs of inventory acquired and subsequently sold, and salaries of employees. The second type, financial cost, was at one time more controversial; and the most straightforward example is interest cost of debt.

Many decades ago, interest costs were seen to be fundamentally different than the costs of using productive resources. They were merely distributions to stakeholders, i.e., more analogous to dividends than costs of production. Eventually, though, in response to political pressure from railroads and other large corporations, taxing authorities adopted a shareholder perspective to tax deductions. In regards to interest costs, they should be deductible since they reduce the maximum amount that could be distributed to shareholders. In other words, from the perspective of the shareholder, expenditures on productive resources and the interest are both costs that reduce the amount of funds available to be distributed to shareholders.

Moreover, the tax law straightforwardly provides for the amount of interest that may ultimately be deducted as the difference between the total amount borrowed and the amount ultimately paid back to the lender. There is nothing magical about this, and it is consistent with the measurement of other tax deductible costs, including the stock-based compensation rules that are being challenged by Senators Levin and Brown.

So, one problem with their bill is that if you believe that the tax deduction for stock-based compensation should be consistent with interest costs, then you should agree that the ultimate cost of stock compensation should be the intrinsic value realized by the employee when the stock options held are recognized. And, in principle, the answer should not change whether the options are net settled, physically settled, or in the form of stock appreciation rights.

The Free Accounting Lesson

The foregoing is so mundane, I feel almost ashamed to have written it. But, I needed to do that to tee up the really interesting part: somehow, these two senators (and probably a few more) are either being grossly disingenuous or are laboring under the mistaken belief that U.S. GAAP on stock-based compensation (Topic 718) must be 'right,' since it was issued by the FASB after a decade of "due process." In point of fact, it is an embarrassing political compromise that was allowed to survive because its most outstanding feature is that it generally reports only a small portion of the full cost to shareholders of such programs (as I explained in the previous section).

Surely, the senators are aware that it was only relatively recently that U.S.GAAP began to require any recognition of compensation expense for stock options. The controversy was intense, and the best the FASB could do against stiff political resistance when they promulgated FAS 123R was to require that stock compensation expense be limited to the value of the options on the date they were granted – as opposed to either the date on which they were earned ('vested') – or most accurately and consistent with the measurement of other expenses, the date the options were exercised.

For example, assume that an employee is granted an "at-the-money" option to purchase one share of her employer's common stock for $8 per share, and she eventually exercises the option when the share price is $20 per share.

The option was granted on January 1, 20x1, at which time it was valued at $2 per share. It vests (i.e., becomes exercisable) four years later, and expires three years after that. The fact that a company's earnings reported to its shareholders is reduced by only $2 (and spread out over the four-year vesting period) while the amount of wealth transferred from shareholder to employee is $12 (i.e., six times greater than the $2 recognized for financial reporting) is one of the most glaring inconsistencies in gazillions of pages that comprise U.S. GAAP (or IFRS, for that matter).

* * * * * *

Bless these innocent children, who happen to be U.S. Senators, and keep them forever. Will they ever come to realize that the so-called 'excess tax deduction' (a financial reporting concept, not a taxation concept), which they have decried with indignation and sanctimony, is a blatant misnomer? A more accurate moniker would be 'insufficient financial reporting deduction', for the failure of GAAP to record the full amount of wealth ultimately transferred from current shareholders to employees.

Dear senators, GAAP is not gospel, and much of the time it is not even good. And, don't just take it from me. As one retired FASB member, David Mosso, now ruefully admits, GAAP (or IFRS – take your pick) is a "garbage truck."

The Hans Hoogervorst IFRS Sales Pitch Hits the Road

For a standards setter, Hans Hoogervorst, the new IASB chairman, doesn't know much about accounting. By his own frank admission, he wasn't even very interested in the subject until after the financial crisis hit in 2008, and he seems almost proud to disavow a command of the details of IFRS.

Consequently, his role on the IASB is obvious: to sell IFRS to as many countries as possible. Why anyone should expect someone with his background to do that with any sort of credibility is beyond me, but his selection seems to reflect a conscious strategy on the part of the IFRS Foundation: to promote the sizzle instead of the steak.

The Wooing of China

Hoogervorst's first major sales pitch was delivered in China last month. Predictably, there were two parts: a standard litany of the general benefits of IFRS, plus some special words like these to the good folks in China:

"[W]hile Chinese GAAP is not word-for-word IFRSs, I understand that analysis by the Chinese regulator shows that for companies with dual listings in Shanghai (using Chinese GAAP) and Hong Kong (using IFRSs) the average difference in reported profit is 0.6%. The difference in term [sic] of net assets is even as smaller [sic] as around 0.2%."

The impetus for this post was an email from one of my readers, Steve Chai, who made this telling observation:

"If [Hogervoorst] truly believes that the financial results are similar under both IFRS and Chinese GAAP, he should instead recommend switching to Chinese Standards, which are 100 times shorter and simpler than IFRS!!! … For example, Chinese Accounting Standards (CAS) have less than ONE page of guidance on how to consolidate companies (CAS 33), and CAS 24 on hedge accounting is only 7 pages."

To Steve's point I would add that if CAS can generally be expected to come close to IFRS on major financial metrics, then maybe the rest of the world should adopt CAS. Moreover, Hoogervorst doesn't even seem to be aware that the point of that simplistic statistical exercise would more likely have been to support the proposition that convergence to full IFRS was not a necessary condition for achieving "high quality" financial reporting in China. If the actual income and balance sheet numbers are similar, then there would seem to be no point to burdening Chinese companies with more detailed accounting standards.

Steve wrote to me because he is incensed that, right from the start, Hoogervorst is not telling the truth while promoting the adoption of IFRS. I am more than inclined to agree with him. Throughout his speech, Hoogervorst figuratively bows and scrapes to the Chinese for their "work," "support," and "herculean effort" to bring CAS closer to IFRS. The reality appears to be quite different.

For example, the Chinese representative to the IASB (Dr. Zhang Wei-Guo), I am told, says little if anything at Board meetings. The ostensible purpose of holding public meetings is for stakeholders to receive at least some indication of each board member's thinking, and that independent reasoning forms the bases for votes. Therefore, one might reasonably conclude that Dr. Zhang has nothing to add to the conversation.  If his accounting background is indeed rooted solely in working with the bare-bones regime of CAS, then in that respect he is much like Hoogervorst: which means that at least two voting board members are lacking technical knowledge to participate in any effective way in the Board's deliberations.

I suppose one could argue that at least Hoogervorst has a real job to do: hawking IFRS with the zeal of a snake oil salesman. But, for merely showing up and voting with the party line when required, Dr. Zhang is paid around $600,000 per year plus benefits. I wonder how that compares with what he was paid while working in China.  Did I hear anyone say "regulatory capture"?

And the other thing is that China's "herculean" contribution to the budget of the IASB is, I understand, only slightly more than Dr. Zhang's salary. The message there is also loud and clear: China will pay for made-to-order standards only. Won't it be interesting to see how that plays out once the IASB moves its sights from the U.S. towards other big fish!

The Double-Edged Butter Knife

Hoogervorst is probably a pretty sharp guy, and he may have a deep technical knowledge of something, but it isn't accounting. The China-centric aspects of his speech are sufficient by themselves to demonstrate that he will operate as a blunt instrument; a double-edged butter knife, if you will. One edge will blithely spew forth misleading statistics or generalizations, and the other will plead ignorance of the critical details.

I'm Not the Only One Dissing the SEC's IFRS Fixation

Every time I write a post, I might receive a couple of non-spam comments, and perhaps a few more private emails intended for my eyes only. Most of the feedback is positive, and even encouraging. Nonetheless, I am by nature particularly sensitive to negative feedback, even when delivered in a kindly and constructive manner.

For example, Edith Orenstein thinks I jumped the gun with my assertion that the "fix is in," on the forthcoming SEC Roundtable on IFRS; and Lane suggested that my arguments lack force when I predicted that some panelists would be shills. These comments came even prior to my most irrascible rant on the Roundtable after it took place. In some ways, this post is a response to Edith and Lane: I know that my comments are often unkind and liberally dosed with irreverence and sarcasm; but in my defense, I am not the only one out there letting their frustration with the SEC's IFRS fixation hang out.  Consequently, even in my most untethered moments, it feels kinda OK to know that I'm in pretty decent company:*

Lynn Turner, a former SEC chief accountant no less, circulated this email bearing the incendiary subject line "Stacked Deck":

"I find it interesting that so many credit rating agencies are given slots at the SEC IFRS roundtable when they were the very ones who so shafted investors. And Jonas who was at one of them, now at Morgan Stanley, and who was head of the AA national office is another one of the participants.

Take a look at the panelists on the small-company panel. Bank of the West isn't a public company – it's owned by BNP Paribas. Cuisine Solutions has a subsidiary in France – sort of unusual for a small U.S. company. Viropharma has a European unit. Tandy Leather has operations in Canada and the UK. Are you seeing a pattern here? They specifically aren't having as panelists the kind of strictly domestic small public company that wouldn't benefit from IFRS."

And in a subsequent email:

"The SEC so stacked this deck it is beyond one's imagination as to why they would expect anyone outside their 4 walls would see this as anything short of the typical Washington DC contrived outcome."

Jack Ciesielski, former member of FASAC, AcSEC, EITF and author of one of the most highly respected publications for financial statement analysts, described the upcoming Roundtable as a "railroad job." And he also wrote a must-read comment letter on the SEC staff's paper, "Exploring a Possible Method of Incorporation." Like Gaylen Hansen's remarks from the Roundtable, all of Jack's criticisms are quite devastating, but the one from Jack that resonates with me for its originality and the vividness of the example is the following:

"If the FASB is barred from starting projects independently of the IASB, how are American investors best served? There could be financial reporting issues that are unique to our country, that would never be addressed by the IASB - simply because they are not a problem in the rest of the world.

An example may help make the point. In the United States, many … are troubled by what they consider to be excessive executive compensation. There is only a limited amount of information available annually regarding executive compensation. More comprehensive information about all of a firm's human capital costs (not just executives' compensation), directly displayed in financial statements on a quarterly basis, would be useful for investors to help them assess the value of pay packages on which they vote annually. … There's no cohesive model or set of disclosures for reporting pay information. What gets measured, gets managed - and since there's not much reporting of pay information to investors, it's likely not to be managed too well.

It's a uniquely American problem, not shared elsewhere in the world. The FASB should undertake a project for improving investor information in this area - but it would be barred from doing so under condorsement, unless the IASB deemed it necessary. That's not likely to happen unless it became a problem elsewhere in the world. Is it fair to ask American investors to wait until an American issue that may be resolved by better accounting and disclosure is a problem in the rest of the world? In a word: No." [ first line bold in original, bold italics supplied]

Professors Ed Ketz and Anthony Catanach (Grumpy Old Accountants blog) evidence even less restraint in venting their frustration than yours truly. The title of their latest blog post, "IFRS is for Criminals" is more than sufficient evidence for that.

Floyd Norris, NYT columnist, trenchantly observed that, if the SEC were to follow through on its "condorsement" idea, many "flavors" of accounting would be the result for many years – if not indefinitely. The drive for IFRS to eventually replace U.S. GAAP increasingly appears to be coming from large companies who would like the SEC to give them the option to report using IFRS, just like many of their counterparts overseas.

But, I enjoyed Floyd's column the most for his one-liner response to the latest lobbying by IASB chair Hans Hoogervorst for the EU to endorse its latest pronouncement on the accounting for loan losses. Hoogervorst said straight out that the rule should appeal to the European Commission because it gives banks the free option to ignore economic reality, e.g., Greek bonds trading at junk debt levels:

"But it may not appeal as much to those who rely on financial statements, and would prefer to know when a bank's loans go bad. As a sales pitch, 'Adopt our rules and you won't have any losses' does not sound like a promotion for a superior set of accounting standards." [emphasis supplied]

Gosh, I wish I had written that!

Some say that the same sorts of political machinations are at work on U.S. GAAP. Even granting that point today (which I don't), imagine how things will look if more countried created an EU-like infrastructure for the purpose of lobbying the IASB for just the right IFRS standard to incorporate into its own system. The EU, the US, China, Japan and a hundred other smaller economies would be 'on board' with IFRS, but the IASB chair's head would have to be on a swivel in order to fend off each and every attack from increasing numbers of 'incoporators', 'endorsers', 'advisory groups', etc. The IASB will, in effect, devolve to something awfully akin to its early beginnings when the IASC (the IASB's predecessor) worked as a 90-person committee.

The only "standards" or "principles" back then were that there were none. A new era of balkanized accounting jurisdictions could put the IASB right back to where it started.

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*Some of the comments made were in private correspondence with me. In every case I received permission to reproduce them here.

SEC IFRS Roundtable Debrief: March of the Zombies

If IFRS incorporation is supposed to be some fantastic opportunity for achieving one set of accounting standards worldwide, then why was no one at the SEC's Roundtable on IFRS jumping for joy at the prospect? You would think that someone, anyone, would have projected at least a modicum of excitement and energy in anticipation of great things to come.  Instead, try as I might, I couldn't eradicate the image from my mind ofa bunch of zombie CPAs chasing after me for five hours.  

I also take no joy in reminding everyone that I predicted that the Roundtable would amount to nothing more than blatant pretense and deception. If I do say so myself, my prediction was very close to hitting the bullseye. Where I missed, it was because, as hard as SEC Chief Accountant Kroeker as putative moderator tried to stifle/ignore them, there were some telling blows to the SEC's cause.  Unfortunately, they were spaced too far apart to score the knockout the SEC deserves.

 The "Investor" Panel

There were a number of panelists whom I think shouldn't have been there: present and former employees of rating agencies and Big Four partners. So, I found it supremely ironic that the most apt panelist, Gerry White as representative of the CFA Institute, made an early grab of the overall gold medal for shilling. It's an open secret that the Institute is pushing IFRS adoption in the U.S., because that's what its leadership perceives the non-US membership wants. The percentage of non-U.S. CFAs could be as high as 70%.

Gerry might could have stated that 'x% of U.S.-based CFAs in analyst positions strongly support convergence with IFRS'; but since he didn't, I expect that 'x' must be an embarrassingly low number. What he stated (according to my notes) was that the Institute's membership surveys showed "overwhelming" support for a single set of global accounting standards.

Of course, as any great shill is wont to do, White omitted some important qualifications to his statement that the SEC might at least pretend to be interested in knowing. Most critically, he didn't mention which accounting standards were supported by U.S.-based analysts. Although a majority of U.S. respondents to one of the Institute's surveys said that the global standard setter should be the IASB, it wasn't "overwhelming" – and the data is about 2 ½ years old. And, when you consider that only about one-half of CFAs actually work as research analysts or portfolio managers, the other CFAs (auditors, corporate accountants and corporate financial analysts) in the sample could have been the reason that the total responses tilted towards the IASB.

Another curious moment occurred when this panel appeared to have expressed a consensus view that the basis on which the financial statements are prepared matter very little, ostensibly because investment analysis is cash-flow focused. I find that to be a gross oversimplification, which might be explained by a ratings agency mindset of at least three of the panelists. My concern with such notions is that the SEC is on a scavenger hunt for any shred of evidence that will justify incorporation of IFRS into U.S. GAAP. In this case, the panelists are telling the SEC that accounting is only the starting point of an exercise in reverse engineering with the goal of producing estimates of future cash flows. Of course, any text on financial statement analysis, including Gerry White's co-authored book, will tell you that financial statement analysis is much more than that.

But, if those who take the cash flow view really believe it, then the solution to the IFRS v. GAAP problem is actually quite straightforward: require that financial statements are accompanied by detailed roll forwards of every balance sheet account. If this actually were to be a requirement, then all of my concerns regarding IFRS incorporation would dissolve. But, it won't, of course, simply because the proponents of IFRS incorporation are more interested in hiding the ball. I.e., not revealing to much about the way that earnings were manipulated through contrived 'principles.'

Finally, no investor expressed any concern whatsoever for the effect that conversion to IFRS could have on management decision making – and consequently shareholder value. The SEC has yet to express the slightest concern for the effect that changing the basis of accounting will have on decision making.

Why is that? Of all the potential costs of conversion to consider, skewed decision making relative to shareholder value creation may be the most significant by far. It is also the most difficult concern to minimize, for there is no doubt that fewer accounting rules will mean fewer restraints on managers to steal from the cookie jar. I fear not only those managers who would act with financial malice aforethought, but also about those in regulated industries or are simply fixated on earnings. Would European banks still be holding on to their Greek bonds, now worth something like 30 cents on the dollar, if they had been forced to mark their investments to market? No way. Even more fundamentally, would banks have been willing to expose themselves to the degree that they have to a Greek default if they knew those bonds would have to be marked to market? Same answer, and the same again for thousands of similar questions one could ask about the nexus between managerial decision making and financial reporting.

 

The "Smaller Public Companies" Panel

The first ray of sunshine (being the best disinfectant, of course) came from the smaller public companies panel when its members were asked whether incorporation of IFRS into U.S. GAAP would be a good idea. The consensus was virtually unanimous that it would cost them far too much money; and not only would the costs exceed any conceivable benefit, there wouldn't be any.

That took only about 10 minutes, and the rest of the time was spent on: 'OK, even if you don't think we should incorporate IFRS into U.S. GAAP, how should we do it?'

This, for me, was the nadir of the proceedings. A reasonable inference from the feedback from its handpicked panelists should have been something like this: at least half (very conservatively) of the public companies registered with the SEC must really want any and all talk of IFRS to go away ASAP. It was a full stop moment, but instead, the intrepid chief accountant forged on down his prepared list of questions as if he were utterly oblivious to the near universal condemnation of what he clearly hopes will be his legacy at the SEC.

 

The Regulators

The SEC was very lucky that Gaylen Hansen, the NASBA representative, was given the floor only as the zombie march was winding down. For, if the "investor" and "smaller public companies" panels were given the chance to digest and respond to his prepared remarks, a full zombie assault on civilization might have begun in earnest.

Basically, in about ten minutes, Gaylen shot down every stated reason and unsupported assertion for incorporating IFRS into GAAP into oblivion:

"International standards may be likened to the Holy Grail, worth searching for but only if you think there is a reasonable chance of finding it. In the meantime, there is a real risk of obsessing in the quest at the expense of more pressing and worthy goals. There are extremely high risks in the "condorsement" approach suggested by the Staff. We may not know for several decades whether it was a very bad idea and, if so, in time to recover." [emphasis supplied]

If you are interested enough in this topic to have read all the way to this point, then PLEASE click here to read Gaylen's remarks in their entirety. Here are just a few of his remarks (accompanied by parenthetical observations from yours truly):

• The SEC owes it to the national interest to establish that IFRS itself is at least better than U.S. GAAP, if not far superior, to justify such a radical change with so many unknown (and uninvestigated) variables. (Of course, it can't be done. Moreover, the SEC's IFRS fixation has helped to improve IFRS, but it has done more to harm the quality of U.S. GAAP than to help it.)
• The notion that one version of IFRS (i.e., the Holy Grail) has been gaining currency in the rest of the world is a myth. "It has been hyped that over 120 countries worldwide have adopted IFRS issued by the IASB. That is simply not true – carve-outs resulting in jurisdictional versions are legion … I have spoken to Canadians who have indicated some of their companies are not doing anything other than wrapping the IFRS name around Canadian GAAP. The same has been reported about France." (And, I have heard presentations from large Canadian companies reporting that conversion to IFRS was extremely costly, and without benefit.)
• Let's face it, this is not about accounting, it's about politics. "[T]he original dream of comparability seems to have taken a back seat to the real agenda of some promoters…. I have read the 200 plus comment letters sent to the SEC on the 2007 Roadmap. Despite the spin of overwhelming support for global standards, there is actually substantial concern and much outright opposition."
• "I have never had a lender or investor request international standards. I have never even heard of such pleas. On the contrary, the call for IFRS always seems to be from the suppliers [of financial statements], primarily large multinationals and international accounting firms."

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I'm sure any negative reaction to the SEC's current thinking on IFRS was to the chief accountant and his staff like water off a duck's back.

Accordingly, and on this basis only, I am issuing my first stock tip to readers of this blog: buy Accenture. Or for that matter, any publicly traded consulting company that is surely gearing up to help U.S. companies make the costly "transition" to IFRS.

As for the companies that will be converting, buy puts.

 

IFRS Adoption is Dead! (I Think)

Way back in November 2008 when Christopher Cox was calling the tune, the SEC issued its proposed "Roadmap" for achieving a "single set of globally accepted accounting standards." That was the point at which the IFRS-adoption-is-inevitable" pot banging reached deafening levels. Thankfully, however, it has been mostly downhill from there:

• Both boards and their staffs have racked up many vacations' worth of frequent flyer miles in their efforts to "converge" U.S. GAAP with IFRS; but there has been little else to show for it, leaving a trail of abandoned, stalled, half-done and half-baked projects in their wake.
• The Financial Accounting Foundation (which has no legitimate claim to power since Sarbanes-Oxley funded the FASB from issuers' fees) first shrunk the FASB and then re-expanded it, in a series of futile gambits to grease the IFRS adoption skids, but to no avail.
• In February 2010, after months of virtual silence, the SEC issued a statement reiterating and defending its commitment to a single set of global accounting standards, and committing its staff to a putatively rigorous examination of that possibility. Six months later, the Staff issued what was clearly a hastily cobbled together report right at the only deadline to which it had been committed (end of October 2010). It is now almost seven months hence, and not another peep from the Staff has been heard.

But, only a couple of months after that clearly embarrassing report – both for the admission that precious few countries have fully adopted IFRS and given up their sovereignty over accounting standards, and for its vacuity otherwise – the SEC seems to have switched to face-saving mode. I mean that in two respects.

First, the SEC has sat on the sidelines for far too long, and far too often. If progress on the Memorandum of Understanding (MOU) between the FASB and IFRS to converge of their accounting standards is so important to the process of moving to a single set of accounting standards, why has the SEC chosen to be so passive during that process, practically abdicating its role by stating that a converged standard would presumably be a "high quality" standard? Sarbanes-Oxley does not permit the PCAOB to issue a new auditing standard without explicit SEC approval. If the same were required for FASB/IFRS accounting standards, you can bet that the Commission, and hopefully even individual commissioners, would be staking out their positions well in advance, instead of sitting on the fence while issues are interminably batted back and forth by the boards and its "constituencies."

Second, the political hold on global accounting standards seems to emanate from the G-20, which (for its own political purposes) has called for converged accounting standards to happen post haste. The notion of outright IFRS adoption may have become passé, especially as it has become widely known and acknowledged that so few countries are actually doing it; but the Obama administration, perhaps with good reason, does not want to be seen as the dissenter on this issue, particularly if it is relying on cooperation on other issues that could be more important to the U.S.

Face-saving mode was effectively launched by Deputy Chief Accountant Paul Beswick in a speech last December, as he described a hybrid convergence and endorsement approach, which with evident impish pleasure he dubbed, "condorsement."

Beswick – "[A] new set of priorities would be established where the FASB would work to converge existing U.S. GAAP to IFRS over a period of time for standards that are not on the IASB's agenda." [emphasis supplied]

Me – This is tantamount to re-visiting all of the many topics for which convergence was already given the old college try and failed. Bad idea.

Beswick – "At the same time, the FASB would have a process where they would consider new standards issued by the IASB for incorporation into U.S. GAAP … However, criteria would need to be established for [incorporation] – for example whether incorporation of a given standard is in the interests of U.S. investors or the U.S. capital markets." [emphasis supplied]

Me – In concept, "incorporation" doesn't sound so terrible, perhaps because I'm still trying to stop the ringing in my ears brought on by the pot bangers. But, I object to any suggestion that the U.S. should be reduced to seeking converged standards instead of superior standards. The whole notion of convergence rests on the presumption that it can be expected to result in enhanced comparability, and I think that presumption has already been demonstrated to be specious. Attaining convergence is never going to be any sort of valid rationalization for failing to promote a better standard than IFRS has offered.

And so it came to be a few weeks ago that the SEC announced that it would be hosting public roundtables this coming July on the question of "incorporating IFRS" [italics supplied] into U.S. GAAP. If "incorporation" is going to mean what Beswick said it means, I might be able to live with that outcome, so long as it doesn't mean that the SEC stays off the hook in determining any of the substantive issues – such as "whether incorporation of a given standard is in the best interest of investors," or whether a different standard would serve U.S. investors better.

So, I say let the "incorporation" discussions begin! But, whatever the outcome, the one thing that has to change is the SEC's passivity with regard to standards setting.  And, let's start now: if "incorporation" is what the SEC is really down to, why wait until July or later to inform the accounting standards setters that their convergence MOU is hereby rendered null and void?