The Accounting Onion

Goodwill Impairment: I Love a Charade (Re-posted)

Kind readers:  To the best of my knowledge, the first version of this post was not picked up by the software that magically distributes it to my email subscribers; therefore, I am re-posting it for them. I apologize to anyone who has received duplicate notices. 

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

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

To Illustrate

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

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

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

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

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

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

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

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

Is IFRS Any Better?

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

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

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

Don't Worry, Be Happy

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

I love a charade.

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

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

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

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

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

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

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

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

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

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

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

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

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

Spinning "Convergence"

"Converge" from Merriam-Webster's Online Dictionary:

1. to tend or move toward one point or another: come together: meet

2. to come together and unite in a common interest or focus

3. to approach a limit as the number of terms increases without limit

Now that it has become abundantly clear that convergence of IFRS and U.S. GAAP is not likely to happen, the proponents of IFRS adoption in the U.S. are trying to downplay its importance, and spinning what convergence is supposed to mean. That stratagem should come as no surprise to those who have observed the numerous instances where immutable plain English words have been misappropriated by accounting standards to serve as terms of art no more artful than Dickens' Artful Dodger.* (For some examples I have posted, see here, here and here.)

I have been meaning to write about the notion of convergence and its implications for some time now, but I was having trouble organizing my thoughts until I read D.J. Gannon's article, The IFRS Convergence Quandary.  Gannon is a Deloitte & Touche partner and as far as I can tell, he is his firm's point person on issues related to the SEC Roadmap.  (As Gannon seems to be singing in unison with the Big Four chorus, I hope that my criticisms are not taken to be a personal attack, but simply as a convenient point of reference.)

"Let's start with what convergence is. Convergence is designed to bring U.S. GAAP and IFRS closer together. The focus is on having similar general principles. Many have misinterpreted convergence as meaning the development of the same or "identical" standards. The reality is that convergence never really contemplated "identical" standards.

In fact, the FASB and IASB have acknowledged that doing so is too difficult to accomplish. This is evident in the boards' recently issued business combinations standards that contain differences in certain requirements. And, based on the boards' current thinking on topics such as consolidations and leasing, differences likely will exist in future converged standards."

I would like to suggest that a reading of very plain language in the Boards' 2008 joint progress reporton the Memorandum of Understanding between the FASB and the IASB indicates a very different view of "convergence":

"Convergence of accounting standards can best be achieved through the development of high quality, common standards over time." [italics supplied]

In other words, both Boards have stated that convergence was intended for GAAP and IFRS to actually meet, and not merely come "closer together." The distinction is crucial, because, by claiming that "convergence" has a meaning that is not in the ordinary-folks dictionary, proponents of IFRS adoption now seem to be trying to find excuses for a lack of progress on convergence—and more important, the increasingly dysfunctional relationships between prime movers at the IASB.  I also can't resist pointing out that the phrase "differences likely will exist in future converged standards" makes no sense without some special meaning for convergence, which neither appears to have been contemplated by the MOU nor accomodated by the dictionary definition of "converge."

As to what the FASB and IASB have "acknowledged" regarding their convergence efforts, the alleged facts are that IASB representatives sat in Norwalk as the FASB determined to finalize their new business combination standards (FAS 141(R) and FAS 160). Those envoys reportedly gave assurances that the areas in which the FASB was sticking its neck out would be adopted by the IASB as well. In essence, the IASB reneged on its assurances; and that's as close to an 'acknowledgement' that I am aware of.

Convergence Has Reached the End of the Road -- Now What?

Actually, D. J. Gannon and I do agree on one thing. We both believe that convergence has probably gone as far as it can go. Our differences concern the question of what to do next. Gannon thinks that the U.S. should be ready for IFRS adoption:

"…[Y]ou only have to look at the recent events surrounding the current financial crisis. What historically have been seemingly harmless differences between U.S. GAAP and IFRS now are the source of much politicization.

Take, for example, the issue of when companies can change the classification of financial assets, which in turn impacts the measurement of these items. Prior to last year, the "technical differences" on classification between U.S. GAAP and IFRS were never considered a significant issue in practice. However, the financial crisis put the IASB under tremendous pressure to conform IFRS to arguably a "lesser-quality" answer under U.S. GAAP. This is only one example of literally hundreds of differences between U.S. GAAP and IFRS that likely will never be addressed by convergence."

Actually, it was the EU (not the "financial crisis") that put the IASB under "tremendous pressure," and just as the FASB responded to the U.S. Congress, the IASB caved. I see nothing compelling about this particular case, but that's not my main point. I find it curious that of the "literally hundreds of differences" that could have been picked, Gannon happened to pick one whose lessons are obscured by anomalous constraints imposed by inefficient banking regulations. Just because Congress and the EU want to shoot the messengers, that doesn't mean the U.S. should appoint a new messenger who will no doubt be harder to shoot the next time Congress wants to engage in that distasteful exercise.  

Also, my wandering mind wants to liken the relationship between the FASB and the IASB, as set out in the 2002 MOU, to a crumbling marriage. Both spouses have made some very poor choices in the past and it's as if one spouse is desperately imploring the other to stay together despite a tumultuous past together. "Everything could be just like it was when we first fell in love if we started a family—just like we were planning when we got engaged!" (sob, sob)

Whoa. I say divorce now rather than take a crazy risk like having kids. And, don't think further counseling is the answer either. As Gannon points out, there are "literally hundreds" of irreconcilable differences. Maybe none of those little tics and peeves matter by themselves, but collectively they're sure to drive the whole family nuts.

In case you don't get it from my cutsey troubled marriage analogy, let me spell it out for you.  Adopting IFRS any time soon will require a giant leap of faith that is not at all warranted by past actions. 

What Exactly is the Problem that IFRS Adoption Will Solve?

I learned from a colleague some years ago that the way to resolve a turf battle is to ask the power grabber to describe precisely what the problem is they are trying to solve, and how their solution solves that problem. 

Gannon's opening statement lays out that problem, insofar as IFRS adoption proponents would have the rest of us see it:  

"One thing most everyone in the financial reporting community can agree on is the need for a single set of high-quality globally accepted accounting standards."

Let's start with the presumption that IFRS is "high-quality." I see that as the biggest reason why the arguments of IFRS adoption proponents are not persuasive to skeptics such as myself. To my way of thinking, the one thing that most everyone in the financial reporting community really should finally admit is that IFRS is deeply flawed, and U.S. GAAP is no better.

In far too many respects that belie any pretense of quality, IFRS merely apes GAAP. The GAAP standards that have wrought the savings and loan crisis, the pension crisis, the thousands of pages of hedge accounting rules, hidden executive compensation costs, and now the worldwide financial crisis are converged all right. They're converged at a point barely above lousy.  In short, we will certainly be no closer to high quality accounting standards by adopting IFRS.

As to the advantages of having a "single set" of standards, it would certainly be desirable for all financial statements to spring from a single set of high-quality accounting standards, but we are worlds away from that utopia.   Indeed, dysfunction is beginning to take over the IASB's most prized relationship, the EU.  Charley McGreevy is grumbling that the IASB may not be able to be satisfy the financial reporting needs of the EU, so it remains a distinct worst-case scenario that the U.S. could adopt IFRS just as the EU is trashing it.

But let's ignore that, and assume that we do end up with a single set of accounting standards, albeit badly in need of improvement.  In that case, I predict that, with the U.S. voice muted, the chances will only increase that broken financial reporting standards will stay broken. I still have high hopes that better financial reporting standards can be obtained, but getting them is much more likely to spring from competition between standard setters than cooperation. In all things capitalistic, competition breeds excellence; and cooperation is the fuel for a race to the bottom.

In summary, failure to converge may be a "quandary" for IFRS adoption proponents.  Should we stop convergence efforts and set the stage for adoption?  "Absolutely," they say.  "Damn the risks and costs... full speed ahead (towards higher consulting fees)!"  But for me, the whole notion of convergence is, and always has been, nothing more than propaganda.

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*"He was a snub-nosed, flat-browed, common-faced boy enough; and as dirty a juvenile as one would wish to see; but he had about him all the airs and manners of a man." (Oliver Twist)

SAB 112: Let the New Earnings Game Begin

In a recent post on business combinations accounting that is related to SAB 112, I criticized the FASB for creating yet another loophole in business combinations accounting that make M&A transactions more attractive than they really should be. To recap, I described how JP Morgan wrote down toxic loans acquired from WaMu so that, going forward, JP Morgan had a built-in stream of future earnings at very high interest rates.

First, a Mea Culpa

I was feeling pretty satisfied with myself until reader Michael interrupted my reverie with several interesting and valid comments. With great reluctance, I began to re-think parts of my screed.

First of all, he found a couple of inaccuracies in my telling, which should be corrected:

"Tom, I think I'm with you on your conclusion (i.e. mark all financial assets to fair value (replacement cost?)) but the area of GAAP causing the inconsistent measurement is not FAS 141(R). FAS 141(R) was first effective for transactions that closed on or after 1/1/09 for calendar year companies. JPMorgan was subject to FAS 141 (no R) for this transaction and disclosed as such. However, you may be aware that even under FAS 141, certain loans were required to be accounted for at fair value, notwithstanding the SAB [Topic 2A-(5)]...those loans that were purchased at a significant discount are subject to the guidance in SOP 03-3, which requires a fair value measurement [at the acquisition date] for such loans. Given the purely awful composition of WaMu's portfolio, it is not surprising that half their loans fell into that guidance. I think most of the focus should be on the criminal allowance put up by WaMu pre-transaction...$2 billion on $240 billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes." [italics and bolding supplied]

That's a really interesting last sentence, especially coming from an auditor, and I'm betting that even the PCAOB will not want to go near that one. As important as that may be, it's a digression from the mea culpa I now proffer to all who read that post: I overlooked the fact that SOP 03-3 would be applicable, because I mistakenly thought the acquisition of WaMu was accounted for under FAS 141(R).

Michael's comment and my mea culpa notwithstanding, the fact remains that henceforth, FAS 141(R) has taken over for SOP 03-3 in the earnings management toolbox when it comes to making sure that a business combination transaction will be accretive to future earnings. (Note: that doesn't mean that SOP 03-3 has become obsolete. Loan acquisitions that are not part of a business combination are also within its scope.)

Michael also responded to my suggestion that the offending provision of FAS 141(R) should be suspended until loans are fair valued.  He pointed out that should that day ever come, the invitation for earnings management of which I spoke doesn't completely go away:

" … [L]et's assume that all financial instruments were remeasured each period at fair value. While there will be timing differences with loans that are measured at fair value at acquisition, net income over the life of the same loans will be the same...if JPMorgan had to continue to remark the loans, they'd still recognize that accretion into earnings if the loans ultimately perform. I understand your generally well founded skepticism, but I think this is one of the less offensive areas of FAS 141R.

Michael is right (again). I could live with an outcome whereby unbiased fair value measurements will provide a stream of accounting earnings to an acquiree. But, I am indeed more than a little skeptical that two versions of fair value will emerge from FAS 141(R)—if they haven't already from other games that executives will play with earnings. The WaMu's will still have strong incentives to overstate market value, and even Michael implies that auditors are not likely to stand in their way. The JP Morgans of the world have incentives to understate the same fair values.

Enter SAB 112

That's where SAB 112 comes into the discussion. Among other ministerial changes, it deleted Topic 2A-(5) of the SAB codification, which I described in the earlier post and became unnecessary after FAS 141(R) instituted the fair value requirement for acquired loans. The crux of this post is this: if the SEC thought that manipulation of loan loss reserves during a business combination merited an anti-abuse rule, then more than ministerial adaptations were called for.  How can the SEC be so naïve as to think that fair value will fix the problem of loan value manipulation? Instead of merely deleting Topic 2A-(5), they should have re-written it to put the brakes on what will surely become a new recipe for chicken salad. It would have been really simple for the SEC to make the following rule:

Irrespective of pre- and post-acquisition bases of measurement, the new carrying amount of every asset recognized may be no less at the date of acquisition than the carrying amount recognized by the acquiree; similarly, the fair value of liabilities assumed may be no greater than amounts recognized by acquirees.

I know that my suggestion may sound unprinicpled and draconian to some (and I would be prepared to allow for some exceptions), but the reality is that no set of business combination accounting rules will be perfectly 'efficient.' For any accounting rule, it is inevitable that some value-creating transactions will be discouraged, and some value-destroying transactions will occur because the accounting result is too sweet to resist. The key for regulators is to strike an appropriate balance based on broadly acceptable objectives for financial reporting.

In regard to business combinations, there have been no such objectives ever before.  It is clear that the rules have been completely out of whack since the inception of GAAP in the 1930s. As for the last few decades, the evidence is crystal clear that our economy has been administered a nearly lethal dose of value-destroying business combinations to juice executive compensation while killing share prices and wreaking havoc among rank and file employees. That's why I believe it is time to trying something more radical: an acquiror should not be able to create a stream of reported earnings by writedowns to assets or increases to liabilities. Therefore, post acquisition writedowns of assets and write-ups of liabilities would be charged against the post-combination earnings of the acquiror.

Let's see if the 'new SEC' is up to the task. We'll know they're doing it right if the EU and IASB have conniptions over it.

FAS 141(R): Turning Toxic Loans into Star Performers*

From a MoneyNews.com story published this Wednesday headlined "Banks Stand to Reap Billions from Purchased Bad Loans," came an account of a jaw-dropping transaction. It was spawned by FAS 141(R), the latest and greatest standard on accounting for business combinations:

"When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule [FAS 141(R)] to record impaired loans at fair value, marking down 118.2 billion of assets by 25 percent.

Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank within an accretable-yield balance that could result in additional income of $29.1 billion."

Business combination accounting has forever been fertile ground for earnings and balance sheet management for one simple reason: the opportunity to tweak the amounts reported for the assets acquired and liabilities assumed, with the ultimate objective of brightening post-acquisition earnings reports. But, as tiresome as that old game might be, the kind of maneuver that JPMorgan's management has engineered is a novel twist on an old loophole that had once been closed pretty tightly by the SEC.

The Closed Loophole that Would Be Re-Opened by the FASB

Once the "pooling of interests" method of business combination accounting of APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)), the most basic surviving principle of business combination accounting became thus: the acquisition of a business should always be reflected on the financial statements of the acquiror by assigning a new carrying amount to each of the acquired company's assets and liabilities. This new carrying amount would be updated, based on current assumptions and estimates regarding the future role of the acquired assets and liabilities in the combined entity. The implementation of this principle had long been known as the "purchase accounting" method for business combinations.

With certain important exceptions, SFAS 141 mandated that new carrying amounts for assets acquired in a business combinations would be based on their fair values. The exception that is germane to the JPMorgan story pertains to loans (i.e., trade receivables, interest-bearing loans and marketable debt securities classified as held-to-maturity). The measurement bases for these items were carried forward from APB 16's version of the purchase accounting method: a gross amount reduced by an appropriate allowance for uncollectible accounts. This exception to loan measurement was important, because it also meant that a 1986 SEC staff position would still be applicable to purchase accounting.

At that time, the SEC saw fit to put a stop to unwarranted increases in the allowance for loan losses as part of the business combination transaction. Increases to loan loss allowances would mathematically transfer future loan losses to goodwill, where they would be deferred indefinitely, with the effect of reporting inflated earnings in future periods as the loans were eventually settled for more than their understated carrying amounts. Staff Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit any adjustments of the acquiree's estimate of loan loss reserves, unless the acquiror's plans for ultimate recovery of the loans were demonstrably different from the plans that had served as the basis for the acquiree's estimates of the loss reserves.

FASB Amnesia?

FAS 141(R) did away with the "purchase method" and established the "acquisition method" of accounting for business combinations. It apparently did so out of a belief that measurements of assets and liabilities that are based on the most current information available are usually, if not always, preferable to valuations based on less-current information. The JPMorgan case glaringly points to a significant flaw in that belief: inconsistent application of fair value could be more harmful than consistent application of a less desirable attribute. As to the case at hand:

• WaMu, as is quite common, accounted for its loans based on a held-to-maturity model. That is, except for recognizing declines in creditworthiness, the loan carrying amount is based on the original contractual terms; interest is accrued by multiplying the net carrying amount by the yield to maturity as of the date the loan was originated/acquired.

• Even though the market value of these loans had declined significantly as they turned toxic, WaMu apparently was not required to record losses to bring the loans down to their fair values.

• JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans to market. Subsequent accounting by JPMorgan will continue the WaMu the held-to-maturity model.

It would be a pretty safe bet that JPMorgan was very 'conservative' in their estimates of fair value for the loans; that's because the lower the fair value, the higher the yield to maturity, and the higher the amount of reported future earnings. Of course, there are some limits to JPMorgan's estimate of fair value: auditor pushback, SEC review, increased risk of goodwill impairment charges, and capital adequacy regulations. But, at least in this case, it is possible to become rich without being greedy.

Where is the SEC!?

Maybe there has been more coverage of this issue, but I haven't seen it; kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that bank executives are being overcompensated, especially on the taxpayers' dime, here is a prime example of where insufficient oversight has spawned a new source of moral hazard.

For starters, the SEC should put a stop to this obvious and blatant abuse, immediately. They should issue another SAB, carving out the offending provision of FAS 141(R) and restoring the long-established and functioning status quo. Every company that benefitted from the ill-conceived accounting rule should be forced to retroactively restate their earnings – especially any financial institution on the government dole.

Perhaps the lack of permanent leadership in the Commission's Office of the Chief Accountant is contributing to a lack of attention to this obvious problem, but it is in no way an excuse. Also, this is a problem created by the FASB. Let's be charitable and call it an unintended consequence, but whatever the cause, the FASB should move to fix it forthwith. I'm suggesting that the SEC should act first, solely because they have the demonstrated capability of being able to move the fastest. That's because a SAB doesn't have to be exposed for comment before it can be issued.

But, lacking any actions by either the FASB or SEC to put the cat back in the bag, auditors (perhaps via the PCAOB), and boards should be put on notice of a new potential scheme to inflate executive compensation in the absence of actual value creation for stakeholders. If a single dime of executive compensation comes out of accreted excess earnings from these business combination games, I hope that private securities lawyers will round up the proxies and the lawsuits, settling for nothing less than "a pound of flesh."

A larger lesson is important to briefly discuss in order to understand how this kind of loophole can occur: in accounting for financial assets, the only workable system is comprehensive mark-to-market, all of the time. The current situation is a consequence (intended or otherwise) of the piecemeal approach pursued by the FASB (and IASB) towards fair value accounting.

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*Note:  I made a technical correction to this post, that you can view here.

High Time to Abandon the Accounting for Contingent Liabilities

What the FASB calls "contingent liabilities" in FAS 5, the IASB terms "provisions" in IAS 37. I prefer the IASB's language, because of its pejorative ring to my American ears: it more clearly connotes the virtually unchecked discretion issuers have abused to obfuscate liabilities and trends in earnings.

In a previous post, I described how the IASB has been working on giving issuers even more discretion to manage their provisions.At the same time, the FASB has been fighting the good fight, but getting its butt kicked in the process. Their latest defeat was the issuance of FSP FAS 141(R)-1, to back off of their requirement to measure at fair value contingent liabilities assumed in a business combination.

Part of the FASB's problem is that they still haven't fully come to grips with measuring the fair value of any liability, much less a contingent liability. It seems reasonable enough to aim for consistent measurement of all assets acquired and liabilities assumed; but, how does one measure the fair value of a matter under litigation? Even if it were legal to pay a third party to assume the consequences of a matter in litigation, a 'moral hazard' is likely an unwanted by-product. Specifically, the transferor's incentives to act in ways that could lessen the ultimate consequences of the obligation could diminish significantly. The bottom line: score one for the issuers who fought the offending provisions in FAS 141(R) and made the FASB retreat.

But, as the FASB has retreated in one area, it is retrenching in another with the issuance of Proposed FSP No. FAS 157-f, Measuring Liabilities under FASB Statement No. 157. The FSP, among other things, addresses fair value measurement of a liability when contractual restrictions may prevent it from being transferred. The proposed FSP provides that if a quoted price in an active market for the identical liability is available, that price must be used to measure fair value. In all other circumstances, fair value would be measured by selecting the one approach, of four allowable approaches, that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The four allowable approaches are as follows:

• The quoted price of the identical liability when traded as an asset in an active market;

• The quoted price of the identical liability, or the identical liability when traded as an asset in markets that are not active;

• The quoted price for similar liabilities, or similar liabilities when traded as assets in markets that are active;

• Another valuation technique that is consistent with the principles of SFAS 157.

So, as best as I can tell, the issue of measuring contingent liabilities is still not resolved. Since FAS 157 defines the fair value of a liability as the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date (para. 5), it seems that the FSP is providing no help for contingent liabilities. The first three approaches permitted by the proposed FSP are clearly inapplicable, and there is nothing new in the fourth approach that would permit the evaluation of a contingent liability from the perspective of the asset holder.

A Solution: Assume There is No Problem

As I mentioned earlier, both the FASB and the IASB have been working on the contingent liability problem in their own separate ways. The FASB has been getting lambasted for their proposals to enhance disclosures and fair value measurement, while the IASB is going on its merry way to see how they can make a new and improved version of chicken salad for issuers. They have been mulling over an approach that would recognize all 'present obligations' (whatever that means), regardless of likelihood of payment, if they can be measured 'reliably' (whatever that means).  Since likelihood of payment is being taken out of the equation, whatever 'present obligation' means is the crux of the matter. And, as it turns out, a hypothetical case scenario that the IASB discussed during its deliberations is a convenient vehicle for me to express how I think contingent liabilities ought to be handled.

Here's the case:

A vendor sells hamburgers in a jurisdiction where the law stipulates that the vendor must pay compensation of C100,000 to each customer who receives a contaminated hamburger. Past experience indicates that one in every one million hamburgers is contaminated. On the last day of the reporting period, the vendor sold one hamburger.

And, here are some questions, along with my responses:

Question #1: Does the vendor have a present obligation at the balance sheet date?

My response: No.

Businesses have many responsibilities under various laws: reasonably ensuring that no physical harm will come to their customers as a result of their actions, truth in advertising, not polluting, and so on and so forth. Although investors would care to know about these exposures and their potential affect on future cash flows it is simply not practical to convey this information through recognition of contingent liabilities on the balance sheet.  It has been vividly demonstrated over the past 35 years that FAS 5 has been in existence that it is a pipe dream to think that reliable estimates can be expected from issuers when doing so conflicts with the interests of executives. (Note as well, that the ability to precisely state an amount for the contingency does not affect my response to this question.)

Question #2: Does the answer change if the probability of contamination is more likely than not instead of one in a million?

My response: No.

This gets at the key issue as to whether the probability of an outcome should determine whether a contingent liability is recognized. I agree with the IASB in so far that the probability of an outcome should not affect recognition. Whatever their reasoning, however, mine is that FAS 5 and IAS 37, which depend on probability estimates, have failed. Moreover, from my point of view, which is different from theirs, it is undesirable to let preparers continue to abuse the opportunities to exercise "judgment" in FAS 5 to manage earnings. The only solution is to restrict liability recognition to legally certain obligations.

Question #3: Should the answer change if the customer who purchased the hamburger claimed it was contaminated?

My response: No, unless it is established with virtual certainty that the vendor has a legal obligation.

I admit that judgment would be required to determine whether a legal obligation exists, but it is significantly less consequential than estimating probabilities and expected outcomes of contingent liabilities.

Question #4: Reverting to the original scenario, should the answer change if the vendor warranted the safety of their hamburgers, and stood ready to pay C100,000 to anyone with a valid claim?

My response: Yes.

The vendor clearly has a present obligation to stand ready to compensate customers who have been served contaminated hamburgers. That obligation is strongly analogous to an insurer's obligation, and should be accounted for the same way. Amazingly, neither GAAP nor IFRS currently require recognition of liabilities arising from a product warranty unless the warranty is separately priced.

Question #5: Reverting to the original scenario, should the answer change if there was a "constructive obligation" to compensate customers who were served with contaminated hamburgers?

My response: No.

Basically, a constructive obligation is defined in both GAAP and IFRS as a non-legal obligation inferred from business conditions indicating that if a payment would not be made, then the impairment of future business prospects would be greater than the payment saved. While there is some justification to be made on economic grounds, the practical problems of inviting preparers to exercise "judgment" once again trump.

 

In summary, after years of thinking about ways to improve the accounting for contingent liabilities, I am now throwing in the towel on what I have come to see as a futile exercise. By limiting liability recognition to present legal obligations, standard setters can kill two birds with one stone: first, financial statements will become more reliable and auditable; second, some of the difficult issues in measuring the fair value of liabilities that have not yet been satisfactorily addressed would become moot.

Compromising Accounting Principles: A History Lesson (and a Mea Culpa)

(I apologize to anyone who has read an earlier version of this post. Due to a problem with my blogging software, it was not sent out to subscribers. Therefore, I am re-posting it.)

First, the Mea Culpa

Over the year that I have been writing my blog, I have been fortunate to receive kind words every now and then from readers.  Writing alone, being provocative at times, and hitting the "publish" button perhaps too soon to meet a self-imposed deadline often combine to give me an uneasy feeling that I could be sitting way out on a high limb.  It was inevitable that at times I have been accused of being wrong, but never unfair -- until now.

I recently received from two readers similarly critical missives concerning some not-so-nice things I wrote about Jim Leisenring, former FASB and current IASB member. One of the commenters, identifying himself as "Guest," wrote:

"That's a pretty unfair attack on Leisenring with no appropriate context regarding the background of FAS 133. The alternative to FAS 133 was virtually no recognition of derivatives in financial statements. Is it perfect? No. Were compromises made? Absolutely. But it was better than what was there before. And it certainly doesn't indicate a pattern of Jim "capitulating to the majority." If you've ever met Jim [actually, I have], then you know he's not real concerned with what the majority thinks." (comment in brackets is mine)

After thinking about these comments for a few days and discussing it with my genious wife, I have decided that I owe an apology. When I gratuitously remarked that I was not surprised by Jim Leisenring's decision to "capitulate" on IFRS 3(R) because of his past participation in FAS 133, I crossed a line.

The Point I Was Really Trying to Make

Now that I hope I have cleared that up to the satisfaction of all, I want to address the related issue raised by Guest, which should have been the real point of my criticism.  I do not believe that compromising one's principles in crafting accounting standards in the name of incremental progress can be expected to produce a net benefit for investors.

Merely being "better than it was before" (to quote Guest) may still be far from good enough, and there is plenty of U.S. GAAP history to back that up. The table below is a partial list of standards where compromises clearly must have occurred, and serious consequences ensued:

Statement	What Gained	What Lost and Consequences
FAS 87 - pensions	Balance sheet recognition of some pension liabilities.	Timely recognition of gains and losses in pension plans. Plans were mismanaged because of FAS 87.  The toll in shareholder value destruction and lost pension benefits has been enormous.
FAS 13 - leases	On-balance sheet treatment of some leases	Most leases can still be classified as "operating." Managements have misspent vast sums over the past 30 years on financial advisers and auditors because FAS 13 invites unnecessarily complex and inefficient lease contracts.
FAS 133 - derivatives and hedge accounting	Fair valuation of derivatives	Complex and unprincipled hedge accounting rules distort values of other assets and liabilities, or permit deferral of gains and losses from holding derivatives. Managements engage in costly and inefficient accounting hedges that may not result in appropriate hedges of economic risks. The value destruction caused by Fannie Mae's misapplication of FAS 133 may be enough by itself to regard FAS 133 as having failed.
FAS 115 - marketable securities	Current values for some investments whose market value is readily determinable	Securities classified as available-for-sale or held-to maturity categories are mismanaged because ofFAS 115. The held-to-maturity category unreasonably deprives investors of current value information.
FAS 123 - stock options	Grant date present value of options granted to employees	Because of FAS 123's option for footnote disclosure without income statement recognition, excess stock options were granted to employees.
FAS 114 - loan impairment	Consistent measurement of impaired loans	Measurements are still based on historic interest rates, and the criteria for timing of loan loss recognition provide inappropriate discretion to manage earnings. As a result, investors have been deprived of accurate and timely information; management makes inefficient decisions on delinquent loans out of a desire to manage reported earnings.
FAS 141, 142 - business combinations	Elimination of pooling of interests and amortization of goodwill	Costly goodwill impairment test on a number that provides minimal information to investors. As a result, excess financial statement preparation, auditing and consulting costs are incurred.
FAS 95 - statement of cash flows	Converting inconsistent funds flow statements to more consistent cash flow statements.	The direct method of presentation is rarely used, depriving investors of information regarding actual operating receipts and disbursements.  Subsequent attempts to revise this glaring flaw in FAS 95 have failed.

What would have happened in each of these cases if those who those who gave up the fight in the name of incremental progress refused to yield the high ground?  For example, how would derivatives and non-derivative marketable securities be accounted for today if compromises had not been made ten and fifteen years ago? Fair value is still the only plausible answer. The lost momentum of compromise with closure reigns forever and a day.  In the case of FAS 133, it's been 10 years and counting.  As for lease accounting, it's been 30 years and even getting a second wind no less; the FASB has recently announced that it is limiting the scope of the project to revise lease accounting rules, which has already dragged on for far too long.  I may be able to add to my list of compromises with negative examples, and I cannot think of a single compromise that ended up as a standard making those who compromised eventually look like heroes instead of patsies.

My point is that the absence of patience and fortitude can leave its stain on accounting standards for generations.  The IASB's process leading to IFRS 3(R) tells me that the lessons of history demonstrating the futility of compromise go unheeded by the putative heirs to U.S. GAAP.

I have read from numerous sources that adoption of IFRS in the U.S. is regarded to be "inevitable." I don't know about that, but I am convinced that uneconomic mergers doing immeasurable harm to both shareholders and work forces will occur because of IFRS3(R)'s loosey-goosey business combination standards. Even more important, if the non-U.S. members of the IASB come to understand that we in the U.S. are effectively committed to allowing sausage-factory-style accounting standard setting in our capital markets, we will be doomed to a steady diet of sausage.

That's why Jim Leisenring should not have voted for IFRS 3(R). 

The Revisions to IFRS 3: Bad Enough to Abandon Faith in IFRS?

In my previous post, I described how an SEC honcho, while speaking to the choir at an event sponsored by FEI, espoused his version of faith-based accounting; though he could not provide a single, solid reason to explain why the U.S. should adopt IFRS, he has seen the light and has become a true believer.   In contrast, reason-based accounting permits recitation of a vast litany of blasphemies against IFRS to make one a serious, if not committed, agnostic.  Today, I write of one of these latest abominations: the latest revision to IFRS 3 on the accounting for business combinations.

Goodwill and NCI:  IASB Fakes Right and Goes Left

Perhaps the most significant development in the accounting for business combinations is that FAS 141(R) now requires the same basis of measurement for assets acquired and liabilities assumed, regardless of the percentage of a company acquired (so long as control is achieved).  Therefore, if control is attained without purchasing 100% of the existing equity interests in the acquiree, non-controlling interests (NCI) must be measured at full fair value. 

As you may be aware from reading my post "What Good Comes from Goodwill Accounting?", I am not a big fan of recognizing 'goodwill' under any circumstance, so I will grant that the justification for the FASB's approach is not airtight.  Nevertheless, it was common knowledge that the FASB was given to understand that, by sticking its neck out to make these controversial changes to FAS 141(R), the IASB would follow suit. 

Instead, the IASB renegged on its promise in the worst way imaginable: they voted to allow entities a free choicebetween the partial and full fair value alternatives to goodwill and NCI measurement.  What's more, issuers can make their choice on a transaction-by-transaction basis -- kind of like going to church one week and synagouge the next.  Not even the most devoted acolyte can spin this any other way except as a significant step backwards from establishing the IASB as a credible agent of quality financial reporting and investor protection. 

And, it's not just me who is outraged.  Read the strongly-worded dissents* of Mary Barth and John Smith, two of the three Americans on the IASB.  As to the third American, Jim Leisenring, I guess I shouldn't be surprised that he capitulated to the majority.  Leisenring was the most prominent voice in support of FAS 133 (on hedge accounting) when he was on the FASB; a standard whose middle name is inconsistency.  Be that as it may, one can only imagine where the IASB will take the interests of U.S. investors when our membership, and hence our influence, on IFRS inevitably wanes. 

Mind These GAAPs, Too 

If the unprincipled and unconstrained choice of accounting treatments for goodwill and NCI aren't enough for you to abandon any faith in a high-quality convergence, consider two more of the numerous departures from U.S. GAAP; these may be even worse.

First, the devilish game of managing the timing of contingent liabilities still thrives in IFRS.  FAS 141(R) now requires that any non-contractual, contingent liability assumed in a business combination must be recognized at fair value, if the probability of occurrence is more likely than not.  IFRS allows any contingent liability to be recognized, regardless of likelihood, if it can be reliably measured. 

As I discussed in a previous post on IASB machinations of contingent liability accounting, the ubiquitous criterion of "reliable measurement" is one of those areas of "judgement" in IFRS that help management make their numbers with little chance of being challenged by auditors.  Here is how this game will be played in a business combination under IFRS 3(R):  if management thinks that goodwill won't be impaired any time soon, they will recognize contingent liabilities to the max.  The effect is to create an earnings bank of liability writedowns when unlikely events become, as anticipated, resolved without the incurrence of an actual liability.  And speaking of inconsistency, IFRS 3(R) provides that all intangible assets are to be recognized, even if their fair values cannot be measured reliably.  Where is the "principle" for that one? 

Second, FAS 141(R) requires extensive disclosures that are designed to aid analysts in determining the past and future effect of a business combination on earnings and financial position.  For example, FAS 141(R) requires the following disclosures:

• The amount of revenue and earnings of the acquiree since the date of acquisition. 
• Revenue and earnings of the combined entity for the current period as though the acquisition had been consummated as of the beginning of the period
• Revenue and earnings of the combined entity for the previous period, as if the acquisition had been consummated as of the beginning of the previous period. 

Inexplicably, IFRS does not require the third item, above.  Therefore, inferences as to earnings trends of the combined entity from historical financial statements are defeated.

The recent activities of the IASB, the high priests of IFRS, confirm that they are most definitely not the august body to which the future of U.S. financial accounting standards should be entrusted.  To those who persist in practicing faith-based accounting, put IFRS's accounting for business combinations in your pipe and smoke it.

--------------------------

*Unlike statements of the FASB, IFRS publications are not freely available.  Just thought you might want to know why I didn't provide a link.

Peeling the Onion on the New Business Combination Standards: FAS 141R and FAS 160

This post examines the onion skin, if you will, of the new business combination standards. I'm going to explain the differences between the so-called 'purchase' method of accounting and the new 'acquisition' method. As is my habit, let's begin with a simple example.

Assume that ParentCo acquires 70% of the outstanding shares of SubCo for $1,000. Additional facts are as follows:

• ParentCo estimates that the fair value of 100% of SubCo is $1,405:
  • You should note that the fair value of SubCo may not ordinarily be calculated by extrapolating the purchase price paid to the remaining shares outstanding (i.e., $1,000/70% = $1,429 is not ordinarily the fair value). The reason is that a portion of the purchase price contains a payment for the ability to exercise control.
  • In this case, the control premium would be $55, calculated as follows:

($1000 - .7($1405))/(1-.7) = $55

• It may be difficult to estimate the control premium, because it may have to be derived from an estimate of the full fair value of the acquired company, as above.
• The book value of SubCo's assets and liabilities approximate their fair value, except for one asset with a remaining useful life of 10 years. For that asset, the fair value exceeds the book value by $100.

The table below displays the following: (1) respective balance sheets of ParentCo and Subco at the date of acquisition, (2) consolidated results under the purchase and acquisition methods, and (3) the goodwill calculations under each method.

The purchase method had a lot of warts, but it took the FASB decades to replace it. In essence, it was nothing more than a slavish application of the historic cost principle to mute the future effect of an acquisition on operating expenses. The idea was that if you purchased 70 percent of the outstanding shares of another company, then revaluation of assets would take place only to the extent of the shares purchased. Among other things, this meant that the basis of the assets of a subsidiary acquired in business combination transaction would be the sum of the fair value of the portion acquired and the historic cost of the portion not acquired. This is illustrated above by the calculation of consolidated assets: $2,000 + $800 + .7($900 - 800) = $2,870. The mix of fair value and historic cost to measure one asset reminds me of something my father would say when someone (mainly me) was less than fully committed to a principle: "you can't be half pregnant."

The acquisition method represents a full commitment to fair value, yet ironically, the FASB still doesn't require fair value for all assets and liabilities assumed (more on that in another post). In other words, if the transaction results in the acquisition of control of an entity, assets acquired and liabilities assumed will be initially measured at 100% of their fair value--even if less than 100% of the outstanding shares are purchased. That's why consolidated assets are $30 higher in the illustration under the acquisition method.

The example also illustrates two other important differences between the methods:

• The consolidated amount attributed in consolidation to the non-selling shareholders was� termed 'minority interests' under the purchase method. It was reported on the balance sheet between liabilities and shareholders' equity'; and following the same reasoning allowing half-pregnant measures of consolidated assets and liabilities, was measured based on the historic costs of the subsidiary. 'Noncontrolling interests' (NCI), has replaced minority interests, and are now measured on the same basis as the 'controlling interests', and firmly categorized as part of shareholders equity.
  • Well, maybe not so firm. See my post on the FASB's recently issued Preliminary Views document entitled Financial Instruments with Characteristics of Equity, which proposes to move NCI to liabilities. In fact, one intrepid FASB member objected to the issuance of FAS 141R until the FASB could actually enunciate clear principles for distinguishing between liabilities and equity. Until then, it's just another rule that's subject to change.
• "Goodwill" is higher under the acquisition method, because as can be seen by comparing the calculations, it now includes amounts attributable to NCI.
  • What hasn't changed, though, is that goodwill is still a euphonious sobriquet for a random number masquerading on the balance sheet as an asset measurement. (I'll write more about this in a post soon to come.) Under the purchase method, it's the difference between the purchase price and amounts for the other assets and liabilities recorded. Under the acquisition method, it's fair value of SubCo (equivalently, purchase price plus amount recognized for noncontrolling interests) minus the amounts for the other assets and liabilities recorded. SFAS 141R may describe goodwill in more dignified terms, but the way I just did is more accurate. At least I'm not as blunt as Walter Schuetze, former SEC Chief Accountant, who is fond of calling goodwill "the lump left over." I smile to myself every time I think of that.

Since only balance sheet differences are illustrated above, I have only told part of the story so far. The table below extends the illustration to the end of the first year subsequent to the acquisition of SubCo.

The foregoing illustrates that there is an additional step on the income statement. It may be hard for some people to get used to, but net income is no longer the bottom line. In fact, the bottom line doesn't change in this case, because $3 of additional depreciation expense is recorded, but it is taken out of the earnings attributed to NCI. If you are familiar with the SEC's required presentation of 'net income applicable to common stock (SAB Topic 6.B.1), you will know that the idea is not new.

Well, that's all for now. If you want to look at my spreadsheet, you can get it by clicking here. I'll have a lot more to say about goodwill and accounting for business combinations in the near future, and it won't be pretty.

Note: The original version of this post contained an error in the calculation of the control premium. Thanks to Wallace Enman of Moody's for pointing out the error, and for helping me to get it right. Thanks also to Barb Foerster of Western Union for finding another technical error that I have now corrected.

EITF 07-1: Can a Good Accounting Rule Drive Out a Bad One?

It seems that business practice tends toward greater exploitation of opportunities for collaboration over time.  On a personal note, it has been said that people don't choose to become professors because they are smart, but because they couldn't play nicely (i.e., collaborate) with other children. 

My own neuroses aside, the first standard on the accounting for collaborative arrangements, APB 18, was the subject of one of my earlier rants--I mean posts.  EITF 07-1, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property, is a recent and interesting sequel to APB 18. 

Setting the Stage for Evaluating EITF 07-1 

At the risk of appearing to re-invent the wheel, I'll start with a broad look at collaboration itself. It seems that there are two kinds:  (1) financial arrangements to provide capital (i.e., wealth or risk transfer), and (2) operational arrangements to use capital effectively (i.e., wealth creation).  There is no dearth of detailed accounting rules governing financial collaborations, with the multi-tentacled 'Liabilities and Equity' project being just the latest example.  However, operational collaborations have not received near the same attention, despite their prominence and importance to investors.

As EITF 07-1 is about operational collaboration (my term, not theirs), let's go deeper into that concept; it seems that there are two ways to operate a business: with and without collaboration.  Here's a list, including annotations of related accounting rules, to illustrate what I mean:

• Operating modes not involving collaboration
  • Develop a product, purchase equipment and inventory, pay salaries and overhead, sell finished goods. (All of the rules you were introduced to in Accounting 101)
  • Acquire a controlling interest in another company that will take over, or complement, one or more business functions. (FAS 94, FAS 141, FAS 142, FIN 46(R))
• Operating collaboratively
  • Acquire a stake in another company that is less than controlling, but large enough to be able to influence its operations in ways that can benefit your own. (APB 18)
  • Acquire a stake in a joint venture (JV) that will do part of the work.  No investor in the JV can act without the permission of the other venturers. (The AICPA has impaled JVs with APB 18.)
  • Retain an agent, compensated with commissions, to help you sell or buy inventory. (EITF 99-19 provides guidance to determine whether you should accounting for a transaction as an agent or as a principal.)
  • Contract with another company to divide up the work. (EITF 07-1)

EITF 07-1,considers four related issues:

1. What constitutes a collaborative arrangement for the purpose of the new rule about to be created?  This is a fence-building exercise for the purpose of preventing encroachment on the scope of other standards and practices--mainly APB 18.  It would not be necessary to do so if the FASB were to take instead a way overdue fresh look at collaborative arrangements.  But, for the purpose of this post, the following example of a collaborative arrangement will suffice:
   
   Company A, having secured patents for a new product, collaborates with Company B, which has a manufacturing facility and an established distribution channel.  The companies have entered into an agreement whereby A will perform the development activities and B will perform the commercialization activities.  All revenues and costs would be split equally.
2. Reporting costs incurred and revenues generated by the collaborators from transactions with third parties.  This is the issue (hereinafter, Issue 2) that I will focus on.


3. Reporting revenues and expenses generated by a collaborator from transactions with other collaborators.  This is an important issue, but not as important as Issue 2 in terms of examining how EITF 07-1 affects the tenor of the accounting for collaborative arrangements.


4. Disclosure. 

The EITF's tentative consensus on Issue 2 is that, unless one party is acting as an agent for the other (see EITF 99-19), each party records its share of expenses and revenues separately on their income statement. 

Get to the Point!

The tentative consensus on Issue 2 makes sense.  That means they contradict the nonsensical presentation provisions of APB 18.  Under APB 18, each collaborating party would report its share of revenues and expenses net, and not gross as would be required by EITF 07-1.  In other words, the legal form of the collaboration (whether or not the collaboration is housed in its own legal entity), and not its commercial substance, will dictate presentation.  This is especially curious since the stated reason for the EITF taking up the issue was to achieve greater uniformity. 

Finally, take note that EITF 07-1 has not yet been ratified by the FASB.  I wonder if they have considered the implications of the issue on APB 18 as I have.  If so, do they care?