The Accounting Onion

More Reasons to Excise Contingent Liabilities from Balance Sheets

In responding to my previous post on contingent liabilities, a few of my kind and sensitive readers raised the following points:

• Why should there be a difference in the accounting for a law requiring sellers to compensate their customers for defective products, and an express warranty to the exact same effect? (Discussed below.)

• Are deferred taxes arising from, say, a higher carrying amount for an asset relative to its tax basis a liability? Why do we have deferred tax accounting in the first place? (Discussed below.)

• I incorrectly characterized the provisions of IFRS 3(R) pertaining to contingent liabilities assumed in a business combination. (I made the correction.)

A Legal Requirement versus an Express Warranty

I did not explain myself fully on this point. The power of a government to change its laws creates a possibility that an obligation could be arbitrarily and capriciously eliminated, while stiffing the 'receivable' holder in the process. Moreover, the same merely legal obligation (in the absence of a contractual warranty) could be cancelled by the obligor by dissolving itself. 

Are these distinctions between a legal obligation and an express warranty too fine, glib, or heaven forfend, theoretical? Perhaps I could be guilty of mere post hoc rationalization to support my subjective point of view: to wit, the futility of harboring any hope that accounting standards can be effectively crafted to result in reliable and consistent measures of contingent liabilities?  But, whatever my conscious or unconscious motivations, the point that all must concede is the impossibility of enunciating an accounting policy that will result in the recognition of all of the liabilities of an entity. So, if you have to draw a line somewhere, I am humbly suggesting where that line can be drawn, in a principled manner, no less. 

Deferred Taxes: My Conspiracy Theory

Whatever you may think about whether a deferred tax liability is a legitimate liability, you should know of the conspiracy between issuers and auditors that gave birth to the ersatz accounting theory of "interperiod tax allocation. It is the curtain behind which corporate America tries to hide the reality of just how little in the way of taxes a company might be paying in to government coffers.  A systematic earnings reduction in the way of an additional tax expense accrual can be a bitter pill to swallow, but so long as everyone has to take the same proportional hit, nobody actually gets hurt.

The political pressure to modify corporate tax laws in the name of some congress person's pet cause/peeve resulted in a tax code replete with accelerations of deductions, deferrals of payments, exemptions, shelters, loopholes, etc. Post WW II, the corporate tax code quickly got to the point that the actual taxes paid by corporations could be miniscule relative to reported GAAP net income before taxes. The public rightly asked why corporations' 'effective' tax rates were so much lower than the advertised 'statutory' rate. In order to evade directly answering that question, deferred tax accounting was invented to make it appear that corporations were paying their 'fair share' – or at minimum, make it appear that corporations would eventually have to pay their fair share.

Which brings us to the question of whether a "deferred tax liability" is really a liability? Once again, and for the same reasons I gave above, my answer is "no." If a government wants to reduce its tax rate, for whatever reason, the liability goes away. And, companies can control their "deferred taxes" as well.  Take, for example, the deferred tax liabilities of a company in dire financial straits, like General Motors. After bondholders are paid ten cents on the dollar in some sort of re-organization, and the deferred tax liabilities on the balance sheet melts away, can the government say it was stiffed? No way.

Another Reason to Exclude Contingent Liabilities

If the FASB and IASB are going to keep tweaking their respective contingent liability standards, and they envision a day when balance sheets will be stated at full fair value, they will eventually have to face up to the fact that there is no reasonable way to measure the fair value of a contingent liability that cannot be transferred. The only approach that comports with reality is to measure the amount it would cost the counterparty to replace (as opposed to transfer) a pattern of cash flows identical to its non-contractual, contingent 'receivable.' But, even that can be so problematic and subjective that I say, 'fuggedaboutit.'

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.

The SEC's Fair Value Roundtable: No Fireworks

On July 9, 2008, in Washington, DC, the SEC hosted a roundtable "to facilitate an open discussion of the benefits and potential challenges associated with existing fair value accounting and auditing standards." The roundtable was webcast and lasted about four hours. I admit that I literally fell asleep after listening to the discussion for the better part of three hours, so I missed the end. For all I know, the grand finale was a fireworks display, but I doubt it – this time, both literally and figuratively. When the SEC schedules these roundtable events for 9 a.m. on the east coast, I can't help but wonder what they are trying to tell those of us located in PAC-10 country (Go Sun Devils!). Maybe they would really prefer that no one listens.

Anyway, the topics included, among other things, discussions of the aspects of current standards that could be improved, and the usefulness of fair value accounting to investors. I'm going to address three issues that are so basic and important enough that accounting professors may want to consider using them for a class discussion.

Issue #1: "Held-to-Maturity" Investments

James Tisch of Loews Corp., when talking about his company's insurance subsidiaries, teed up this issue by describing a situation where his company would invest in marketable debt securities whose valuation might be affected by interest rate changes -- even though there would be no changes to the borrower's credit risk. Being an insurance company subject to various regulatory authorities, a rise in interest rates would supposedly force Loews to declare the investments in the held- to-maturity-category of marketable debt securities, the least onerous of three evils (the other two requiring fair value accounting).

Without the held-to-maturity option, the carrying amount of the investment would initially decline as interest rates rose, but could be expected to recover to the amount of the contractual obligation as the maturity date approached. Tisch's view seems to be that either fair value accounting would unreasonably record losses when it is highly probable that the entire investment plus interest will be recovered, or that constraints imposed by regulators trump the accounting that is most appropriate from an investor's viewpoint.

I think that the best way to approach a question like this is to ask yourself a simple question: did Mr. Tisch's company suffer a loss because it chose to invest in fixed-rate, as opposed to variable-rate, debt instruments? Yes it did. While regulators may find that it obscures their own peculiar needs, there must surely more straightforward ways to solve the conflict with investor needs than to muck up the financial statements.

And don't forget that apart from appeasing the needs of regulators, the held-to-maturity category is chicken salad for management: as Mr. Tisch implied, his company would manage its reported financial position by "cherry picking": if interest rates were to decline instead of rise, those same investments are probably classified as trading in order to get the asset and earnings bumps.

In short, FAS 115 on marketable securities could have been a lot simpler if the goals for financial statements could be (and should be) a lot simpler. As another panelist observed, one shouldn't need a legal degree to be capable of reading all the disclosures. I believe the disclosures he was referring to owe their existence to low-quality solutions cobbled together to meet the needs of someone else besides investors. The SEC should be telling other regulators to go and make their own accounting rules if they don't like the ones that are supposed to protect investors.

Issue #2: Fair Value of Liabilities

Joseph Price, the CFO of Bank of America, expressed his opposition to applying fair value measurements to contractual obligations such as litigation (and by the way, one of my more recent posts discusses the misguided way in which the IASB would require fair value measurement for some non-contractual obligations). Mr. Price has no problem with a mixed attribute model of accounting, which is just another way of saying that he has no problem adding apples and oranges.

The larger question, however, is whether any liability should be subject to fair value measurement. In addition to the claims that gain recognition on liabilities from deterioration of credit risk would distort earnings, other speakers pointed out that the character of the gain itself, often incapable of being monetized absent liquidation, creates problems.

The academic, Kathy Petroni, conceded that it can be confusing when an operating loss can be more than offset by gains from writing down the value of one's own debt. However, she is also of the view that the gain on the debt is representationally faithful; in other words, the problem is not with the current valuation of the debt, but with incomplete asset revaluation. This is because not all balance sheet assets are measured at fair value, and not all economic assets are even recognized. Tom Linsmeier, of the FASB and also an academic, made the interesting observation that a write-down to liabilities could be reasonably interpreted by investors as a signal of the asset losses that were not recognized.

As you may already have guessed, I am not sympathetic to stating liabilities at something other than current values. For one thing, we will never get to the point where all of the assets of a business are recognized, so we will never get to the point of measuring all of the components of economic income. Investor's don't expect financial reporting to account for all of the components of economic income. (Actually, that's what changes in stock prices do, but they have the distinct disadvantage of not allowing an analyst to directly identify the drivers of stock price changes.) What investors do expect is that the components of economic income that are measured are measured properly. If the deterioration of a company's credit worthiness creates an opportunity, amidst the other problems it must be experiencing, for it to restructure its debt advantageously, doesn't that opportunity benefit shareholders? Absolutely.

And, by the way, I am not advocating that all liabilities, regardless of the likelihood that a cash outflow will occur, be given recognition. And perhaps, some non-contractual liabilities, due to their nature, should be excluded from recognition. So the problem of incomplete recognition extends to the liability side just as much as to the asset side.

As the old saying goes, "perfection is the enemy of the good". What that means here is that we should not be distorting liability valuation just because some other element is not perfectly taken account of.

Issue #3: Fair Value Accounting for Non-Financial Assets

There was some discussion and support for measuring non-financial assets at fair value, but that support may have been even less enthusiastic than the support for fair value measurement of financial assets.

Logic dictates that whatever approach to fair value for financial assets is taken, that same approach should be applicable to non-financial assets. What's good for the goose is good for the gander; otherwise, we permanently consign ourselves to adding apples and oranges. And speaking of which, I have also pointed out here that some folks who don't care whether they are adding apples and oranges don't even care how assets and liabilities are measured -- just so long as they can control what is reported on the (their) income statement. One of my favorite examples is the historic cost of a tract of land carried on the balance sheet of a foreign subsidiary: when multiplied by today's current exchange rate to translate into dollars, we don't end up with an historic cost in dollars, or a current value in dollars. We end up with what is essentially a random number. How do you test impairment of a random number?

Speaking of impairment, for those of you who have had to apply FAS 144 on the impairment of long-lived assets, or FAS 142 on goodwill impairment, or even inventory impairment, you would know from that unfortunate experience that the impairment model of accounting is perhaps the biggest source of complexity, if not broken altogether. Some would argue that it is a reason, in and of itself, to abandon historic cost accounting and move to some version of current costs.

So, what if we went to fair value accounting for non-financial assets? That might solve the impairment problem, but it would raise another big issue, that being gain recognition before the non-financial assets, usually inventory, were actually sold. In a nutshell, that's why I think proponents of fair value are hesitant to extend the concept to non-financial assets -- more than anything, it exposes the main problem of fair value serving as a core accounting principle.

The appropriate non-financial asset attribute to measure is replacement cost (entry prices), and not fair value (exit prices). To further appreciate this, take for example the issue of transaction costs to acquire inventory. If FAS 157 were applied to purchases of raw materials inventory, transaction costs (perhaps a brokerage fee) would be expensed immediately upon acquisition. We all know that this makes no sense: we immediately have an expense to report before we have any chance at all to generate a return on our investment. (By the way, the same anomaly applies to financial assets, but it has already been established by FAS 157 that the FASB doesn't seem to care much about this.)

A replacement cost approach, on the other hand, would mean that all of the expenditures required to replace the asset should be part of the carrying amount of the asset. If we ultimately sell inventory for an amount greater than it would cost us to replace it, then we have a profit.

Getting back to geese and ganders, if replacement cost is the appropriate attribute to measure for non-financial assets, then it must be the appropriate attribute for financial assets as well.

Oh, Well…

Overall, the roundtable contributed very little to the fair value debate that hasn't already been expressed and considered before. Nonetheless, it reinforces two points that may well conclude that class discussion I've suggested:

First, I would prefer to have a dialogue at the SEC instead of in London at IFRS headquarters. Chairman Cox himself unwittingly pointed this out when he asked one set of panelists whether they believe current accounting rules contributed in some way to the economic issues the financial institutions are now dealing with. What if the answer to his question is "yes"? That, by itself, should settle forever the debate about who should be setting accounting standards for the U. S. capital markets. What if the answer to Cox's question is "we don't know"? QED.

Second, it would be refreshing if for once, an issue were settled by simply asking what it is that investors would want. Why does it seem that policy makers are incapable of doing that?

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.

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*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.

Contingent Liabilities: A Troubling Signpost on the Winding Road to a Single Global Accounting Standard

By the logic of others, which I can’t explain, fuzzy lines in accounting standards have come to be exalted as “principles-based” and bright lines are disparaged as “rules-based.”  One of my favorite examples (actually a pet peeve) of this phenomenon is the difference in the accounting for leases between IFRS and U.S. GAAP.  The objective of the financial reporting game is to capture as much of the economic benefits of an asset as possible, while keeping the contractual liability for future lease payments off the balance sheet; a win is scored an “operating lease,” and a loss is scored a “capital lease.”  As in tennis, If the present value of the minimum lease payments turns out to be even a hair over the 90% line of the leased asset’s fair value, your shot is out and you lose the point.  

The counterpart to FAS 13 in IFRS is IAS 17, a putative principles-based standard.  It’s more a less a carbon copy of FAS 13 in its major provisions, except that bright lines are replaced with fuzzy lines: if the present value of the minimum lease payments is a “substantial portion” (whatever that means) of the leased asset’s fair value, you lose operating lease accounting.  If FAS 13 is tennis, then IAS 17 is tennis-without-lines.  Either way, the accounting game has another twist: the players call the balls landing on their side of the net; and the only job of the umpire—chosen and compensated by each player—is to opine on the reasonableness of their player's call.   So, one would confidently expect that the players of tennis-without- lines have a much lower risk of being overruled by their auditors… whoops, I meant umpires.

Although lease accounting is one example for which GAAP is bright-lined and IFRS is the fuzzy one, the opposite is sometimes the case, with accounting for contingencies under FAS 5 or IAS 37 being a prime exaple.  FAS 5 requires recognition of a contingent liability when it is “probable” that a future event will result in the occurrence of a liability.  What does “probable” mean?  According to FAS 5, it means “likely to occur.”  Wow, that sure clears things up.  With a recognition threshold as solid as Jell-o nailed to a tree and boilerplate footnote disclosures to keep up appearances, there should be little problem persuading one’s handpicked independent auditor of the “reasonableness” of any in or out call.

IAS 37 has a similar recognition threshold for a contingent liability (Note: I am adopting U.S. terminology throughout, even though "contingent liabilities" are referred to as "provisions" in IAS 37).  But in refreshing contrast to FAS 5, IAS 37 unambiguously nails down the definition of “probable” to be “more likely than not” —i.e., just a hair north of 50%.  Naively assuming that companies actually comply with the letter and spirit of IAS 37, then more liabilities should find their way onto the balance sheet under IFRS than GAAP.   And, IAS 37 also has more principled rules for measuring a liability, once recognized.   But, I won’t get into that here.  Just please take my word for it that IAS 37 is to FAS 5 as steak is to chopped liver. 

The Global Accounting Race to the Bottom

And so we have the IASB’s ineffable ongoing six-year project to make a hairball out of IAS 37.    If these two standards, IAS 37 and FAS 5, are to be brought closer together as the ballyhooed Memorandum of Understanding between IASB and FASB should portend, it would make much more sense for the FASB to revise FAS 5 to make it more like IAS 37.  After all, convergence isn’t supposed to take forever; even if you don’t think IAS 37 is perfect, there are a lot more serious problems IASB could be working harder on: leases, pensions, revenue recognition, securitizations, related party transactions, just to name a few off the top of my head.  But, the stakeholders in IFRS are evidently telling the IASB that they get their jollies from tennis without lines.  And, the IASB, dependent on the big boys for funding, is listening real close. 

Basically, the IASB has concluded that all present obligations – not just those that are more likely than not to result in an outflow of assets – should be recognized.  It sounds admirably principled and ambitious, but there’s a catch.  In place of the bright-line probability threshold in IAS 37, there would be the fuzziest line criteria one could possibly devise:  the liability must be capable of “reliable” measurement. We know that "probable" without further guidance must at least lie between 0 and 1, but what amount of measurement error is within range of “reliable”?  The answer, it seems, would be left to the whim of the issuer followed by the inevitable wave-your-hands-in-the-air rubber stamp of the auditor. 

It’s not as if the IASB doesn’t have history from which to learn.  Where the IASB is trying to go in revising IAS 37, we’ve already been in the U.S.  The result was all too often not a pretty sight as unrecognized liabilities suddenly slammed into balance sheets like freight trains.  As I discussed in an earlier post, retiree health care liabilities were kept off balance sheets until they were about to break unionized industrial companies.  Post-retirement benefits were doled out by earlier generations of management, long departed with their generous termination benefits, in order to persuade obstreperous unions to return to the assembly lines.  GM and Ford are now on the verge of settling faustian bargains of their forbearers with huge cash outlays: yet for decades the amount recognized on the balance sheet was precisely nil.  The accounting for these liabilities had been conveniently ignored, with only boilerplate disclosures in their stead, out of supposed concern for reliable measurement.  Yet, everyone knew that zero as the answer was as far from correct as Detroit is from Tokyo – where, as in most developed countries, health care costs of retirees are the responsibility of government. 

Holding the recognition of a liability hostage to “reliable” measurement is bad accounting.  There is just no other way I can put it.  If this is the way the IASB is going to spend its time as we are supposed to be moving to a single global standard, then let the race to the bottom begin.  
 

AS 5: The Illegitimate Child of FAS 5

This is a rather long post, for which I apologize in advance.  It is an adaptation of a much more diplomatic comment letter that I wrote to the PCAOB, criticizing its proposed, and ultimately adopted, definitions of 'material weakness' and 'significant deficiency' in AS 5. As you will soon see, my critique addresses a larger problem having to do with how poorly uncertainty (for example, contingent liabilities) is dealt with in key financial reporting standards.

Let's start with a common example outside of the realm of financial reporting.  We all pretty much know that the threshold burden of proof to find someone guilty of committing a crime is 'beyond a reasonable doubt.'  What does that mean?  Methinks that individual jurors have their own personal definitions for 'reasonable doubt.'  However, to express uncertainty as a quantitative probability might create more problems for the jury-serving public than it would solve.

It has long been a puzzlement to me that the SEC, FASB and PCAOB take the same vaguely-worded approach as the criminal law--as if accountants and managers were innumerate.  Yet, all business schools and accounting programs have required courses in statistics and the use of quantitative probabilities in decision making.   

Here are some of the major examples of weasel words standing in for probabilities in financial reporting standards:

• MD&A requirements for forward looking information concerning uncertainties that could affect future profitability, liquidity or capital resources is based on a probability threshold vaguely specified as 'reasonably likely'. 
• FAS 5 on the accrual of contingent liabilities can require an accrual when the likelihood of occurrence is 'probable.'  Disclosure only is required if the contingency is less than probable, but more than 'reasonably possible'. 
• AS 2 (now replaced by AS 5) required an auditor to conclude that a material weakness existed if the probability of a material misstatement was 'more than remote.'
• AS 5 replaces 'more than remote' with 'reasonably likely' in its definitions of 'material weakness' and 'significant deficiency'

Incidentally, the PCAOB stated in its proposing release for AS 5  (page 9) that by changing terminology, it would not be changing meaning, but merely providing clarification.  This is supposedly because (1) auditors were familiar with how to apply the weasel words of FAS 5, as they have been around since 1975; and (2) 'more than remote' is not a term used by FAS 5.  The first reason is disingenuous, because everybody is aware that auditors have been ineffective in curbing abuses of FAS 5 by their clients.  The second reason is simply false (see FAS 5, paragraph 3b).  In FAS 5, 'more than remote' is indeed a lower threshold than 'reasonably possible.'  Evidently, weasel words can beget weasel logic.

I now want to explain why weasel words to express uncertainty inevitably result in low quality standards of financial reporting.  I'll be discussing FAS 5 and AS 5, but as with my comment letter, my focus will be on AS 5. 

Analysis

The points A, B and C in the diagram below denote unspecified probabilities that must, of necessity, demarcate the ranges of uncertainty used to apply SFAS 5, AS 2 and AS 5: 

Before proceeding further, it is important to note that Points A, B and C do not change.  In other words, the points are unaffected by the facts and circumstances of a particular transaction or internal control; by way of confirmation, no publication of the PCAOB or FASB that I am aware of provides any indication that either of these august bodies believe that the points should vary across audit engagements or particular events.

Since the FASB is the fount of the weasel words that are the subject of this quixotic diatribe, it is also important to note that the FASB did not disclose any information concerning the process by which “probable” and other qualitative terms for describing uncertainty were selected in the Basis for Conclusions section of SFAS 5; or whether quantitative probabilities were even considered.  Arguably, many of the well-known problems in application of SFAS 5 have resulted from the absence of explicit points of demarcation—particularly Point C in the above diagram.  The ambiguity and inevitable disagreement between auditors, preparers and users as to the appropriate demarcation Points B and C has had two effects: (1) substantial lack of comparability of financial statements, and (2) windfalls to auditors and preparers by allowing them to avoid being held to account for misleading financial statements. 

But, regardless of the FASB’s motives for promulgating SFAS 5 as it did, it was neither in the public interest, nor is it consistent with the PCAOB’s mission, to continue to follow their conveniently vague approach to dealing with uncertainty set forth in SFAS 5.  In particular, investor protection is less than it could be due to the ambiguation through weasel words of the point between “more than remote” and “reasonably possible” in AS 5 (i.e, Point B in the above diagram).   Blurring terminology adds judgment and cost to financial reporting while providing no discernible purpose that is consistent with the mission of the PCAOB. 

Some may argue that quantitative probability thresholds constitute bright-line rules that are contrary to the notion of principles-based standard setting.  This is wrong, because weaselly wording runs contrary to  normative economic principles on the application of judgment in decision making.  These overarching principles require that subjective probabilities be quantified.  These principles have been widely applied for generations, taught in all accredited schools of business and accounting (Managerial Economics 101), and incorporated into more recent accounting standards. 

Note on recent accounting standards: SFAS 144 on impairment of long-lived assets recognizes that probability-weighted cash flows may be used to test the recoverability of long-lived assets (¶17).  SFAS 109 on income taxes specifies a probability threshold of 0.5 when measuring the deferred tax asset valuation allowance (¶17).  Perhaps most germane is the auditing literature, wherein it is stated in AU Section 350 on sampling, “…the auditor should determine an acceptable audit risk and subjectively quantify [emphasis supplied] his or her judgment of the risk of material misstatement.” (¶20).

Now, let's set FAS 5 aside and speak only of auditing.  The auditor's assessment of risk is inherently quantitative and structured, even though an assessment of materiality may be more judgmental and dependent on facts and circumstances.  Along these lines, the Board’s contention that “evaluation of whether a control deficiency presents a reasonable possibility of misstatement can be made without [emphasis supplied] quantifying the probability of occurrence as a specific percentage or range”  [¶73 of proposed AS 5] runs counter to norms of rational decision making.  Here is an illustrative example of what I mean:

Assume that Point B in the earlier diagram represents the probability 0.4. In the terms of proposed AS 5, this is the lower bound of “reasonably possible.”  Further assume that the auditor determines the materiality threshold for a misstatement of revenues to be $1,000,000.  Therefore, $400,000 (0.4 x $1,000,000) represents the maximum allowable expected misstatement (given that a misstatement is at least reasonably possible) such that an internal control weakness would not be disclosed as material.

The PCAOB is simply wrong to expect an auditor to obtain reasonable assurance for its opinion within the framework of AS 5 without undertaking a process substantially similar to the one described by the above example.   Stated another way, as AS 2 was written, and as proposed AS 5 is currently written, it should be unacceptable for auditors to adopt different threshold probabilities for different clients, or even for different financial statement amounts  (although materiality thresholds may reflect case-specific factors).   The unavoidable conclusion from the PCAOB’s language in these auditing standards is that it should not be necessary, or required, for each auditor and client to come to separate conclusions on each engagement, and negotiate the threshold probability for “reasonably possible.”  Yet, the weaselly specification of Point B is an invitation for such costly and counterproductive negotiations to occur.

Note: To illustrate another problem of logic in AS 5 (some might call this a loophole), consider the following extension of my numerical example: if a particular control over revenues had a probability of misstatement of 0.39, the control would never be reportable as a material weakness even if the resulting misstatement would be significantly greater than $1,000,000.   Thus, thresholds per se in proposed AS 5 lack foundation in principle.

Summary and Looking Ahead

For both FAS 5 and AS 5, probability thresholds can be, and therefore should be, explicitly quantified.  For example, a change from qualitative terminology (i.e., “more than remote” in AS 2, or “reasonably possible” in proposed AS 5) would simplify auditing standards, increase reliability of ICFR audits, and reduce audit and compliance costs.  Such a change would better protect the interests of investors and further the public interest through greater clarity and transparency of auditing and financial reporting.  I know of no reason consistent with investor protection for intentionally blurring the lines with ambiguous language when precise thresholds are feasible.

Looking to the near future, the FASB may soon require recognition at fair value of contingent liabilities assumed in a business combination.  But, how will the FASB specificy which contingent liabilities would be recognized--'probable' contingent liabilities, or some other weaselly-worded standard for recognition? Will a bad accounting rule beget another bad accounting rule?  Indeed, the FASB has long known that FAS 5 is not working (nearly universal understatement of environmental liabilities being just one example), and their stated intention is to consider contingent liabilities as part of the project to revise the conceptual framework. But, don't hold your breath; if improved recognition criteria for contingent liabilities should ever come to pass, it may not be until the year in which both the Cubs win the World Series and the Rangers win the Stanley Cup.