The Accounting Onion

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.

On the New Conceptual Framework - Part 2

To begin this second installment on the boards' (IASB and FASB) Conceptual Framework project, here is a brief summary of my first post.

• A 'bridge to nowhere' – The boards (FASB and IASB) are planning to construct a new conceptual framework without first specifying how they would use it.
• Concepts without principles – The boards have studiously avoided being pinned down by a formal statement of basic accounting principles. That's why statements of mere concepts have proven, and will continue, to be utterly useless except as a storehouse of excuses for low-quality accounting standards.

I pride myself on "peeling the onion" of complex issues, so I feel (slightly) guilty that the first installment of my critique of the Conceptual Framework was pure low-hanging fruit. I didn't even have to peel back the cover on the new Statement of Financial Accounting Concepts (SFAC) No. 8 to find sufficient reason to conclude that the entire seven-year-and-counting effort was little more than old rotgut in new bottles. I had resolved to make amends for my sloth, but it again turned out to be the case that I wouldn't have to reach very far into SFAC 8 to come up with more of the same; the first few paragraphs of SFAC 8 were more than enough.

"General Purpose" – The Stealth Concept

Behold these excerpts from the first two paragraphs of SFAC 8:

"The objective of general purpose financial reporting forms the foundation of the Conceptual Framework…." [para. OB1]

"The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors …." [para. OB2]

If you have ever taught Accounting 101, early retirement would have been a cinch if you had a dollar for each time a student inquired as to which of several possible accounting treatments being discussed was "the right one." I eventually learned to reply with the following discussion-priming question: "For what purpose will the resulting financial statements be used?" That's when the fun would begin.

No student of mine ever proffered that the financial statements in question were to be used "for general purposes," because even those newbies to accounting could deduce that this was an absolutely dead-end answer. The boards' answer is even more dumbfounding for its naiveté: henceforth, these wise men and women will choose accounting treatments in their general purpose financial statements "…that will meet the needs of the maximum number of primary users." [para. OB8, italics supplied]

Need I say that the boards have given no indication as to how they will go about the task of determining "the needs of the maximum number of users"? Imagine how the FASB will apply its rubric to the deliberations on loan accounting: I shudder to think.

So, right there on the first page of the new and improved Conceptual Framework, we have a stealth concept, "general purpose financial reporting." There is nothing written in SFAC 8 to give you a clue as to how "general purpose" modifies "financial reporting." To even begin to understand the boards' intent, you would have to be nerdy enough to know that the term was accorded full status as a (fuzzy) concept more than 30 years ago in SFAC 1, which ironically has now been replaced by SFAC 8.

Be that as it may, the description of the concept of general purpose financial statements in SFAC 1 does nothing to explain why financial reporting shouldn't be more narrowly focused on, say, shareholders (you can see for yourself at paragraphs 28 – 30).  That goes a long way toward explaining why the boards have abandoned all pretense for failing to recognize the primacy of current shareholders in financial decision making, and hence, financial reporting.

Shareholder-Purposed Financial Statements – Simple, and Therefore to be Avoided

Consider these reasons for why financial reporting should be shareholder-purposed:

• SEC rules (Regulations 14A and 14C) require that a company furnish its current shareholders with an annual report prior to holding a vote to elect members of the board of directors (as well as other significant matters).
• Virtually every (if not all) professor of corporate finance teaches that the sole financial objective criteria for financial decision making should be the maximization of return on shareholder investment. 

If those examples are not convincing enough, here is some added reasoning. First, the resolution to some of the most vexing accounting problems becomes crystal clear if financial reporting were to become shareholder-purposed; shareholders should want assets to be measured at current worth,* because that is the only measure that should mean anything to them.

Second, and more fundamentally, shareholder-purposed financial statements yield the best possible measurements for assessing whether management has created value for shareholders. In accounting theory parlance, this is known as "stewardship." Financial reporting evolved out of mere bookkeeping as ownership and management tended toward functionally and physically separate activities. When owners are not involved in running a company, management is bound to act stewards of the shareholders' investment; and financial reporting is the principal way that 'absentee' shareholders assess how well management is doing that job.

Stewardship implies that shareholders want financial reports to help them answer two questions: (1) what is the current value of the resources invested in the company – both gross and net of liabilities; and (2) what is the expected return on that investment, considering the various sources of risk that could result in the actual return being different than the expected return. Shareholder-directed financial reporting can straightforwardly get at the first question, and it can also be a source of high quality information for answering the second.

I cannot conceive of an accounting standard, which if it were shareholder-purposed, would create information barriers for others. To take a timely example, I suppose one could argue (although I would not) that potential and current bank creditors are more interested in the discounted – at a totally arbitrary interest rate – net cash flows of the bank's own loan portfolio as estimated by the bank's management than the current value of the loan portfolio. Yet, I can't for the life of me see any honorable justification for depriving shareholders of knowledge of the current value of the portfolio. There should be absolutely nothing to prevent an accounting standard setter from requiring banks to provide the information that lenders supposedly crave in the notes to the financial statements.

In summary, these three criticisms of the Conceptual Framework – bridge to nowhere, concepts instead of principles, and general-purpose instead of shareholder-purposed – are nothing more or less than exercises in reverse engineering. The boards have started with a picture of where they think financial reporting should end up, and they are now engaged in a very drawn out process of cobbling together a joint "conceptual framework" to support their future Rube Goldberg creations.

The viability of accounting as a profession depends on the trust that users of financial reporting have in the integrity of their judgment. Since no set of rules or concepts can completely specify how those judgments are to be made for every circumstance, accountants need to have valid and boldly-stated principles for guidance. The predictable consequence of the absence of such principles has been the inexorable decline of the public trust in accountants and accounting. Nothing about the current conceptual framework project has dispelled concerns that accounting standards will continue to be available to the highest bidder.

Get ready for my next conceptual framework post on "reliability" versus "representational faithfulness." I'll bet you can't wait!

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*Current worth to economists is generally replacement cost, and that's how shareholders should also see their company's investments in product assets as well as financial instruments.

The New Conceptual Framework: Renewing a License to Produce Lousy Accounting Standards

The IASB and FASB jointly announced the completion of the first stage of their joint conceptual framework project this week. The eight-phase project was begun almost exactly seven years ago, and the first stage has just now been 'finalized.' For the FASB's part, completion of the first phase was marked by the publication of Statement of Financial Accounting Concepts No. 8, to replace Concepts Statements No. 1 and 2. The contents of SFAC No. 8 are to be published as Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information of a single document containing the revised conceptual framework.

This is the first of what I hope will be several posts on the conceptual framework project. In this first post, I'm going to discuss two preliminary matters: "concepts" versus "principles"; and the "purpose and status" of the conceptual framework that is under development. Notwithstanding the fundamental problems I have with the overall approach taken by the Boards, the next post in the series will address two of the "concepts" promulgated by the recent joint publication: the notion of "general purpose" financial statements; and the "primary users" of financial statements prepared in accordance with GAAP/IFRS.

A (Conceptual) Bridge to Nowhere

Why would you renovate the kitchen of a house if you have no plans to live there yourself, you couldn't rent it profitably, or you couldn't possibly recover the costs of the renovation through sale? Sure, the kitchen is antiquated; but that reason, in and of itself, obviously does not justify the costs of replacing it.

Obviously, one should not renovate one's kitchen without planning to use it for something; and likewise, one would think that the Boards must have an intended use for a new conceptual framework. But, if they do, they're not telling anyone just yet. The publication of SFAC No. 8 marks the completion of the first phase of their project, and the next three phases are reported to be "active." However, the phase in which the question of the "purpose and status" of the framework (number six) has not even begun.

I'm tempted to state that this approach taken by the Boards, to defer consideration of purpose and status until the document is essentially complete, is the accounting equivalent of a bridge to nowhere, but my gut tells me that it's more like a bridge to an undisclosed location. I suspect that the destination for the new conceptual framework is the same as the old one: a humongous warehouse of accounting "concepts" that the board members will draw on as they concoct elaborate rationalizations for having allowed The Accounting Establishment to play the tune – instead of investors.

I will concede that the Boards may be reasoning that the contents of the framework would be unaffected by its ultimate "purpose and status," but I simply don't buy it. There is no question that the nature of the discussions and their affect on the final document would be profoundly affected if, for example, the Boards were to state that the provisions of the conceptual framework sat on top of IFRS and GAAP instead of its current location, which within the universe of accounting rules is located somewhere in outer space.

It's a Matter of Principle, Not Concept (with apologies to Abe Briloff)

"Concepts" are ideas at some relatively high order of intellectualization, but "principles" are of a higher order. They are commitments to behave in a certain manner. My sense of the history of the term "generally accepted accounting principles" is that preparers recoiled at being committed to overarching principles, and thus successfully fought off their formal promulgation. That's why, by the way, academics became gradually but inexorably shoved to the side by standards setters – for principles are the quintessential academic topic. It's also why, I believe, that David Mosso, former FASB member, in his new book, which I summarized here, called for academics to set accounting standards. (Hooray for David!)

Kindly allow me to explain how I see the difference between accounting concepts and accounting principles with an analogy. (I sure hope this works.)

We don't need a statute (or even the Ten Commandments) to know that taking a human life violates the most fundamental principle of civil society. But, there are allowed exceptions, which, in order to be as clear as is practicable, are explicitly stated in the law. When it comes to applying this principle, concepts, such as "human life," have a role, e.g., such as when it would be permissible to take a hospital patient off life support. But, the principle is of a higher order than the concept: all civilized persons live by the principle that it is wrong to take a human life, although not everyone accepts the same conceptualization of "human life."

My point with respect to financial reporting is that the question of a framework's purpose and status would be indisputable if it were comprised of principles instead of concepts; it would be at the very top of a GAAP/IFRS hierarchy. A transaction or event could not be reflected in financial statements in a manner that violated the promulgated principles, unless a specific rule permitted a departure from them.

Tellingly, I could not find a single occurrence of "principles" in the new SFAC No. 8 (except for use as part of that antiquated term of art, "generally accepted accounting principles." Instead, the core issues embodied by fundamental principles, are circumnavigated with discourses on specious concepts like the "primary user group" and "general purpose financial statements," along with peripheral considerations such as the re-packaging of the properties that financial statements are considered to possess. (Can anybody tell me the practical difference between "representational faithfulness" and plain ole truth telling?)

Notwithstanding my belief that principles should be the dominant subject of the framework project, I'll have more to say about the specific concepts covered by SFAC No. 8 in a later post. But, for now, I'll conclude with a brief, yet fairly complete, example of principles that could reasonably be placed at the top of a financial reporting hierarchy. I'll be bringing these up again as benchmarks against which I will be evaluating the conceptual framework project:

1. The purpose of financial statements prepared in accordance with IFRS/GAAP should be to provide information to investors.
2. Investors should be provided with information relevant to assessing: (1) the amount of wealth available to the reporting entity; (2) claims on wealth; and (3) how wealth has changed over time. However:
   • It is highly unlikely that financial reporting will provide all of the information investors may desire for assessing these items;
   • It is not the goal of GAAP/IFRS to provide all of the information investors may desire for assessing these items.
3. Financial statements should be prepared from the perspective of the current holders of common stock, or its equivalent (hereafter, common stock). Therefore:
   • The present holders of common stock should be viewed as the primary users of financial statements prepared in accordance with IFRS/GAAP;
   • The claims on wealth should be distinguished by non-owner claims (liabilities) and owner claims (owners' equity).
4. The needs of non-primary users of financial statements should not be considered when determining policies for the preparation and presentation of the primary financial statements (e.g., balance sheet, income statement, statement of cash flows). However, the informational needs of non-primary users may provide the basis for requiring certain disclosures outside of the financial statements.
5. The balance sheet should report items of wealth (assets) and claims on wealth (liabilities).
   • An "asset" is an economic resource to the reporting entity that satisfies at least one of the following conditions: (1) the reporting entity holds legal title to the resource; (2) the reporting entity holds the legal right (conditional or unconditional) to receive the resource; or (3) the reporting entities holds the legal right (conditional or unconditional) to use the resource for some purpose (specified or unspecified).
   • Liabilities are legally enforceable obligations (conditional or unconditional) to either: (1) deliver an asset or the common stock of the reporting entity; or (2) permit another party to use an asset. Therefore, all liabilities of a reporting entity are assets of another entity or person.
   • The attribute of an asset to be measured for purposes of financial statement presentation should be the asset's economic utility to the reporting entity. In most cases, this is represented by the asset's replacement cost; however, in some circumstances measurement of utility is best captured by the asset's net realizable value through sale under current business conditions.
   • A balance sheet may not violate the axioms of arithmetic (e.g., unlike measurements may not be summed).
6. The income statement reports changes in assets and liabilities for a given period resulting from the following: (a) transactions between the reporting entity and persons that were not common shareholders (or not acting in the capacity of common shareholders) during the period; and (2) other events that affect the measurement of assets and liabilities. Such changes should clearly delineate the effects of operating and financing activities.
7. Providing information about wealth is costly. Financial reporting standards must weigh the aggregate costs an entity will incur in producing information against the benefits of being provided with information. This weighing of costs and benefits, has, among other things, the following implications:
   • Not all assets and liabilities of the reporting entity may be recognized on the balance sheet.
   • The most accurate approach to measurement of some recognized assets and liabilities may not be economically justifiable. Therefore, financial reporting standards may require or permit alternative measures that are less accurate, without sacrificing the objective of wealth measurement.
   • The needs of regulators, managers, or auditors are not directly germane to establishing financial reporting standards, except to the extent that their past and future actions cause the costs of producing information for investors to change.

If the Boards' goal for the conceptual framework project were the establishment of a rock solid foundation for high quality, investor-oriented accounting standards, then their approach would look something like my list -- or perhaps one of your own making. We could have a lively discussion on some of the finer points, but what is being passed off as a "framework" for some yet-to-be-determined purpose is a far cry from what investors need and are entitled to. All the Boards have given investors thus far, and after seven years of conceited, quasi-academic deliberation, are a sleep-inducing list of lame excuses for the current sorry state of affairs – and a license to continue with business as usual.