The Accounting Onion

Merrily We Roll Along -- Forward and Up

It took seven years for the FASB and IASB to publish its "preliminary views" exposure draft (ED) on the fundamental issues addressed by the Boards' joint financial statement presentation project. And just recently, the FASB staff has posted a ten-page tabular summary of their "tentative decisions as of December 2009."

My own views, which I have expressed in four previous points (see the list, below) are neither "preliminary" nor "tentative." Granted, I am not bound by due process constraints, but eight years and counting has been far too long to wait for closure on a project that will have absolutely nothing to say about recognition or measurement. As my previous posts will indicate, I have also been extremely frustrated by some of the puff-pastry notions contained in the DP—and that are still on the table in some form or another:

First, there is no investor value created from allowing management to determine how a transaction is classified on the financial statements. Yes, every business is different, but there are still only two principles-based categories of transactions/events in which an enterprise may engage: 'financial' and 'non-financial.'

Even rudimentary delineation of the non-financial category into 'operating' and 'investing' activities has proven futile, and should be abandoned. For example, is the acquisition of inventory an investing or operating activity? Is purchasing one new machine to replace a worn-out machine on the factory floor arrayed with 1000 machines an investing or an operating decision? At best, even the operating/investing dichotomy it is too subjective to be audited, and at bottom, it is a distinction without a substantive difference.

Even allowing that there are some informative ways to further delineate ongoing operating activities, affording management the latitude to make those determinations is a loser before the opening bell is rung. Accounting standards should require a principled separation of financing from non-financing, but that would challenge the sacred cow of interest cost capitalization—so it ain't gonna happen.

Second, no investor value can possibly be created simply by re-arranging the financial statement deck chairs, even in the name of a newly coined "cohesiveness principle." Disaggregation is where it's at, and in that regard there does happen to be a role for that idea; as I am about to explain, however, it appears to not a role envisaged by the Boards.

A Promising New Direction

Having gotten that off my chest, I do very much want this latest missive to be seen in a positive and constructive light. To wit, there is one new piece of information, to be found in the very last item of that ten-page table that knocked my socks off. It's somewhat lengthy, but worth repeating:

"Replace the proposed reconciliation … [of cash flows to comprehensive income] with an analysis of the changes in balances of all significant asset and liability line items. Each line item analysis should distinguish the following components:

a. Changes due to cash inflows and cash outflows

b. Changes resulting from noncash (accrual) transactions that are repetitive and routine in nature (for example, credit sales, wages, material purchases)

c. Changes resulting from noncash transactions or events that are nonroutine or nonrepetitive in nature (for example, acquisition or disposition of a business)

d. Changes resulting from accounting allocations (for example, depreciation)

e. Changes resulting from accounting provisions/reserves (for example, bad debts, obsolete inventory)

f. Changes resulting from remeasurements

Present information about remeasurements in the financial statements.

• FASB: require disaggregation of remeasurements on the face of the statement of comprehensive income (SCI) in a columnar format. Those two columns should be labelled total comprehensive income and remeasurements.

• IASB: require presentation of remeasurements in the notes to financial statements.

Modify the definition of a remeasurement. The working definition of remeasurement is: an amount recognised in comprehensive income that reflects the effects of a change in the carrying amount of an asset or liability to a current price or value (or to an estimate of a current price or value). A current price or value includes the following measurement attributes: fair value, fair value less costs to sell, value in use and net realisable value. [bold italics supplied; dates omitted]"

This is pretty big news, AND IT COULD BE HUGE! However, I'm afraid the devil will be in the implementation details. That's why I'm going to spell it out for the Boards in simple terms: what is actually needed, why it's needed, and how to do it.

The What — The Boards enunciated in their original exposure draft an objective that financial statements should be presented in a manner that "presents a cohesive financial picture of an entity's activities." I'm not exactly sure what they mean by "cohesive" even after looking up that term in a few dictionaries.  Nonetheless, as a metaphor to financial reporting, the term resonates as regards the relationship between financial statement notes and the financial statements themselves. "Cohesiveness" should mean that the financial statements hold together, in a coherent or cohesive manner, the quantitative information in the notes. Stated even more plainly, every balance sheet line item should be "rolled forward", and each line item in the 'flow financial statements' (e.g., income statement, statement of cash flows, statement of changes in shareholders' equity) can be found to be the sum of line items in those balance sheet item roll forwards. That's what I mean by HUGE.

The Why — As I have already stated, disaggregation is where it's at. With XBRL around the corner, analysts will most certainly be competing with each other to create the sexiest non-GAAP measures of financial performance they can by plucking a little tagged something from here, and combining it with a little tagged something from there. If you're a sports fan, you are probably aware of all the new and interesting baseball stats created by imaginative analysts—once they were able to get their hands on the underlying data.

The statistics revolution in financial reporting should make the baseball stats revolution look like—well, what it is—a mere game. To pick just two of hundreds of possibilities an analyst should be able to identify each component of a foreign currency translation adjustment, and decide whether to accept it as presented, or to make one's own pro forma adjustments. Or, if you don't like capitalized interest, an analyst should be able to reverse every stinking dollar of it.

A more subtle, but equally important reason for comprehensive roll forwards is that it will be a huge enhancement to external controls over financial reporting (and along with that, something for an auditor to really audit). Much has been said and written about the importance of internal controls over financial reporting, but a financial regulator's basic responsibility is not merely to mandate internal controls, but to impose substantive external controls. Any control expert should tell you that if you can't roll forward a balance sheet account, you can't hardly test its accuracy. If everyone should be doing their roll forwards internally, and they are quite obviously an efficient form of disclosure, then what is keeping regulators from mandating them? (The sad answer to this question shall be provided anon.)

The How — The extract I have provided from that ten-page table leaves a lot of implementation questions unanswered; and admittedly, it's only a summary of what the Boards may be thinking. The area of greatest concern to the Boards appears to be the level of detail to be provided in the roll forwards.

Once again, that new-fangled "cohesiveness principle" makes the answer to their dilemma straightforward: the Boards need merely to specify that the line-item detail of the roll forwards must be sufficient to allow "roll ups" to each of the lines in the flow statements. For example, if the FASB wants to separately identify "remeasurements" (more on that unfortunate term later) on the statement of comprehensive income, then the remeasurement components in a balance sheet line item roll forward must perforce be set forth.

I am compelled to add as an aside, though, that if the board is struggling to define "remeasurement," they should first acknowledge that the term is already spoken for in another part of GAAP. ASC 830-10-45-1 (within the Foreign Currency Matters topic) identifies remeasurement as a process by which the books of record of an entity are converted to its "functional currency." Contrary to the Boards' proposed new definition, what is currently regarded as remeasurement does not necessarily result in "current prices" or "current values." So, if new terminology is indeed required, which I recognize is likely the case, I would humbly suggest a couple of terms that convey the objective more straightforwardly: like "revaluaton" or "valuation adjustment."

Alas, the "Why Not"

The sad reality is that issuers will balk severely and senselessly at comprehensive roll forwards. And, who knows whether the toes-in-water approach now suggested by the Boards will prevail, or perhaps ultimately drive a wedge between them? I'm betting that the FASB will insist on something at least close to the sensible approach that they have finally put forward.  Meanwhile, the EU will threaten to ditch the IASB unless they get back with the a la carte chicken-salad-for-issuers program they have ordered.

As for yours truly, I don't believe issuers who will claim that balance sheet roll forwards (much less a direct cash flow statement) are a bridge too far – and neither should any reasonably intelligent undergraduate accounting major. If consolidated income statements already articulate to consolidated balance sheets, then why can't the components of those statements articulate? The simple answer is that they should – and they must.

Simple can be beautiful; that's why I like accounting. Comprehensive roll forwards that permit comprehensive roll ups would not solve every single problem that exists in regard to financial statement presentation.  But, by comparison to every other concept or objective offered up by the Boards during the past eight years and counting of this project, everything else is weak tea.
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*Those four posts are as follows:

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

Financial Statement Presentation: The Sequel

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Financial Statement Presentation: Will Issuers or Investors Prevail?

A Modest List of Financial Analysis 'Red Flags'

My blog 'readership' (shame on me for using such a stuffy term!) primarily consists of preparers, auditors and journalists. But, for those intrepid analysts who actually do read my blog, this week I have something especially for you! I humbly offer you a list of red flags for you to think about adding to your own personal collection.

But first, permit me this minor rant.

I have given some thought as to why analysts may be somewhat indifferent to my commentary – or more importantly, why very few submit comments of their own on SEC/FASB rulemaking proposals. My gut feeling is that analysts tend not to create much value for themselves by taking time to think about what financial reporting should be. To do so would just take time away from one's core activity of decoding the steady stream of dressed-up offal, prepared according to the latest financial reporting recipe book and tastily seasoned by management.

My objective in pointing this out is to make the point that it is a grave mistake for policy makers to believe that analysts are interested in accounting rules that make the world a better place. Just like most everyone else, financial analysts are focused like laser beams on creating value for themselves. The policy implication is that, instead of pining for more comment letters from investors, the FASB and SEC (and IASB) should acknowledge the free rider problem in their 'due process' deliberations. To my way of thinking, investor protection is usually accomplished by the exercise of common sense a la Justice Louis Brandeis' sunlight being the best disinfectant rule of thumb, and policymakers should have the gumption to act accordingly. Comment letters from special interests urging some other path are dross, even if they outnumber investor comments by a margin of 100 to 1.  

Now, on to the red flags.

#5 – Younger companies meeting growth projections for the umpteenth time in a row. I am suspicious when a relatively young company has consistently generated above average returns even while its product portfolio is clearly maturing, and its industry has become more competitive. It is often the case that management seeks to extend its recent record of rapid growth in sales and profitability by unconventional means, because it has not been able to identify investment opportunities within its historical core competency (generally, some form of cost reduction or product differentiation strategy). That's when the earnings games begin: aggressive estimates, drawing down 'earnings banks', selling assets for accounting gains, taking on excess leverage, or entering into byzantine financial transactions.

The Apollo Group, which I wrote about regarding the SEC's investigation into its revenue recognition policies, seems to fit the profile. It entered the for-profit college degree business when it was still young, and appears to have established the model for later entrants to emulate. Moreover, one of its more distinctive products, online classes, seems to be becoming commoditized as non-for-profits have undertaken changes in their "business models" to better respond to the needs of part-time and geographically distant students.

#4 – Management has adopted a minimalist approach to disclosure. My suspicions, and my hackles, are raised by multibillion dollar companies claiming that they have only one reportable segment. Some might say that that management, by evading segment disclosure, is fighting the good fight so as to prevent actionable information from falling into the hands of competitors. But, something is rotten in Denmark when companies alter their internal communications for the apparent purpose of floating a disingenuous tale that their "chief operating decision maker" is willingly in the dark when it comes to significant components of its operations.

When ITT Educational Services Inc. reports having an executive officer of its "online division," yet implicitly claims that it has no obligation to provide disaggregated information on that part of their business (either in MD&A, or the financial statement notes), I become suspicious. Although Apollo does provide some segment disclosures, its annual report is notably silent on the effects of online courses on recent earnings trends. (Some unsolicited advice to both companies: I respectfully suggest that they read the SEC's enforcement release regarding Sony's MD&A deficiencies and take heed. All it could take is one impairment charge or restructuring to put the Enforcement Division on their tails for similar omissions.)

I also blanch at boilerplate MD&As, particularly when no overview section is provided, the summaries of critical accounting policies are rote recitations of standard GAAP, and mechanical recitations of numbers masquerade as "analysis."

Here's a portion of Apollo's MD&A that caught my attention, and which I did not to mention in my earlier post. To set the stage, you should know that Apollo reported gross student accounts receivable of $380 million less an allowance for doubtful accounts of $110 million. Total revenues reported were $3,974 million.

"For the purpose of sensitivity, a one percent change in our allowance for doubtful accounts as a percentage of gross student receivables as of August 31, 2009 would have resulted in a pre-tax change in income of $3.8 million. Additionally, if our bad debt expense were to change by one percent of total net revenue for the fiscal year ended August 31, 2009, we would have recorded a pre-tax change in income of approximately $39.7 million."

Even ignoring the wow factor of Apollo's gigunda allowance for doubtful accounts, SEC rules imply that a sensitivity analysis should flex base estimates by a minimum of 10% (see Regulation S-K, Item 305, on sensitivity analysis for "market risk sensitive instruments) to be reasonably indicative of the underlying risks being modeled; Apollo's is only 3.5% (= 3.8/110); by comparison, a grudging token.

On the other hand, Apollo does report that if their allowance were an additional 1% of revenues, net income would be reduced by a much more significant sum. However, that statistic hardly qualifies as a "sensitivity analysis." That's because cash flows underlying revenues can come from either tuition payments made in advance (a very substantial amount in Apollo's case), or from payments made in arrears. Multiplying a non-collection rate, however determined, by cash flows that have already been collected makes no sense.

Finally, another pet peeve of mine is when there are no substantial differences between this year's and last year's MD&A, except for different numbers inserted between the words.

#3 – Management is obsessed with earnings reports. Beware of companies whose management appears to be fixated on reported earnings, usually to the detriment of attending to real drivers of value. Indicators include the aggressive use of "non-GAAP measures of performance," "special items" or "non-recurring charges." Watch out as well for highly decentralized operations where division managers' compensation packages are heavily weighted toward the attainment of reported earnings or those non-GAAP measures of performance.

Here are two examples of apparently obsessed managers. The older example is one that I have written about in the past. GE, under Jack Welch's leadership, had acquired Kidder-Peabody in the mid-1980s.  It was ultimately determined that much of the earnings that Kidder had reported were bogus.  As a consequence, GE was would announce within two days that it would take a non-cash write-off of $350 million.  Here is how Jack, "there was only one way – the straight way," Welch described the ensuing meeting with senior management in his memoir, Straight from the Gut:

"The response of our business leaders to the crisis was typical of the GE culture [my emphasis].  Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap.  Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise.  Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people." [p. 225]

I doubt if, in this post-Enron and S-OX 404 environment, a CEO today would so openly express such a blatant disregard for reporting to investors, but I also doubt if things have changed much at many companies – especially those where the CEO and board chair are one and the same, stock options to the CEO have the potential to dwarf the other compensation components, and the audit committee lacks gumption and sophistication.

A more current example is Overstock.com, which Floyd Norris very colorfully described in his NYT blog. In brief, their CEO fired the company's newly-appointed auditor before it could even render its first opinion on the company's annual financial statements. The auditor's crime, it appears, was to have changed course on the treatment of a non-recurring gain: whether it should be reported as income in the current year, or should have been pushed back to a prior year. In other words, no cash flow effect, and no discernable consequences on future operations. I would not be surprised if the accounting treatment directly affected the CEO's 2009 cash bonus, or tips the company toward the wrong side of a loan covenant.

#3 – Restructuring and/or impairment charges. Years ago, it was often the case that a company's stock price would rise after it recognized a "big bath" charge to the current period's earnings. The conventional wisdom was that accounting recognition signaled either that management was now ready to part with the lagging portion of a company, so as to re-direct its attention and talents to the potential 'stars'; and/or the earnings charge itself should be ignored, because it related to past events of no relevance to an assessment of the company's future earnings potential.

My take, however, is that the events leading ultimately to the big bath on the financial statements didn't happen overnight, even though the accounting for those events sure makes it look like the world was destroyed in one fell swoop. Management may want you to believe that the balance sheet cleanup will put the company back on the old path, but the problem is that the old path of reported earnings wasn't itself real. Restructuring charges and impairments mean that expenses of prior years' earnings were very likely overstated relative to economic earnings, even if all was strictly according to the letter of GAAP. When I had students, I counseled that if one cared to extrapolate historic earnings trends, one should make a pro forma haircut of prior years' earnings for a reasonable share of the current period's restructuring and impairment charges.

#2 – Management has the M & A bug. Business combinations accounting has forever been a fertile ground for earnings management. Take Tyco. According to SEC documents, from 1996 to 2002 it acquired more than 700 companies. First, beware of a growth-at-any-cost corporate culture and the likely ineffectiveness of both operational and financial reporting controls to efficiently absorb all of those changes. Second, the SEC claimed that Tyco used just about every business combinations accounting trick in the book to juice earnings. Granted, the rules of the game have been changed somewhat by FAS 141R, the newest business combinations standard, but opportunities to juice earnings and to create 'earnings banks' still abound by understating assets acquired and overstating liabilities assumed.

#1 – An SEC investigation.  The SEC's investigation of Apollo may only have as its initial focus one particular area of revenue recognition. But, where there is smoke, there could be a forest fire. The SEC may find grounds to challenge Apollo's entire revenue recognition policy. Or, with their subpoena powers wielded broadly, the SEC could stumble onto other questionable areas as well. Is Apollo willfully hiding lackluster performance of, say, its online programs a la Sony; or is it juicing consolidated earnings with questionable accounting for recent acquisitions? Who knows?

For that matter, will Apollo's public company competitors (like ITT) get caught up in the SEC's web? Who knows?

A Final Caveat

Numerous commentators and researchers before me have discovered some pretty powerful systems for extracting negative indications of financial health from accounting data. I am in no way trying to replicate that work, nor am I suggesting that the red flags I have proffered are the product of a similarly rigorous and systematic approach, or the state of the art. My goal has been only for each reader to think just once, "I hadn't thought of that one; it could make sense."

 

Financial Statement Presentation: Will Issuers or Investors Prevail?

The comment period has ended on the IASB and FASB's joint discussion paper (DP), Preliminary Views on Financial Statement Presentation, and it looks like there's going to be a rumble between investor advocates and issuer special interests. I have written three posts in the last few months on this topic (one, two, three), and I am drawing on two additional sources for this post: the CFA Institute's comment letter, and Tim Reason's CFO.com piece headlined "Critics Pan New Financial Statements."

The Statement of Cash Flows: Direct v. Indirect Method

The most basic of all proposals in the DP was to fix the loophole in SFAS 95 allowing the indirect method and mandating the direct method for the statement of cash flows. Among those who issuers claim to serve, however, it's a must have; according to the CFA Institute:

"We strongly support the adoption of the direct method cash flow statement as it would be a significant step towards improving financial reporting. The DM [direct method] offers insights into the quality of revenues, earnings and the characteristics of the cash conversion cycle, which are not available from an indirect method of reporting cash flows from operating activities. The DM is also consistent with and achieves greater relevance of disclosure of gross rather than net amounts. We strongly believe that the benefits outweigh the cost of adopting this method. In addition, we believe that the information provided by DM cash flows would be beneficial to management as well as investors. [Bolding in original]

But, according to CFO.com, issuers appear to sing a different tune in their comment letters. Here's CFO.com quoting from IBM's comment letter:

"IBM 'is aware that limited academic research supports the hypothesis that the direct method of cash flow provides better predictive value to future operating cash flows than either the indirect method or the income statement,' wrote Gregg L. Nelson, the company's vice president of accounting policy in financial reporting. But if that were true, he argued, companies themselves would use that information for internal reporting, something IBM and many other companies insist they do not do. 'To state the obvious,' added Nelson, 'future cash flow is largely driven by future transactions. Historical data is of limited predictive value.' IBM, he wrote, believes that revenue, days sales outstanding, changes in accrual balances and company information should be sufficient for investors to make their decisions." [Italics supplied.]

I love that part about 'if the direct method were useful, we'd be using it.'  It makes me feel like Voltaire's Candide, smugly assured by Pangloss, the pseudo-intellectual, that all is for the best; if there had been a better way, management would be all over it.

Right.  Are you really saying, Mr. Nelson, that IBM doesn't actually care to know where its precious cash came from, and where it went? How about cash planning?  If Nelson is actually saying that IBM management cannot answer those questions for itself, then I say "SELL!" Just to ratchet things up a little, ask yourself how credible Nelson's statements would be if they emanated from the ruby lips of his counterparts at GM, Ford, Chrysler or some other company flirting with bankruptcy. 

Implementation costs of switching to the direct method are also a factor noted by issuers. CFO.com cites Intel's letter, which claims that it will cost them $5 million in the first year to convert their accounting systems over to the direct method, plus $2 million every year thereafter. I'm not a software guru, but I have trouble taking such dire warnings at their face value. It can't be too hard to pull out each cash receipt and disbursement, sort them into about fifty different buckets, and add up the totals in each bucket; probably 99.9% of that be done automatically. 

On the other side of the cost equation, I'm guessing that the thousands of investors who actually want to understand Intel's financial statements spend a lot more than $5 million worth of time each year attempting to reverse engineer Intel's indirect method statements, along with trying to make heads or tails of the gobbledygook, boilerplate explanations of liquidity trends in their MD&A (I haven't actually read Intel's). For those of you accounting educators who I am fortunate to have as a reader, you will especially appreciate the millions of hours we spend trying to get students to think while they are standing on their head, as it were, in order to get their brains around preparing a cash flow statement; or just being able to read and understand the indirect format.

The Reconciliation of Cash Flows to the Comprehensive Income

The CFA Institute's comment:

"The requirement to present the schedule in the notes to financial statements that reconciles cash flows to comprehensive income and disaggregates comprehensive income into four components: (a) cash received or paid other than in transactions with owners, (b) accruals other then read measurements, (c) remeasurements that are recurring fair value changes or valuation adjustments, and (d) remeasurements that are not recurring fair value changes or valuation adjustments. We would not get information on operating changes versus investing decisions versus foreign exchange rate effects – currently provided (albeit poorly and/or incompletely) in the indirect cash flow statement reconciliation. We recommend and strongly prefer the statement of financial position reconciliation as it provides more comprehensive information and includes the statement of financial position and direct cash flow statement."

Just like one of my earlier posts, the CFA Institutes wants a line-by-line reconciliation of each balance sheet category. That's essentially what I have been pushing for (see this post), but the CFA is asking for comparative balance sheets in full reconciliation format. I imagine that the CFA Institute is working on the entirely valid assumption that disclosures are not taken as seriously by auditors and issuers as amounts on the financial statements. That's a great point, but I'm concerned that important information can become overly aggregated. For that reason, I had envisioned highly detailed reconciliations presented as tabular disclosures -- like what the IASB requires for some, but not all, accounts.  It's critical that it be required for all accounts.

CFO.com did not report that issuers squawked much about the cash flow reconciliation. Execs, no doubt, are aware that the Boards considered balance sheet reconciliations in their deliberations, but ultimately got enough pushback to contract a case of cold feet. So, issuers probably want to let sleeping dogs lie at this juncture. That's one reason why I would be willing to, albeit reluctantly at this point, settle for note disclosure, as a sort of compromise.

Classification According to Operations, Investing and Financing

CFA Institute supports the Boards' preliminary views to carry the same classification scheme (i.e., operations, investing and financing) across the three main financial statements, but issuers are objecting. Banks, in particular, are not sure how to reasonably go about separating their operating activities from their investing activities. There may also be a difference in preferences between the IASB and the FASB here; the former might be more comfortable with classification decisions made by management subject to some general 'principles' (a view I absolutely abhor), but U.S. issuers may prefer more FASB-like rules to back them up.

I am actually in the issuer camp on this one. I don't think it is possible to make a principled distinction between operations and investing for any industry. Try these:  Is the acquisition of inventory investing or operations? Is purchasing new equipment to replace old equipment an investing or an operating decision? Are planned expenditures on a 20-year-old oil field to extend proved reserves a part of normal operations, or are those expenditures an investment?

However, as I have stated here, I am very much for a principled distinction between financing transactions and everything else. I see no useful purpose in allowing management the discretion to fiddle with what goes where; but, it should be a straightforward exercise to write rules for classifying financing transactions apart from everything else.

Overall, though, I think organizations like the CFA Institute treat the FASB much too gently. They should be telling them also that, even though there are some satisfactory portions of the DP on financial statement presentation, it doesn't come close to going far enough. They should be telling them that convergence is not near as important as getting it right for U.S. investors. They should be SCREAMING that irrespective of the rules we have for recognition and measurement or the reporting of other comprehensive income,  financial reporting will never be what should be without a full balance sheet reconciliation and a direct method statement of cash flows.

Reason #2 to Dump on the IASB/FASB Leasing Proposal

In my previous post, I let 'er rip at the IASB/FASB "preliminary views" on measuring lease contract assets and liabilities. A close second on my list of investor-unfriendliness contained in their joint lease accounting Discussion Paper is the proposal that lease options (e.g., renewal, purchase, cancellation, etc.) and all other separately identifiable components of a contract should be balled up into one big ole asset and a corresponding liability. 

My unsubstantiated suspicion is that the leasing industry served this one up to the boards in exchange for lowering their resistance to the elimination of operating lease accounting.  It seems plausible, because, as I'm about to illustrate, that if we fail to require separate measurement for all of the material components of a lease contract, we will end up right back where we started. In other words, off-balance sheet lease accounting will continue to plague us.

Here's the example:

• The fair value of an airplane is $100; economic depreciation is expected to be $10 per year. Airline A enters into a one-year lease contract with Lessor B for $12, paid in advance. The lessee has an option to buy the airplane for $90.01 at the end of the one-year lease term.

• Separate and apart from its lease with Lessor B, Airline A purchases an option from a third party, Lessor C, to enter into another $12, one-year lease, commencing one year from now. The leased asset under this 'option to lease' would be a one-year-old airplane, with an option to buy for $80.01 at the end of the one-year lease term.

• And so on, and so forth. Airline A also enters into similar option contracts for subsequent years with new, or perhaps the same, lessors.

In accordance with the DP and the FASB's preliminary views, Airline A will conclude that the probability of exercising the purchase option is less than 50%. Therefore, Airline A will not add any portion of the expected future cash flows related to the option to the measurement of the rights acquired under the lease, or to the corresponding liability. Also, the numerous 'options to lease' do not meet the definition of a derivative per FAS 133 or IAS 39 (physical delivery of the leased asset will be required), so they won't be recognized until exercised.

Bottom line: $12 lease expense, no asset, no liability. Even though operating lease accounting will supposedly gone away, Airline A essentially achieves operating lease accounting in Year 1, and for subsequent years as well.

Is there a cost to constructing this crazy web of leases and options? You betcha, but I don't expect that would deter Mr. Schmo CEO from incurring that cost to get the accounting he 'needs.' Moreover, the result under the IASB's preliminary views would be even sweeter. (Are you surprised?) Let's say that the lease crosses over two accounting periods. The IASB approach would recognize $55 (=$10 + $90.01/2) of expense in the first fiscal year. This creates a $45 earnings bank that can be used in the second year. If Schmo CEO doesn't 'need' more earnings and the purchase option is in the money, then he will go ahead and exercise; otherwise he will let the option expire and withdraw $45 of earnings from the bank.

The Stated Rationale for Rejecting a Components Approach, and Why They're Wrong

Here's the boards' reasons—and my reasons for why theirs are bad reasons:

• A components approach may be difficult to apply.

Funny, but that hasn't stopped the boards from promulgating anti-abuse provisions before. I'm thinking about the FAS 133 requirement to bifurcate embedded derivatives. I'm also thinking about FIN 46(R) a complex an anti-abuse standard in its entirety. The point of my airline example is that, without some sort of components approach, the leasing industry is going to have a field day offering new and 'innovative' financial products designed solely to minimize the effect of lease capitalization on the balance sheets of lessees; and it's why I think all of this may be their idea.

• Components are often interrelated. For example, recognizing a liability in respect of a residual value guarantee may not provide useful information to users if the lessee is likely to exercise a purchase option.

That's like saying that the fair value of an option doesn't provide useful information if the probability of its exercise is low! It certainly has not deterred the boards from requiring fair value measurement for all options within the scope of FAS 133 or IAS 39, regardless of their probability of being exercised.

Having said that, however, any sensible and principles-based standard should provide that insignificant lease components need not be separately measured, and perhaps combined with the most basic rights and obligations associated with the lease contract.

• All components would have to be measured on the same basis, like fair value, in order to result in comparability and to curb abuse.

Amen. If you will be so kind as to read my previous post, I may be able to convince you that a principles-based approach to lease accounting would perforce require measurement of all rights and obligations at their replacement costs.

• The fair value [or replacement cost] of some components may be difficult to measure, because there is no market for them, and they are not normally priced separate from the lease contract.

Right again, but generating random numbers that are misleadingly labeled 'historic costs' is not at all a substitute for a good faith effort to measure a real financial attribute of an asset/liability.

But, I do understand the cost/benefit tradeoff, and would retain operating lease accounting for small, non-public companies. The IASB has done a good thing by creating a simpler version of their standards for use by smaller companies. If there is one area in which the FASB should follow the IASB's lead, it is in providing more accomodations to small companies, and leasing is an excellent place to start. But, while they are at it, they should also relax the requirements in FAS 133 for bifurcation of derivatives from certain host contracts, ease up on business combinations, goodwill impairment testing and FIN 48 (deferred taxes).

If you think I'm being paranoid about potental abuses of a new lease accounting standard that is not principles-based, then think about this:  if it took me 10 minutes to cook up my little example, then who knows what other schemes currently lurk in the minds of the 'financial engineers,' who actually get paid to think up new ways to steal from shareholders?

Replacement Cost Rebound

In the public FASB meeting on Tuesday, one of the topics was revenue recognition under circumstances where the consideration received is other than cash.  The Board discussed how to value the consideration received, and I am told that a majority of the Board favored fair (exit) value.

HOWEVER, Chair Bob Herz made a "strong case" for replacement cost. I don't know anything yet about the substance of Bob's comments, but following on the publication of the SEC's study of mark-to-market accounting, this is the first ray of hope that a full-blown reconsideration of fair value could occur.

Another reason I am writing so soon again is to provide those of you who happened to read yesterday's epistle via email with a link to Walter Schuetze's speech, which I inadvertently omitted.  I also want to take this opportunity to address some of the concerns that some readers have already expressed about the positions I have taken. An investor named Andy and an experienced appraiser, Alfred King, have provided representative comments.

The Preferences of "Investor Andy"

Andy wrote that he prefers historic cost "about 80% of the time" because of its objectivity; for the other 20%, mainly marketable securities and loans, he prefers fair value. He is "…most concerned with what an asset cost, because that represents the initial investment, and will allow me to calculate a return on investment."

As to the claim that historic cost is objective, in yesterday's post I spoke primarily about the balance sheet, yet nothing makes my point better than an historic cost income statement.  There is nothing objective about allocations to the income statement for depreciation, bad debt expense, warranty costs, and much more. 

But, the comment I really want to respond to concerns how to go about measuring return on investment.

Consider the oil and gas industry. The value of a producing field has nothing to do with what it cost to develop perhaps twenty years ago, or even how much it has produced to date.  Valuation has everything to do with all sorts of things ignored by historic cost accounting: current oil prices, the current amount of reserves, and the current capability of the current owner to operate and manage the field to maximize its remaining economic returns.

If the current operator cannot generate an adequate return based on the current value of the field, then management should consider selling it to an operator that can achieve a return commensurate with that current value. Historic cost cannot provide me with the information I need to judge whether the current operator is making an adequate return. I have consulted in the oil and gas industry, and the company I worked for adjusted its goals for field managers every year; those goals had absolutely nothing to do with the sunk costs that were reported on the balance sheet by historic cost accounting; and I am positive that investors take the same approach as management.

In summary, Andy, I want the managers of my investment to maximize profit, not simply to generate a satisfactory return based on the amount invested some arbitrary time ago.

Andy also accused me of having a "double standard" when comparing fair value to replacement cost:

"… You eviscerate fair-value accounting, not theoretically, but how it was put into application. Alternatively, you do not consider how replacement value could be taken advantage of preferring instead to think about it theoretically."

I plead "not guilty." I stated that fair value has problems in both principle and its application. But, to be clearer, I should have stated that SFAS 157 is a failed application because it begins with a flawed principle: the flaw being that wealth is command over goods and services. There are two parts to this. First, goods and services are not cash, and fair value measures the potential for cash. Second, and much more important, you can't command anyone to buy your asset. However, every seller does have a 'reservation' price; therefore, you can command goods and services by bidding high enough. In that sense, Andy, replacement cost, as its name implies is actually nearer in concept to historic cost than fair value.

The Appraiser, Alfred King

I have had a series of interesting exchanges over the last few months with Alfred King, author of Executive's Guide to Fair Value. I haven't read the entire book, but I generally agree with his critique of FAS 157.

After today's post, Alfred King wrote, in part:

"I spent about two years of my life working with replacement cost and price level accounting [when that information was required by GAAP].  With the best will in the world, and with some clients no limit on the resources that could be applied, we still could not come up with satisfactory information. …. Nobody in their right mind would replace an inefficient factory building that had been added to five times over 25 years at the same site.  You could build a new modern building with 20% less square feet, and much lower utility costs if you really would replace it.  But of course buildings go on for many many years." [emphasis in original]

"This was one, but not the only, reason the supplemental information died a natural death within three years.  I remember it so well because for about six months we in the valuation business thought it was going to be our equivalent of what the 1933 and 1934 Acts did for Public Accountants.  It wasn't, and we were soon back to our old type of valuations."

I will admit that I haven't read FAS 33 in years, and don't have much recollection as to the details of the requirements. Although Mr. King's critique may have been an important consideration when FAS 33 was in effect, I don't relate it to my vision of what replacement cost accounting should now be.

The most straightforward way to determine replacement cost to meet the wealth measurement objective is to ask oneself what would be the least amount one would have to pay for an asset (or a similar asset that provided the same utility), if one did not actually already own it. It seems to me that real estate appraisers make estimates for specific properties on that basis as a matter of course. Often, their best estimate is the result of making somewhat objective adjustments to 'comparables' for age, floor space and even location.

Having said that, I would allow for any number of approaches to approximating replacement cost, so long as they adequately answered the question I posed in the previous paragraph.  Like FAS 157, the greater the subjectivity in the estimates, the more detailed would be the disclosures.  However, in all cases, I would require reconciliations of the changes in balance sheet accounts in sufficient detail to make all assumptions, and changes in assumptions, transparent.

To be sure, there must be many implementation hurdles to overcome in broadly applying replacement cost accounting, but for goodness sake, consider the alternatives. Sorry, Andy, but I think historic cost has become a bucket of offal, and fair value is falling flat on its face.

Beyond the "Inactive Markets" Problem: The Crisis in Accounting

"It's painful now to read a lecture that Mr. [Lawrence] Summers [who is currently President Obama's principle economic adviser as chair of the NEC] gave in early 2000, as the economic crisis of the 1990s was winding down. Discussing the causes of that crisis, Mr. Summers pointed to things that the crisis countries lacked — and that, by implication, the United States had. These things included "well-capitalized and supervised banks" and reliable, transparent corporate accounting. Oh well."

Paul Krugman, New York Times, March 29, 2009 [emphasis supplied}

"Oh well," indeed. It seems that NYU economist Nouriel Roubini has been given the lion's share of the credit for prognosticating the economic calamity we now find ourselves in. But many independent-minded accountants have warned, decades before Roubini, that our financial reporting standards – not just those rules having to do with mark-to-market – are as thin and flimsy as the paper they are printed on. That nobody would heed the warnings can only be due to the collective weight of the business and banking lobbies pressing on standard setters, with the paid support of the Big 8, 7, 6, 5, 4.   

Contrary to those with whom I usually stand on financial reporting issues, I am not going to excoriate the FASB for its latest kluges to GAAP, which they made at the behest of Congress.  Methinks that a few little tweaks to make banks look sounder was better than at least one other alternative: doing nothing. Who can argue that a 20% run-up in bank stocks isn't something that the economy needed RIGHT NOW?

My own frustration and sense of gloom is from two sources.  First, next-to-know-nothing-about-accounting congressmen may be further emboldened to hunt for messengers to shoot instead of focusing on real problems.  Second, as Krugman points out, financial reporting has been exposed as totally kaput, and it ain't getting fixed any time soon.  The question policy makers should be addressing is not whether we should keep GAAP or adopt IFRS, but rather how long it will take for both the FASB and IASB to become completely discredited as agents of investor protection.

Accounting Needs to Start with a Clean Sheet of Paper

Everyone agrees that there is no silver bullet that can fix the economy. Whatever the capitalist or socialist ideologues will preach, we can't simply scrap the current system and make a new one; every policy decision has to be made at the margin.

But, when it comes to financial accounting and regulation of financial institutions, I believe that 76 years after the enactment of the first federal securities laws, establishing the accounting and auditing disciplines as we know them today, it's high time to start over.

First, we have to start by completing de-linking those banking regulations from the rules of financial accounting. Second, we need to recognize that neither historic cost accounting nor fair value accounting are providing the answers we need. The second point is where I am going for the rest of this post.

The Choices: Fiction-, Fantasy- or Fact-Based Accounting?

The three candidates competing to be the foundation of accounting standards are historic cost, fair value, or replacement cost: stated another way, the choices are fiction, fantasy, or fact. By that characterization, I suppose you can already guess which of the three I would choose.

Historic Cost Accounting as Fiction

The conventional wisdom is that historic cost accounting is fact-based, objective and verifiable. The sad truth is that it is a fiction, however it has been practiced.

To account for historic costs, we subjectively choose which portion of a particular cost should be capitalized; and consequently, which portion should be expensed immediately.  Of the capitalized costs, we have to decide on a plan for transferring them to the income statement.  There can be no right answers, and there is hardly a pretense of impartiality in the numbers that management presents for the auditors to bless as "reasonable."

But even setting aside concerns of bias, so-called "historic cost accounting" only pretends to measure the historic cost of, say PP&E. Instead, fragments of historic costs are dumped in a parking place, bearing the fictitious name PP&E on a financial statement, fictitiously and pompously titled the "statement of financial position."  So, cutting through the pretense, historic cost accounting is simply a rules-based protocol for describing past cash flows and selected 'expected' future cash flows. Big deal.   

Proponents of historic cost, defend it as "verifiable," but as the example of PP&E illustrates, net book values are not verifiable; neither is the allowance for doubtful accounts verifiable, or any other estimate management makes.  The term "verify" stems from "truth", and there is nothing true about these numbers other than the unavoidable fact that management made them up.  

And the auditors?  We derive little value, if any, from an audit report that opines on "reasonableness" of the estimates that make up those fictitious book values.   Walter Schuetze, former FASB board member and SEC Chief Accountant (where he was my boss) gave a zinger of a speech in 2003 on this topic a few years ago to the New York State Society of CPAs. Among other things, he proposed a much more limited role for auditors (and an expanded role for other independent appraisers).  To my mind, the speech is Roubini-esque – so disquieting that the accounting profession and its regulators could respond only by acting as if one of the most visible and prominent accountants in the world did not make it.  If I were teaching an accounting theory class or auditing today, I would spend at least two sessions discussing its implications.  You can access it here.

Fair Value as Fantasy

Fair value, sometimes referred to as mark-to-market or exit value accounting, consists of a series of predictions of the outcomes of liquidating transactions that probably won't occur.  Some people like exit values, especially for gauging the health of financial institutions, because the values assigned to assets provide some indication of margin of safety in the reporting entity's financial structure, should liquidations be required to pay off creditors.

But the sturm und drang of the past few years in implemting SFAS 157 should be some indication that fair value has some real problems -- if not as a principle, then at least in its implementation.  I think it's both.

The fundamental problem with an exit value approach is the need to imagine the market conditions that would exist at the time of the hypothetical liquidation. Therein lies the fantasy; the Pollyanna FASB wants preparers to assume that liquidation won't happen under duress, but the reality is that unplanned liquidations happen under duress more often than not.  Not only that, whatever the market conditions that are to be imagined do nothing more or less than replace the market conditions that actually did exist around the time of the balance sheet date. 

To clarify the implications of fair value, let's momentarily step away from financial assets, and consider a very simple scenario (inspired by an unnamed source, who claims that it is based on fact):

A Ford dealership in rural Vermont has an inventory of 300 model F150 pickup trucks. The dealer sold about 50 - 60 trucks a month in 2006 and 2007.  In 2008, the dealer sold 30 trucks all year, with only 10 from July through December.  In January 2009, the dealer had one sale.  In February 2009, the dealer had no sales.  In March 2009, the dealer has had no sales.  What is the fair value of the 300 trucks in the dealer's inventory? 

Zero, or something close, would be a simple answer that everyone can understand, but most would consider useless as information relevant to assessing the present financial position and future prospects of the dealership. But, under these circumstances, no higher amount could be legitimately described as an 'exit value,'  simply because anything other than a recent price is a made-up number.   

Seeking fair value is just as problematic for subprime mortgages as it is for those pickup trucks. That's because, as I just stated, the question of 'fair value' or 'exit value' is nonsensical when there are no currently active markets for either trucks or subprime mortgages. Valuing a subprime mortgage by the discounted cash flows to be derived from holding it does not magically change a 'value in use' to an 'exit value,' even if the parameters to the DCF model are based on so-called 'marketplace assumptions.'  When we rely on management to estimate the sales price that would clear out the inventory of pickup trucks, or to estimate default rates and discount rates for subprime mortgages, that's fantasy and not fair value. Even worse, we are back to where we started with historic costs: biased estimates buttressed by audits of, to be kind, questionable value.

Replacement Cost as Fact

Every western economist, from Paul Krugman to Gary Becker, accepts as axiomatic the notion that wealth is manifested by the command over goods and services. For a non-cash asset, the appropriate measure of its wealth effect is the amount it would cost to replace it (let's leave aside the question of obsolete assets for the moment).

In a nutshell, if you think accounting is about reporting financial margin of safety, then fair value is for you. And by "you," I mean primarily the bank regulators. But if financial accounting is supposed to be about reporting wealth and changes in wealth to investors, then you gotta go with replacement costs.

Replacement cost accounting is fact-based. It accounts for the wealth you now have. It's not about what you hypothetically could have if, in some imagined scenario, you suddenly  sold an asset for its 'fair' price, whatever that means. Replacement cost accounting is most certainly not about fantasizing that you can command a nice price for an asset from selling it in a market that may not, and in many cases does not, actually exist. Replacement cost accounting is much simpler and, dare I say, saner: it measures actual wealth and actual changes in wealth – isn't that what we were taught accounting is supposed to be about?

Of course, measuring the replacement cost of what you have is subject to error, just as is any other measurement. Getting back to trucks, how does replacement cost accounting handle the absence of a market in which to sell an asset? Perhaps not easily, but a heckuva lot easier than FAS 157, or any other implementation of exit value accounting could. The Ford dealer still knows almost exactly how much he would have to pay to buy 300 trucks, even if every single Ford dealer in New England were feeling the heavy breathing of lenders on the backs of their necks. Nevertheless, the price would be a lot higher than zero; and, that's because the trucks are still worth a substantial amount of money. As for the subprime mortgages, even though there haven't been a lot of recent transactions, dealers and other holders should have a pretty good idea (indepdent of management) of how much it would take others to part with their holdings.

I prefer fact-based reporting of wealth to fantasies of exit value. In both of the new proposed FSPs, the FASB has invoked the SEC's recent study on fair value accounting. That study has also recommended that replacement cost should be given a closer look.

When the FASB takes time from responding to the congressional command to chase its own tail, perhaps we can take out that clean sheet of paper and write accounting rules that are based on fact, instead of fiction or fantasy. I'll be honest, I don't know if it can be done, but I think it can; and we won't know until someone tries. 

FSP EITF 99-20-1: Dissenting Board Members Hit the Nail on the Head

Do you think that stable funding could allow the IASB to divorce itself from the influence of the EU? If so, consider the example the FASB is setting under similar circumstances, and think again.

The U.S. standard setter was granted its own legal separation papers from special interests six years ago by S-OX; yet it continues to play the henpecked spouse. Take, for example, that seven-years-and-running financial statement presentation project, which I wrote about in my last three posts (here, here, here). That project is moving slower than a one-legged turtle because the FASB chooses to debate and procrastinate, rather than give investors what issuers don't want them to have.

But, a brand spanking new example, which I am about to relate, illustrates a corollary: if Wall Street needs the FASB to make a quick fix, they're Johnny-on-the-spot to service the big boys.

EITF 99-20, which the new FSP amends, concerns itself with the once-arcane question of accounting for the impairment of 'retained interests in securitized financial assets' – you know, remnants of contracts or portfolios considered "junk" at the time the better parts were securitized for the consumption of sane investors. The problem became a front-burner issue to the holders of those junk retained interests as they proceeded to devolve into "toxic."  So, already, you may be getting my drift: the capital of financial institutions were about to get hammered, yet again, by fourth-quarter write downs unless they could get a rule change through the FASB – fast. Basically, what happened was that the financial institutions got their wish via an amendment to an impairment methodology that shouldn't have existed in the first place -- and investor interests were further trampled upon in the process.

The Rest of the Story

Before I describe the new FSP, we should review the salient provisions of its progenitors: SFAS 115, sired out of holy wedlock by the prince of accounting gibberish; which in turn begat EITF 99-20.

SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, requires that investments with a readily determinable market value be measured at fair value. Mandating fair value for some assets was a landmark achievement, but beyond that, SFAS 115 is a charade: an exercise in hiding legitimate unrealized losses from view, solely to appease those who can't handle the truth. Unrealized holding gains and losses on marketable securities classified as "available for sale" (weasel word) are reported in other comprehensive income unless and until they are deemed by management to have become "other than temporary"  (a worse weasel word). Of particular relevance to the issues I am discussing here is this: an other than temporary impairment of a debt security within the scope of SFAS 115 would be recognized only if the holder (i.e., management) determines it is "probable" (the worst weasel word) that it will be unable to collect all amounts due according to the contractual terms.

EITF 99-20 arose from two differences between debt securities covered by SFAS 115 and the retained junk of which I ere did speak. First, junk retained interests do not have a readily determinable market value. Second, it is indeed "probable," by any way one chooses to interpret that weasel word, that the investor will be unable to collect all amounts due according to the contractual terms of retained junk remnants.

If I (or any reasonable investor) had my druthers, there would be no such thing as an available-for-sale financial asset. Retained interests in securitizations, junk or otherwise, would be measured at fair value through the income statement. But, that's not how the EITF works its magic.  Its job is to blithely analogize to some extant rule, no matter how ill-conceived it may be, and presto change-o, out pops a new rule for auditors to lean on, even if that rule is the accounting equivalent of sausage made from leftovers.

So, similar to SFAS 115, EITF 99-20 provides that an impairment of junk retained interests is considered "other than temporary" (with a resulting charge to earnings) only if there has been an adverse change in estimated cash flows. But, at least the EITF took care to specify that estimates of cash flows must be equivalent to those that a market participant would use in determining the current fair value of the investment. In fact, you could say that the EITF foreshadowed the approach to fair value that the FASB would take in SFAS 157.

Notwithstanding whether EITF 99-20 was a well- or ill-intentioned adaption of SFAS 115, the EITF's intentions were clear; and unlike the new FSP that undid those two little words, "market participant," the original choice of them made EITF 99-20 better than having to rely on inherent management bias.  The fact that the implications of using market-based assumptions grew to monster proportions as junk retained interests turned to toxic in droves only serves to highlight the need to de-link financial reporting from the overly sanguine projections of management. 

But that's not the way the Wall Street crowd wants the FASB to see things.  Nobody has been buying toxic loan remnants at anywhere near their original valuations, so the financial institutions would prefer to say that there is no market for them, and hence no "market participants." Therefore, instead of writing down their toxic assets, EITF 99-20 needed to be 'fixed.'

Here is the gist of the way EITF 99-20 was:

"If, based on a holder's best estimate of cash flows that a market participant would use in determining the current fair value of the investment, there has been an adverse change in estimated cash flows… [then an OTTI has occurred, and the investment should be written down to its fair value, and a loss recognized in earnings]."

And here is the 'fix' FSP EITF 99-20-1 made:

"If based on current information and events it is probable that there has been an adverse change in estimated cash flows… [then an OTTI has occurred, the investment should be written down to its fair value, and a loss recognized in earnings]."

If you look at them closely, one could argue that there is no difference in princple between those two mandates.  But obviously, in practice there must be a pretty significant difference.  Though I suppose that the three FASB members who voted for the FSP would vigorously disagree, the effect of the 'fix' is to permit management to ignore the input of the indifferent and dispassionate for management's estimates, whose compensation may be directly effected by the reported earnings for the year ended December 31, 2008.  Obviously, there will be a lot of investments that market participants consider toxic and management, in its infinitely biased wisdom, will persuade the auditors that they hire and fire are just fine.

If there is a silver lining to this debacle, it can be found in the eloquent and forceful dissent of two board members.  Here is just the beginning of what they wrote (names hidden, for the sake of more fun to come!):

"[X] and [Y] dissent from issuance of this FSP because they believe this short-term project does not provide sufficient improvements to financial reporting to support its issuance on an expedited basis with limited due process. [X] and [Y] believe that accounting standards should be focused on serving the needs of investors, who did not request this urgent change. They note that the majority of investors who responded strongly opposed the FSP. Investors are exhibiting a current lack of confidence in financial statement information prepared in conformity with current GAAP, as demonstrated by the high percentage of bank stocks that have market valuations below their tangible book values. As a result, these investors favor valuing all financial instruments at fair value through net income and believe this FSP represents a step away from that goal by failing to require that all changes in the reported fair values of Issue 99-20 assets be recognized in income." [bold italics supplied] 

These are damning words to which I would add that the FASB has deliberately ignored key findings of the SEC in its recent report to Congress. On December 30^th, the SEC issued its 211-page Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting. As mandated by the Act, the report addresses, among other things, the adequacy of the processes used by the FASB in developing accounting standards. Among its conclusions, the SEC found that while the existing FASB process works well, additional formal measures to address the operation of existing accounting standards in practice should be established in order to be responsive to the information needs of investors in a timely fashion. Most important, the report states that accounting standards should continue to be established to meet the needs of investors. General-purpose financial statements may be utilized by others, such as prudential regulators of financial institutions; however, GAAP should not be revised to meet the needs of other parties if doing so would compromise the needs of investors.

So, less than a month after the SEC issued its unequivocal views, in FSP EITF 99-20-1 the FASB flaunts those views by short-circuiting due process and diminishing the quality of information provided to investors.

About Those Brave Dissenters

And, who were those masked men (or woman)? If I give you a list of the current FASB members along with a brief description of their backgrounds, I'm betting you can guess correctly, even without knowing anything else about them:

• Robert Herz -- former senior partner of PwC and part-time member of the IASB.
• Thomas Linsmeier -- former academic whose research has explored the role of accounting information in securities markets and consultant to the SEC on market risk disclosures.
• Leslie Seidman -- former consultant to corporations and accounting firms, and former VP of J.P. Morgan.
• Marc Siegel -- a recognized expert in forensic accounting and financial statement analysis.
• Lawrence Smith -- former senior partner of KPMG and chair of the EITF.

The lone rangers are Tom Linsmeier and Marc Siegel, of course -- the only two who did not spend the bulk of their careers serving corporate clients. And incidentally, they are the two most recent additions to the FASB.

The likes of Linsmeier and Siegel give me some hope for the future of standard setting following the second major financial reporting crisis of the decade. If we could somehow get just one more on the board like them, the SEC's recommendations to the FASB could become a reality.

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Following my most recent post on financial statement presentation, Eddie Thomas, a frequent commenter of this blog, wrote: "Wouldn't investors be better off pushing for a more robust XBRL so that they can make their own decisions about what is relevant information and what is not? It seems like an effective end run around the politics of the FASB and the IASB."

I agree with Eddie to a point, but I am afraid he may be discounting the "garbage in, garbage out" rule of data processing. The information value of "robust XBRL" heavily depends on the granularity, uniformity and quality of inputs. As to whether GAAP or IFRS has attained a quality level even approaching 'satisfactory' is, as Eddie implies, highly debatable. With respect to granularity and uniformity, it's not even a close call -- hence the financial statement presentation project in the first place.

But, what I am about to suggest can make Eddie's wish to "end run" politically motivated accounting standards come true: balance sheet account reconciliations. In that last post, I suggested that one of three important things that the Boards could do would be to provide reconciliations of the beginning and ending balances of all balance sheet accounts. The other two were to mandate a direct-method statement of cash flows and to maintain a strict separation between financial and operating items. Upon further reflection, the reconciliations would be the single most important thing the Boards could do. It would also be the simplest and most logical way to do raise the level of financial reporting on all dimensions. Here are just three examples.

Example #1: PP&E

A reconciliation of PP&E can provide a separation of depreciation charges by function, and highlight the effect of discrete events hitting the income statement that are widely regarded to be of interest to investors: e.g., business combinations, restructurings, discontinued operations and impairments.

Perhaps some of this information can be teased out by the FASB/IASB proposal, but certainly not all of it. But, the FASB/IASB proposal would subject much too much to management's whim; and without detailed mandates it would be difficult to develop consistent XBRL tags.

The last two items in the reconciliation example clearly go beyond the FASB/IASB proposal: the effect of capitalized interest, and changes in the balance due to "translation" of accounts on the books of foreign subsidiaries at current exchange rates. The transparency of capitalized interest is essential to investors whose first analytical objective is the isolation of the effect of financial decisions on "operating" profits. The effect of foreign currency translation allows the investor to unwind the purely random effect on comprehensive income from multiplying a historic cost by a current foreign currency exchange rate.

Example #2: Inventories

The inventory example has a couple of extra twists. First, methinks it is not well-known that U.S. GAAP permits the capitalization of interest costs in inventory (IFRS does not). Also, "fair value hedge accounting" under both FAS 133 and IAS 39 permit the historic cost of certain inventories to be adjusted by gains and losses due to certain "hedged risks." The result of fair value hedge accounting on the carrying amount of inventories (and other assets/liabilities) is a process that I heard Tom Linsmeier refer to (prior to his being appointed to the FASB, of course) as "mutt" accounting – i.e., neither historic cost nor fair value. If comparability is truly the key reason for U.S. adoption of IFRS, then the Boards should be seeking to enhance comparability generally, and not merely through IFRS adoption. This should mean that investors are entitled to data for unwinding the effect of hedge accounting, a free choice creating lack of comparability, whenever it is applied.

The IASB/FASB proposal calls for disclosure of expenses by "nature" if management deems it to be significant information. Instead, I would require, where applicable, a statement of cost of products manufactured (i.e., a reconciliation of production costs and changes in inventory balances to cost of sales). The components of cost of sales could be highly informative, and, like reconciliations of balance sheet accounts, they are already being prepared for internal control purposes. Besides, undergraduate accounting students learn how to prepare a statement of costs of goods manufactured in their second semester!

Example #3: Trade Receivables

I include this example in part to illustrate that some legitimate foreign exchange losses are hidden in other comprehensive income (i.e., the translation adjustment). These gains and losses, which are derived from assets and liabilities held on the books of foreign subsidiaries (whose functional currency is not the dollar), are no different in their economic substance from other foreign-currency-denominated accounts receivables on a domestic subsidiary's books. Yet, by a 4 – 3 vote, the FASB decided that they should be presented differently.

Reconciliations are a No-Brainer: That's why Investors Can't Have Them

Imagine having those reconciliations along with programs that can read XBRL data! Service providers would be competing with each other to create the very best 'out of the box' analytics, and just as Eddie predicts, users won't even bother glancing at the financial statements as presented by management and the sleep-inducing narrative disclosures written to obfuscate rather than enlighten. The oil and gas industry could stuff their cherished interest capitalization where the sun don't shine, and multinationals could do the same with their foreign exchange translation gyrations.

But, the reasons why we don't currently have reconciliations are the reasons we won't get them. Managers must continue to make value-destroying choices for the sake of the accounting results that, with reconciliations, could be easily unraveled and even prevent fraud. Even though S-OX essentially requires that these reconciliations must exist somwhere in the bowels of each issuers' accounting system, auditors could not abide the prospect of providing each and every investor with the opportunity to perform its own 'analytical review' from which its own could be second-guessed. 

So, there you have it: the result of a couple of days of talking to myself, as opposed to millions of dollars spent by the FASB and IASB to solemnly deliberate for seven years such weighty issues such as whether the direct method for the statement of cash flows should be required, and a bunch of ad hoc ideas like separate identification of recurring and non-recurring revaluations.

If there is hope for improved financial statment presentation, it may be with new leadership of the SEC.  Historically, disaggregation has been under the purview of the FASB or the SEC. For example, SEC Regulation S-X is the main repository of presentation guidance for public companies. About a dozen years ago, the SEC, as a favor to issuers, eliminated supplemental schedules set forth in Reg. S-X that required details on the movements in long-lived assets. But about eight years ago, it also proposed to augment disclosures of the movements in so-called "valuation and qualifying accounts." The proposal was never acted upon, with the advent of S-OX serving as the official excuse. But, intense lobbying against the proposal by the usual suspects is the only plausible scenario.

I am not necessarily saying that the SEC should be taking over this project, but presentation has long been the purview of the SEC, and the FASB is falling way short. The purpose of S-OX in providing an independent funding source for the FASB is to free the FASB from undue influence, so as to carry out its mission in an unbiased and timely fashion. How could something as straightforward as financial statement presentation take seven years (and counting), if it were not for the meddling of special interests? Intentionally, or not, the FASB has neutered itself, and harmed the interests of U.S. investors by agreeing to join forces on the project with the IASB – which is not independently funded, and more than ever appears to be under the thumb of the European Union.

Financial Statement Presentation: The Sequel

Two readers, including Robert Bloomfield, Cornell accounting professor (my alma mater!) and Director of the Financial Accounting Standards Research Initiative (FASRI) of the FASB, were kind enough to point out an error in my previous post. Here is the gist of what Prof. Bloomfield had to say (his full comment is here):

"… you link readers to the 7-page summary document, but there is a lot more than that. …The discussion paper is quite long and detailed, including elaborate examples of a manufacturing and a banking company.

Also, one very interesting aspect of the proposal is a reconciliation footnote that would reconcile, line by line, the cash flow statement to the income statement. The differences are broken into various categories including accruals, fair value remeasurements, other remeasurements, etc.

So if you are opposed to capitalized interest, you are likely to be able to undo a fair bit of that through the footnotes."

Indeed, I mistook the summary of the DP, which was separately posted on a different page on www.fasb.org, for the entire document. My bad. I guess the page numbering in the summary should have tipped me off that there was more to come. But as a feeble defense, the FASB could have made the project page more user-friendly by posting a link to the complete DP right on the project page itself.

Much more important, is that I am happy to have discovered that the Boards may be proposing some significant changes that can result in incremental information for financial statement users. But, in all of the extra data, what may be some of the most sensitive items are still artfully concealed. Notwithstanding Prof. Bloomfield's statement that I should be able to discover more about interest capitalization, "more" is not enough when "all" is easily achievable and principles-based.

Along the same lines, there is nary a scintilla of disaggregated information regarding the effects of foreign currency translation on earnings, assets and liabilities. As I have pointed out in previous posts, FAS 52 creates some pretty crazy effects: translating the fixed assets on the books of foreign subsidiaries at current exchange rates is nothing more than random number generation; gains and losses on foreign-currency-denominated monetary items held by foreign subsidiaries are not presented in a manner consistent with identical exposures that happen to be on the books of domestic subsidiaries.

Making Financial Statement Presentation Simpler – and Much Better

Even though the Boards hide behind a self-imposed constraint to excuse themselves from consideirng recognition and measurement issues, they can still make the effects of some of their most ridiculous rules much more transparent than they are currently proposing. Here's three frustratingly simple things, which if implemented would far exceed the benefits of their current proposal:

1. Along the lines of the logic I presented by the name Largest Possible Entity, maintain a strict and principled separation between financial and non-financial elements in the balance sheet and income statement. Call me cynical, but I simply can no longer accept that giving management any discretion whatsoever over financial statement presentation will result in higher quality or especially more comparable information (the putative goal of IFRS and U.S. GAAP convergence). Every student of finance is apprised at some point that Modigliani and Miller received their Nobel Prizes in large part for seeding the conversation that financial decisions are fundamentally different than whatever one cares to call the rest of the things that management does. The LPE concept is merely an accounting child of their enduring insights.
   
2. Mandate the direct method for the statement of cash flows. The format for the statement of cash flows proposed in the DP is pretty cool, and so is the reconciliation of cash flows to comprehensive income. I also like the new definition of operating cash flows that would comprehend expenditures on assets. But, all of that is icing on the cake compared to simply eliminating the indirect method alternative that was provided at the eleventh hour by the FASB in SFAS 95. Waiting for this simple change seven years after Enron has conditioned me to not ask for too much in this regard.
   
3. Require a reconciliation of the beginning and ending balances of each account on the balance sheet (I still can't bring myself to 'statement of financial position' for an accounting that suspends rules of arithmetic I learned in first grade). If reconciliations are done properly, users can unwind all sorts of silly things – of which the aforementioned interest capitalization, random number generation through foreign currency 'translation' and inconsistent treatment of foreign exchange gains/losses are but three examples.

   The proposed reconciliation information is much too vague, and again is subject to obfuscation by management. Get ready for the naysayers to dismiss this suggestion as impracticable. But, if Worldcom's auditors had actually reconciled the beginning and ending PP&E balances, they would have been heroes instead of goats – and Cynthia Cooper, the Worldcom employee who blew the whistle on Bernie Ebbers et. al. would be memoirless. Especially in these days post S-OX 404, shouldn't each and every consolidated balance sheet account be reconciled? If not, what's the point of "internal controls over financial reporting"?

   In my next post, I'll provide a couple examples of the simple form of reconciliation I have in mind.

Some Additional Tidbits

First, the first paragraph of the DP states that Phase A of the project addressed "statements that constitute a complete set of financial statements… and … Phase B would address more fundamental issues relating to presentation and display of information … including … reconsidering the use of a direct or an indirect method of presenting operating cash flows." [para. 1.1, italics supplied]

Fundamental? More like "highly controversial"! Maybe I'm missing the boat here, but Phase A is the "fundamental" issue, and Phase B is detail—albeit important detail. The DP process could be much more constructive if the Boards would simply set forth the reasons why investors would benefit from a direct method cash flow statement; and more important, why issuers stubbornly resist the wishes of investors. The absence of a willingness to openly acknowledge the actual controversies does not bode well for a satisfactory outcome.

Second, the third paragraph of the DP states that FARSI, Prof. Bloomfield's group, "…will study investor use of financial statements prepared using the proposed presentation model by conducting a series of controlled tests." [para 1.3] To test what? What parts of the DP are even amenable to controlled experiments?

Notwithstanding the unnecessary vagaries, I have to say that I'm not sure that any testing will provide actionable results. Controlled experiments in accounting overwhelmingly tend to address very narrow research questions whose results are difficult, if not impossible, to validly generalize. My fear is that results that merely weakly support the preliminary views expressed in the DP will be over-generalized by vocal proponents of an anti-investor agenda.

But, setting that cavil aside, my greater concern is that investors will provide some "statistically significant" indication that the new presentation format represents an "improvement" over the mishmash of statement and disclosures currently being fed to them – a pretty low hurdle given the current sad state of financial reporting. That "empirical evidence" will be seen as supporting the proposed changes, tepid as they are, and thereby rendering really needed changes to the bottom of the priority pile for another twenty years. If you need evidence, see FAS 115 and that ugly "other than temporary impairment" standard that currently plagues us in the midst of our economic crisis; or SFAS 95, allowing the indirect method. GAAP is littered with disastrous standards that were passed by narrow margins with at least some board members expressing disappointment, but justifying their "yea" votes as compromises in the name of some modicum of progress. Will the Boards be playing the same sorry tune one more time?

Third, the absence of any discussion of XBRL in the DP indicates that both Boards might prefer that XBRL's significant implications for disaggregation of financial information – the more the better – be swept under the rug for a while. Soon may come the day, perhaps even before a final standard becomes effective, that the value of static presentations will fade to dust compared to simple software programs that generate financial statements in accordance with each user's very own preferences. Thus, the real reporting issue of the near future is not presentation, but rather disaggregation.

Having said all that, I'll conclude by stating that I fundamentally object to a management approach. I also have little confidence that the detailed disclosures regarding cash flows, much less the direct method, will be accepted by the IASB. Financial statement presentation was not designated as a convergence topic in the fabled Norwich Agreement, and I believe that the FASB erred in agreeing to conduct the project jointly with them. I believe they chose to form a cartel on this one, because not to have done so would have once again spotlighted the IASB's record of reluctance to push back against their funding sources.

Evidently, the FASB feels that it is a far better outcome to end up with a watered-down presentation standard that won't be revisited for another twenty years than it is to jeopardize IFRS adoption in the U.S.

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

This past October, the FASB and IASB issued a joint discussion paper with their preliminary views on financial statement presentation:

"[The IASB and FASB initiated the joint project on financial statement presentation to address users' concerns that existing requirements permit too many alternative types of presentation and that information in financial statements is highly aggregated and inconsistently presented…" [¶ S1]

Both boards commenced work on separate projects in 2001, and seven years later have barely anything to show for it except for this five-page document, which amounts to little more than a proposal to re-arrange the living room furniture. For the sake of completeness, I should also point out that the IASB did also make a few minor alterations to IAS 1 that mainly catch up IFRS to GAAP in respect to reporting dirty surplus – whoops, I meant "other comprehensive income."

To give you some sense of the nature of these deliberations, such as they have been, I can draw on a personal experience. After the Enron debacle, the lack of transparency afforded by the indirect method of presentation for the statement of cash flows rightly became a focus of critics. In Enron's case, it would have been kinda sorta nice to be aware of how little cash Enron was getting from its customers. Six months following Enron's implosion, I attended the annual reunion of alumni from the SEC's Office of the Chief Accountant. At a presentation to our group, the erstwhile Chief Accountant assured us that the direct method of presentation of cash flows would soon become required. Supposedly, there was a clear consensus that this was the right thing to do.

That was more than six years ago, and nothing whatsoever has changed, other than that we're knee deep in another financial debacle. The preliminary views document disingenuously continues to spout the party line in support of the direct method, and even for further disaggregation of cash flow information. If this were solely an FASB decision, and if President-Elect Obama appoints a non-partisan SEC Chair (I'm rooting for Charles Niemeier), then I might have some reason to hope. But, there's no way this sort of change will find its way into IFRS. EFRAG (European Financial Reporting Advisory Group), and perhaps China, will contrive some sort of excuse that it would harm the ability of companies in their part of the world to compete; and the proposal will fade to black yet one more time.

Another proposal that would have some merit if it weren't watered down with weasel words is, "An entity should further disaggregate its income and expense items by their nature within those functions to the extent that this disaggregation will help users in predicting the entity's future cash flows." [¶ S11, italics supplied] For example, cost of sales would be disaggregated into materials, labor and other components. But, who would decide what "will help users"? Answer: management, of course, because that is the consistent theme of IFRS – trust management to do what is right. If this were an FASB-only project, I'd bet that the document would include examples and illustrations of the principle functional categories to be disaggregated, together with the principle components of the disaggregation.

Separating Financing from Everything Else

No presentation format can be satisfactory unless it assists readers in assessing the performance of a company, independent of any decisions regarding financing that management made. That's why I am so strenuously opposed to the capitalization of interest costs in any way shape or form: assets values should be reported independent of how they are financed, and financial items affecting profitability should be separated from all other revenues and expenses.

Thus, the cockles of my heart warmed as I read these noble words:

"The proposed presentation model requires an entity to present information about the way it creates value (its business activities) separately from information about the way it funds or finances those business activities (its financing activities)." [¶ S4]

But, then, reality intruded upon my reverie as I read the following:

"The classification decision would reside with management…. The Boards support a management approach to classification rather than a prescriptive approach because they believe it will result in financial statements that reflect how management views and manages the entity and its resources." [¶ S6, italics supplied]

In other words, what constituted financing or "business activities" would be subject to the discretion of management. That's not quality financial reporting, it's farcical financial reporting. But perhaps the boards saw no other way to protect interest capitalization, that sop to the oil and gas industry. Also, don't count on management to disaggregate the interest component of cost of sales, or the cost of anything else.

The main point of this post is to demonstrate that the choice between a "prescriptive approach" and a "management approach" is a false choice. A third alternative, as always, is a principles-based approach.

The Principle of the Largest Possible Entity

The late Tom Burns, one of my mentors, once remarked that the most fundamental problem of financial reporting was choosing the entity of account: in other words, the boundaries that marked the affairs of the entity, and the affairs of others. I didn't fully appreciate that statement until too many years later. I was trying to think of a way to explain to my students in a managerial accounting course how the topics for such a course were selected. I eventually decided that managerial accounting explored decision making scenarios in which managers would decide which "real", or "productive" resources a business should acquire, and how best to put them to use. Questions of financing the resource acquisitions would be explored elsewhere in the curriculum.

That was fine and good, but I needed to have a way to explain what was "real" versus merely "financial." This is when, and I can't explain why, I came back to Tom Burns' observation. I asked myself, what would financial statements look like for the largest possible entity (LPE) – as if the universe were one big happy family? In other words, what if all the entities that existed, personal, corporate, government, etc. were consolidated/combined? This is my depiction (units of measure are arbitrary and only for purposes of illustration):

The Largest Possible Entity
Consolidated/Combined Balance Sheet
December 31, 20x1
Inventories	$   100
Plant and equipment	200
Natural resources	300
Knowledge	400
Total assets	$1,000
Equity	$1,000
Consolidated/Combined Income Statement
Year ended December 31, 20x1
Production revenue	$ 500
Utilization of resources in production	400
Net income	$100

 

The most important lesson from the balance sheet is that all of the assets that remain upon elimination of reciprocal accounts are the "real" assets. Therefore, financial assets and liabilities are distinguished by their absence on the balance sheet of the LPE. For example:

• There is no cash on the LPE's balance sheet. The entity already owns and controls all of the goods and services in the economy, so cash is of no use, except perhaps for the paper it is printed on.
• There are no receivables, derivatives of any kind, or liabilities. They all offset, or eliminate, as "intercompany" transactions.
• There are no investments in other entities, because the LPE can't recognize an investment in itself as an asset.

The only categories of revenue and expense that can appear on the LPE's income statement are revenues from the production of real goods and services and expenses from the use of the assets as inputs to the production of those goods and services. Like all receivables and payables, financial revenues and expense are reciprocal items that cancel out.

From the above, I derive the following simple principles that can be the fundamental basis for a financial statement presentation standard:

• Only those assets that are not eliminated in the consolidation/combination process to arrive at the balance sheet for the "largest possible entity" (LPE) are "real," or call them "operating" if you want. All other assets and liabilities are to be reported as financial in their own separate categories.
• Operating expenses are the utilization of real assets in the production or real goods and services. All other expenses are financial.
• Operating revenues are either (1) the measure of the assets (real or financial) that an entity becomes entitled to for having transferred real resources or for having provided real services; or (2) the measure of the reduction in liabilities that an entity is entitled to from having transferred real resources or provided real services. All other revenues are financial.

Thus, the fundamental distinction to be made in financial presentation is between those items on financial statements that are, or are derived from, real versus financial assets and liabilities. If the boards want to give management the discretion to decide what is "operating" and what is "non-operating", that would be fine with me, just so long as financial items are not conflated with real items in any financial statement. Especially after this latest financial debacle, the potential usefulness of this fundamental distinction should be more apparent than ever.

The day may yet come when we will be freed from the eccentricities of financial statement presentation foisted upon investors by managers who have no interest in giving shareholders more information about their actual performance. Sad to say, after seven years of waiting for a five-page, joint preliminary views document, that day will be no closer if the next generation of SEC leadership doesn't give the accounting standard setters a swift kick in the pants.

On that note, I even sent the gist of my LPE principle to a senior staff member of the IASB a number of years ago, not long after the IASB announced the commencement of its financial statement presentation project. His initial reaction was positive, but after I offered to help develop the idea further, I received no further response. I now invite you, kind reader, to be the judge.