When I started my blog almost exactly 3 years ago now, my opening strategy was to work down a rather limited personal inventory of pet peeves. I wanted to stay above the fray, but that proved impossible. I soon became hopelessly drawn to commenting on the helter-skelter stampede of recent developments driven by the Big Four's IFRS putsch and the undeniable role that lousy accounting standards played in the financial debacles of 2007 and beyond.
But, who really cares what I think? I suspect that the folks being paid the big bucks to make the tough calls on accounting standards don't pay a lot of attention to to the likes of Tom Whatshisname, even were I to announce that the sky is falling. But, I don't take it personally. Over the past 40 years, any PhD not drawing a salary from the Big Four has been viewed with more suspicion than respect by the standard setting establishment.
I mention all of this now, because there is a new voice, whose credibility and qualifications cannot be so easily dismissed. That voice belongs to FASB alumnus David Mosso, who has written an 80-page monograph entitled Early Warning and Quick Response: Accounting in the Twenty-First Century). If you don't want to believe me, take it from him: GAAP is broken.
Mosso is not just some average pedant. He has pretty much done and seen it all when it comes to accounting standards setting, most significantly having spent nearly twenty years at the FASB, and having been a board member for ten of them:
"I spent three decades in helping to create the accounting mess called generally accepted accounting principles, or GAAP. This book is an attempt to make amends." (page 1, italics supplied)
"Eighty years of tinkering [with a broken accounting model] has not done the job. … In the case of business failures, the company's auditors are usually the scapegoats, but I suspect that accounting standards are often more, or at least equally, at fault." (page 78, italics supplied)
I'm not trying to promote Mosso to oracle status, but coming from him—as opposed to whatshisnames like me—this should been seen more as an indictment than merely opinion. (By the way: just to be sure he wasn't just trashing GAAP, I asked David via email what he thought of GAAP/IFRS convergence. He replied that it was like the collision of two garbage trucks.)
Mosso's book has three principle themes:
- Financial reporting is a vital function; however, the politicization of standard setting has been far more harmful than beneficial. Words like "junk," "trash," and "garbage" permeate the references to current GAAP.
- GAAP must be fundamentally changed. Mosso's proposed system of accounting rules consists of little more than a few principles, which together comprise his "Wealth Measurement Model" (WMM). The gist of that model is to recognize "all" the assets and liabilities of an entity and to measure them at fair value, which apparently out of convenience is specified to be in accordance with existing FAS 157. Mosso claims that the comprehensive nature of WMM makes it capable of generating timely signals of looming problems to both investors and policy makers.
- Upon implementation of the Wealth Measurement Model, subsequent accounting standard setting could be limited to a sort of rapid-response version of the Emerging Issues Task Force for addressing implementation issues arising out of innovations in business practices and new technologies.
I don't have much to say about the third theme, because it's not a topic that I spend much time thinking about. I do acknowledge, however, that the current standard-setting system is seriously dysfunctional. And, I can't resist pointing to Mosso's contention that accounting standards should be run by academics, because "…accounting professors are the only group with the untainted standing to represent the public interest." Read, all ye good people, what this brilliant and eloquent man has thusly writ!
As to the pile of trash that GAAP has come to be (#2, above), I licked my chops when in the first chapter Mosso broadly hinted that his readers would receive the down low skinny on those back room machinations, which led to the accounting standards to bring him the most shame. However, there was absolutely none of that in the book. Mosso's only specific mea culpa was this tiny little snippet:
"When standard setting was formalized, standard setters seem to have taken the existing equity classification of [preferred stock, stock purchase warrants and stock compensation options] for granted without much scrutiny. I acknowledge that I did not challenge the conventional classifications when the conceptual framework was under development."
To his significant credit, however, Mosso may be the first real insider to broach the topic of standard setting dysfunctionality so comprehensively, even though I feel more than a little let down by his refusal to dish. Since Mosso is asking his readers to consider proposed solutions from an admitted creator of the problems themselves, I feel entitled to more of something like this:
"We wrongly promulgated X (and I voted for it) because of pressure from Y. The resulting harm was Z1, Z2 and Z3.
I gag every time I think of the quantities of toxic waste that my innocent son and his babe-in-the-woods peers are force-fed from their 1000+-page "intermediate accounting" textbooks. It would be nice if at least one of the authors of the master cookbook strongly advised students that many grains of salt should be added before consuming.
The Wealth Measurement Model
There is a great deal to admire about the WMM. In particular, I strongly support limiting owners' equity to basic ownership interests, and throwing goodwill and deferred taxes onto the trash heap.
But, I do have two important concerns; in regard to how Mosso would measure assets and liabilities, I believe he is not being ambitious enough; and in regard to which assets and liabilities Mosso would recognize, he is far too ambitious.
The Measurement Issues—Although Mosso states that assets and liabilities should be measured at their fair values, I suspect that deep down, he realizes that replacement cost is the attribute of an asset that corresponds to "wealth." I draw my inference of Mosso's true views from Chapter 5, wherein he discusses the insights to be derived from comparisons of the market value of a firm's equity to the replacement cost of its net assets – i.e., a variant of Tobin's Q ratio. Mosso's analysis clearly indicates his awareness that "wealth" embodied in productive assets like machinery is not correctly measured by the current amount for which the machinery could be sold, but for how much it would cost to replace its productive capacity. So, I find it slightly ironic that Mosso condemns the politics of standard setting, but himself seeks a political compromise with the hope of persuading proponents of fair value to embrace his WMM.
The Recognition Issues—These are an even bigger concern to me than the choice of fair value over replacement cost. Mosso contends that accounting standards can be written such that "all" assets and liabilities could be found on the balance sheet. I'll admit that the possibility is tantalizing, because it would eliminate off-balance sheet financing, and it would also transform what is now merely a "balance sheet" to a true "statement of financial position." Unfortunately, Mosso's vision is unrealistic; and here's a couple of examples to illustrate why:
- A competitor's misfortune provides an opening for an entity to introduce a new product. Such an opportunity is what is known as a "real option." An accounting definition of "asset" that would comprehend those circumstances would be far too broad to be of practical use.
- Without going into too much detail here, Mosso would require the recognition of "constructive" liabilities (even though that's not the term he uses), and for reasons I explain here, I would not support that.
Therefore, the set of assets and liabilities that would be eligible for recognition needs to be bounded in a manner that can be consistently applied and audited. For me, legal rights and obligations form natural and convenient boundaries. It has been my position that assets and liabilities recognized should be limited to legal rights of ownership, rights of use, and rights to receive assets in the future.
A Final Thought
When a member of the guild of royal sausage makers issues a health advisory, we need to find something else to eat. David Mosso's new recipe does not perfectly suit my tastes, but it's definitely restaurant quality.