If you were to ask a financial regulator what 'investor protection' means in the context of accounting standards, the textbook response will have something to do with ensuring that investors have enough information to make informed investment and voting decisions.* Indeed, that's what also has been taken as gospel since 1978 when the FASB published its Statement of Financial Accounting Concepts No. 1:
"[F]inancial reporting should provide information to help investors, creditors, and others assess the amounts, timing and uncertainty of prospective net cash inflows to the related enterprise." (¶ 37)
I believe this has been the guiding philosophy of standard setting ever since. It is time to recognize that it is a failed philosophy.
Informativeness is in the Eyes of the Lobbyist with the Most Juice
First, to rank accounting alternatives on the dimensions of their 'informativeness' is deceptively difficult, if not just downright impossible. That's why FASB "due process" takes forever, and is more about politics than reasoned thinking. But, even if the goal of enhancing informativeness were the correct goal for regulators, what can be said about the progress toward informativeness that has been made over the ensuing one-third of a century? Not a whole heck of a lot.
Lawrence Summers gave a speech in 1999, when he was deputy Treasury secretary, which contained this remark about financial reporting:
"If you ask why the American financial system succeeds, at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles; it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities." (source: a 2009 NYT column by Paul Krugman)
I am resurrecting those remarks from an earlier post because they demonstrate how central financial accounting is to the functioning of our economy; and conversely, the vast destruction that can occur when accounting doesn't work as it should. Perhaps, from Summers' perspective in 1999, accounting standards were more or less okay, even though he ignores the S&L debacle and the role played by inadequate loan accounting standards. But from the perspective of 2011, after all that has befallen us in the ensuing 12 years, surely he would have to recognize that accounting has become more a part of the problem than holding out much promise for being a part of the solution. (For a more contemporaneous viewpoint, I suggest you read Floyd Norris's recent column on the utter mess and disgrace that is the accounting for financial instruments.)
Some would say that the mission of the FASB has been to institute improvements to accounting standards, and on a case-by-case basis, there is no disputing that some improvements have been made. But, despite all the new rules and complexities, it's still much too easy to smooth income, and to obfuscate or just plain hide important information about risks and uncertainties. All in the name of informativeness, U.S. GAAP (more so, IFRS) gifts issuers with free choices (explicitly or often implicitly) among accounting treatments, and the privilege to make highly subjective and self-serving estimates. Nowadays, few are surprised at how powerless or unwilling, auditors are to stop issuers from making two plus two seem like something other than four. (Indeed, an important lesson here is that audit reform may not be possible without accounting standards reform.)
Accounting Standards as Weapons of Financial Destruction
Second, there is an aspect of reality that goes essentially unacknowledged in the FASB, SEC or IASB literatures: financial statements issued for public consumption routinely double as convenient, albeit very dangerous, management control systems.
For example, the attainment of a pre-determined amount of earnings under U.S. GAAP can be a surrogate for achieving underlying economic goals. This may ostensibly be the case because of the difficulty in measuring achievement of real targets. I say "ostensibly," because I'm not confident that enough corporate board members sufficiently appreciate the tradeoffs involved; in particular, the difference between reported net income and real profitability. Even granting a genuine willingness on the part of board members to exercise due care, they seem to be too easily won over to the point of view that game-conducive earnings-based compensation is the most effective way to achieve congruency between management's preferences and shareholder value maximization.
In short, "what gets measured gets done." Yet, by fixating on informativeness, the FASB has succeeded in ignoring this self-evident maxim throughout its entire history. And in doing so, the FASB (with the SEC standing idly by) has enabled a national tragedy at many levels: obscene levels of compensation awarded to management, impairment of U.S. competitiveness, mass disruptions of financial markets, shareholder value destruction – not to mention the chaos and misery inflicted on honest, hardworking and capable individuals.
Give Accounting Back to Shareholders
We desperately need to figure out how to make accounting part of the solution instead of a big, big part of the problem.
To start, we need to shift the primary emphasis of accounting standard setting from informativeness to 'stewardship' and 'external control.' By stewardship, I mean economic reality: the identification and valid measurement of the net resources that management has been entrusted to invest and utilize; whether management is taking the appropriate level of risk; and whether management has generated a satisfactory return to shareholders. External control is an outcome of a focus on stewardship in financial reporting, and by stewardship I am referring to the need to explicitly recognize that accounting standards have had, and will continue to have a profound impact on corporate decision making. (Pardon the digression, but this consideration by itself should be sufficient reason to stop all the IASB adoption nonsense.)
Granted, no set of rules can result in an accounting for all of the assets and obligations of an enterprise; and by extension, no set of internal and external controls can be expected to put a complete halt to shareholder value destruction through accounting-based managerial decision making. But, the least regulators can do is to endeavor to recognize a reasonable set of an entity's assets and liabilities, and to measure them in sensible economic terms. For a start, we should be using constant units of purchasing power instead of nominal currency units in comparisons. Even in times of merely low inflation, It is not true that a bank earns an economic profit when it ultimately collects $1,001 on a 10-year $1000 loan; yet, that's the way that bankers appear to think, largely because accounting rules permit them to act like it's okay to think in such naïve terms. And, just like Floyd Norris points out, we don't need about a dozen different free choices and all the subjectivity involved in accounting for stocks, bonds and loans.
* * * * *
My reading of history is more critical than Lawrence Summers'. It tells me that tight regulation of financial markets is necessary, because bad things happen when managers could end up being rewarded for decisions that destroy shareholder value. But, focusing on stewardship and external control does not mean that informativeness gets thrown out the window. In fact, I think the resulting financial statements would be more informative than those prepared in compliance with today's U.S. GAAP or IFRS. If done right, they should also be more auditable, but that's a topic for another post.
If investor protection were a horse, then when it comes to accounting standards the SEC and FASB have spent far too much time looking at the wrong end. (Don't ask me where I think the IASB has been looking!)
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*And also to prevent misleading disclosures, but that's not central to what I am thinking about here.


The 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
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:
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.
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