The Accounting Onion

EITF 96-15: Godzilla and Frankenstein's Love Child

As I was researching a question for a client a couple of weeks ago, I happened upon a love child of two of my pet peeve accounting standards:

• FAS 115 (marketable securities) – especially the part permitting available-for-sale (AFS) classification;

• FAS 52 (foreign currency translation) – practically every word of it makes my blood boil.

I have written a number of posts on FAS 52, and this one here hits the basics, should you feel the need to get canned up on the topic before reading further.

The love child I speak of is EITF 96-15, Accounting for the Effects of Changes in Foreign Currency Exchange Rates on Foreign-Currency-Denominated Available-for-Sale Debt Securities. Based on the title, it obviously deals with an interaction between FAS 52 and FAS 115. But, as to why it was issued three years after FAS 115 is an interesting question. For every crime committed with accounting standards against investors there is some other special interest being served. In this case, I can only guess at what it was, because the EITF issue summaries gave no hint as to how this bee got under their bonnets.

U.S. companies with foreign subsidiaries are generally reluctant to repatriate excess cash from their subsidiaries if negative tax effects attach to the decision. While waiting for a more opportune time to bring the cash back to the mother ship, they have to figure out where to park it; and one strategy is to invest it in marketable securities issued by other companies based in the U.S. From a risk management perspective, at least the money is invested in dollars. However, as I'm about to explain, earnings-obsessed managers might shy away from that choice, even if it is clearly the right thing to do from an economic standpoint.

FAS 52 has many generous elements, but it is relatively demanding in the area of "foreign currency transactions," which, simply stated, are receivables and payables denominated in a currency other than the entity's functional (foreign) currency. Normally, the effect of translating from the subsidiary's functional currency to dollars gets carried into the translation adjustment without affecting income. However, (with certain limited exceptions) the translation of "foreign currency transactions" must be reflected in income. (I have written about this in a previous post, here.)

The question addressed in EITF 96-15 is whether a marketable debt security designated as available-for-sale is a foreign currency transaction. That sounds like a serious question, but it's actually quite ridiculous. Notice that the EITF is not questioning whether marketable debt securities designated as "trading," or designated as "held-to-maturity" are foreign currency transactions – but only those debt securities that are arbitrarily and capriciously designated by management to be AFS. Knowing only that ought to tell you that the fix was in before the first word of debate had been uttered.

The way I thought about the issue before I did my research was, if I must say so myself, perfectly straightforward. First, an AFS marketable debt security is still at bottom a receivable; some arbitrary AFS designation doesn't change that.  Second, FAS 52 is crystal clear as to the treatment of a receivable: it's a foreign currency transaction.

Notwithstanding the obvious, the EITF arrived at the opposite conclusion. By quasi-Talmudic logic that can only be fully appreciated by those ordained to be accounting policy makers, the EITF established a new record for the figurative hop, skip and jump that lead them to conclude that a marketable debt security designated as available-for-sale would not be a "monetary item" – whatever that has to do with the price of tea in China. Anyway, since only monetary items like receivables and payables qualify to be foreign currency transactions, an AFS marketable debt security cannot be one of them.

Eureka! Gold made from copper! In other words, make a loan marketable, arbitrarily and capriciously designate it as AFS to unmake its monetary item characteristics, and presto change-o, you no longer have to worry about income statement exposure. Do you remember the running gag on Late Nite with Conan O'Brien called "if they mated"?  That's EITF 96-15: two wierdos, FAS 52 and FAS 115, matched by a funny guy to beget horrible looking thing that only a CPA could love.

Prior to EITF 96-15, an earnings-obsessed manager might have chosen to invest excess cash in marketable equity securities despite the additional economic risks relative to investing in debt, because the accounting risks happened to be low. That's because marketable equity securities are not receivables; by the perversity of the way FAS 52 converts foreign currencies to dollars, marketable securities might as well be equipment or inventory. Paradoxically, investing in debt would have created income statement volatility, even though economic risks would be lower than by investing in equities.

The clearly evident purpose of the EITF was to create a discretionary safe haven for excess foreign currency. Whether you think that is a good thing or not, it is not my point. What should be clear is that it is for reasons like this the accounting oligarchs deigned to create the grand ole EITF in the first place: to do whatever it takes to spice the sausage we call GAAP to managers' tastes.

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.

FAS 52: Another Goodwill Charade, and IFRS Convergence To Boot

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In a recent post, I argued that goodwill arising from a business combination was just a random number; therefore, any attempt to measure impairment amounted to nothing more than a costly charade.  By coincidence, I recently had an inquiry from a client about the accounting for goodwill at foreign subsidiaries per FAS 52.  Thinking about it for my client also reminded me of yet another sordid tale of accounting convergence for its own sake. 

The General Problem of Goodwill Arising from Foreign Subs under FAS 52

By way of background, FAS 52 requires that assets of a foreign subsidiary with carrying amounts based on historic costs (e.g., plant and equipment) be translated into the reporting currency (e.g., dollars) at the exchange rate existing on the balance sheet date (e.g., the 'current rate).  As I have noted in an earlier post, multiplying historic costs by current exchange rates is the equivalent of multiplying apples and rocks -- with the inevitable result being a random number. 

What about goodwill arising from the acquisition of a foreign subsidiary?  As I am about to show, the choices arising out of a slavish application of the general approach of FAS 52 is so absurd that the FASB buried its own decision deep in an Appendix.  Be that as it may, the specific question is whether goodwill should be measured in dollars, or measured in the currency that is used to measure all of the other assets and liabilities of the subsidiary and translated into dollars.  The implications are the following:

1. If the foreign currency is the answer, then goodwill will be translated to dollars at each balance sheet using the current exchange rate.  Exchange rate movements will affect the carrying amount of goodwill expressed in dollars, which will in turn affect consolidated shareholders' equity through other comprehensive income (the so-called 'translation adjustment'). 
2. If goodwill is measured in dollars from the outset it will remain at a constant dollar amount over time, unless it becomes impaired per the FAS 142 charade.   

From an investor's viewpoint, which treatment of goodwill is preferable? Measuring in a foreign currency and translating with current exchange rates (the first choice, above) adds another information-less element to goodwill measurement, confounding even further any potential to glean something relevant out of the translation adjustment.  Therefore, measurement in dollars (the second choice) would be the lesser of two evils. 

Which answer did the FASB pick?  Hint: look for the answer that creates a consistent set of rules, irrespective of whether the rules themselves make any sense.  Yep, FAS 52, para. 101 requires goodwill measurement in the foreign currency.  The only conceivable reason must be that it is consistent with the treatment of other historic-cost-based assets of the foreign subsidiary.   

Unintended Consequences

That brings me to the question my client asked, which goes something like this:

The functional currency of Company A is the U.S. dollar.  Company A acquires 100% of the outstanding shares of Company B, for which the dollar is also its functional currency.  However, Company B has two foreign subsidiaries, C and D, whose functional currencies are their respective local currencies.  Given the requirement of paragraph 101 of FAS 52, must a portion of the goodwill recognized from A's purchase of B be attributed to C and D? 

It would seem that the fact pattern described above is not uncommon.  Yet, I could not find even a glimmer of insight in the official GAAP literature that would acknowledge that the problem even exists. So this is how my own thinking goes:

• Given that the only purpose of paragraph 101 would appear to be consistent with the accounting for other assets, one would think that a reasonable allocation of goodwill would be intended.  Take the extreme example where the U.S. operations of the acquired company might be insignificant: failure to allocate goodwill among the subsidiaries would result in a significant inconsistency, and perhaps even, an opportunity for manipulation.
• FAS 142, charade that it is, does require a rigorous apportionment of goodwill among reporting units for the purposes of determining whether goodwill is impaired.  A reasonable approach to allocating goodwill to foreign subsidiaries might be similar to the reporting unit approach of FAS 142.   

However, to my surprise, the few inquiries I have made of practitioners with experience in the area are unanimous in the view that, in practice, goodwill would not allocated below the intermediate parent -- in this case, Company B.  Why might practitioners take that view?  Because no rule prevents them from doing otherwise; and because it benefits them to reduce the volatility caused by translating goodwill from a foreign currency to the reporting currency.  In fairness, and as I have noted above, even though what appears to be broad practice may result in inconsistencies, it is arguably better accounting -- or rather less bad -- than results from a rote extrapolation of the extant rules (which is the most I can say of my own reasoning).

The International Convergence Connection

As I have pointed out elsewhere (interest cost capitalization), some changes to IFRS are made for the sake of convergence, with well-reasoned standards thrown on the junk heap for the sake of convergence with U.S. GAAP and the prospect of IASB financial reporting hegemony. The goodwill provisions of IAS 21, the IFRS counterpart to FAS 52, is another case in point.  At one time, IAS 21 allowed either of the approaches we have discussed for goodwill measurement.  But as part of an omnibus project to eliminate alternatives in numerous standards (brought on by the 2005 adoption of IFRS by the EU), the IASB eliminated the option to measure goodwill in the reporting currency, making it the same as FAS 52.  Again, the only conceivable motivation appears to be convergence for convergence's sake. 

I imagine that the progenitors of the original IAS 21 were thinking that at least part of goodwill arises from synergies between a parent that 'thinks' in its reporting currency and a subsidiary that 'thinks' in a foreign currency.  Thus, the source of the goodwill is not strictly foreign or domestic; so, who is to say in which currency goodwill should be measured?  Evidently a race for convergence trumps reason and reasonableness. 

FAS 52: Forex Gains and Losses from Holding Dollars?

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I noticed that 'FAS 52' has been the most popular search term leading web wayfarers to seek inner peace from the Accounting Onion (click here for my earlier FAS 52 post).  I play requests, so here's a riff on another ineffable result from applying FAS 52 (or IAS 21 if IFRS is your bag). 

As usual, let's start with a simple example:

Company Alpha is based in the U.S. and presents its financial statements in dollars.  Company Beta is Alpha's British subsidiary.  Beta holds U.S. dollars (USD); and since its books are kept in GBP, it has to remeasure its USD holdings into an equivalent amount of pounds--just as it would to record any transaction involving payments in a foreign currency.  Over time, if the value of the dollar changes, Beta must recognize foreign exchange gains or losses on its GBP standalone income statement. 

In consolidating Beta with Alpha, it wouldn't take an undergrad accounting student too long to figure out that Beta's dollar-denominated bank accounts should be treated no differently than Alpha's.  Therefore, Beta's foreign exchange losses on the USD should not be carried through to Alpha's consolidated income statement, right?  WRONG. 

Sadly, reason cannot substitute for a sleep-inducing reading of the rules.  FAS 52 requires that Beta's foreign exchange gain or loss on holding USD cash must be expressed in dollars and carried through to the consolidated income statement. The ludicrous effect is that dollars held by subsidiaries are accounted for differently (i.e., exposed to foreign currency fluctuations between the GBP and USD) than the same dollars held by a parent company. In other words, some dollars are just dollars, but dollars on a ledger over the border are ... ummmm ... special.  So far, not a big issue you may think, but now consider that the principle-devoid rule I have just described extends to all dollar-denominated receivables and payables booked by the subsidiary, including intercompany amounts. Yes, a company can report a profit or a loss merely by lending money to its foreign subsidiary.   (If dumbstruck, I suggest you pause to avoid permanent injury to your brain.)

So much for substance over legal form: FAS 52 rules mean that consolidated presentation for all assets and liabilities depends on whose ledger an asset or liability is booked--an unabashed departure from the most basic principles governing consolidated financial statements.  The reason for this is -- never mind, there is no good reason.  The FASB's reasoning, such as it is, begins with the patently false assumption that a subsidiary may operate in a manner so disconnected with its parent that dollar exposures are no different than exposures in other currencies.  The resulting rule is so outlandish, it has shocked (but not awed) too many unwitting accountants, including `a recent client.  These gentle and smart individuals are my excuse for the gap in posting, because I spent three beautiful days indoors in New England, helping them understand (to the extent one can) FAS 52.   I'm betting this slight exposre to the massive dose of radiation I had to administer to my client has led you to question whether accounting resides in our world or Alice's Wonderland.

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Would you like to learn more about FAS 52? 
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FAS 52: Adding Apples and Rocks

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Would you like to learn more about FAS 52? 
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FAS 52 on foreign currency translation took effect in 1982 after one of those infamous 4 - 3 votes.  Like other accounting rules promulgated by the FASB, it is nonsense, for the sole purpose of helping CEO's smooth their reported earnings over the past quarter century.  Largely because FAS 52 makes no sense, it is complex in addition to being much appreciated by issuers of financial statements. This has been fortunate for me, because I have made some good money teaching FAS 52 to accounting professionals for the past 15 years.  It usually takes me a full day to explain the ramificaitons of FAS 52 in reasonable detail, but I thought I would make an attempt in this post to point you to the rule in FAS 52 from which all the other nonsense springs.

Let's start with an example outside of accounting--an example of something you would never do, but bear with me for a moment. 

Two attributes of a person are height and age.  Multiple your height in inches by your age in years; for me, the answer is 4,368. Question: what does the resulting number for you say about the difference between me and you?  Answer: absolutely nothing.    The product of height and age is  a number, completely unrelated to any person's attributes.  The only way to describe numbers calculated in this manner is by the calculation itself--the product of height expressed in inches and age expressed in years.

Now, a similar example, except this time one within the scope of FAS 52. 

• Company A has no subsidiaries and Company B has a wholly-owned subsidiary in the UK that operates independently of the parent. 
• Both companies issue their financial statements in U.S. dollars.
• Both companies buy land in the UK at a price of GBP1,000.  At the date of the transaction, the exchange rate was GBP1.00:USD2.00.  Therefore, the acquisition cost of the land in the reporting currency (dollars) is USD2,000 for both companies.
• The exchange rate moves to GBP1.00:USD1.60 by the most recent balance sheet date; and both companies still own their land.

Every Accounting 101 student knows that, barring an impairment charge, Co. A will report the land on its consolidated balance sheet at its historic cost of $2,000.  Co. A will do this forever until it parts with the land.  But, only a FAS 52 nerd will know the rule that Co. B applies.  The land will be reported at $1,600--i.e. historic cost in UK pounds multiplied by the new exchange rate.  Thus, one company reports their land at historic cost (an attribute of the land), and the other company reports the land at an amount that is not only different, but also at a dollar amount that defies description except for the way in which it was calculated.  (What do you get when you add 2 apples and 2 rocks?  Answer: 4 objects.) 

Here is a brief list of ramificaitons of this nonsense that passes for an accounting requirement--all because the clear purpose of FAS 52 is to smooth reported earnings:

• Economic substance, and not legal form, drives the consolidation of domestic subsidiaries, but not foreign subsidiaries.  The amount reported for the land, or any other asset or liability, and the changes in any asset or liability will be determined by location of the accounting records on which they are maintained.  (Even most CPAs are shocked to learn this.)
• If you cannot describe what attribute of an asset a number is supposed to convey (e.g., historic cost, replacement cost, fair value, expected present value of future cash flows), you cannot state that the number results in 'fair presentation.'  The phrase in the auditors report, 'fairly presented in accordance with GAAP' can only mean one thing: the auditor checked to see that you followed the rules of GAAP.  (I pronounce "GAAP" with a silent "P", like "GAA.")
• There is no 'principle' in FAS 52, yet no one has FAS 52 on their list of things to change in their quest for 'principles-based' accounting.  IAS 21, the International Accounting Standard version of FAS 52 was never a work of art, and it was last revised to become virtually identical to FAS 52.
• Many numbers on the balance sheet can only be described as random drivel as a result of the application of FAS 52.  Therefore, a balance sheet cannot be a 'statement of financial position,'  as intended.  Should accounting be about presenting useful numbers to investors and other decision makers, or is it enough that total assets balance out to total equities?  Don't answer that, because it will only make you as depressed as I am.  As I have pointed out in an earlier post, both the SEC and FASB seem to give lipservice to the asset/liability view of accounting, because FAS 52 is a poster child for the revenue/expense view.

By the way, 4,368 is equal to 78 inches tall multiplied by 56 years old.  That's information.

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