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?

Sarbanes-Oxley and Smaller Reporting Companies: There is a Better Way

I apologize for the long interval between this and my last posting – especially to those of you who have privately thanked me for material just boring enough, and long enough, to induce a good night's sleep. Tax blogs, I am told, are much too potent unless one is planning to spend an entire holiday weekend in bed.

This long-awaited naturopathic sleep remedy is based on Floyd Norris' recent critique of efforts to roll back some of the provisions of the Sarbanes-Oxley Act. Roughly in descending order of offensiveness, we have movements afoot to:

1. Place the FASB under the supervision of a systemic risk agency, which would in turn be heavily influenced by the banking interests who still blame fair value accounting for the financial crisis;
2. Rescind for companies that have a public float of less than $750 million the requirement that an auditor attest to management's assertions regarding the effectiveness of internal controls (S-OX 404(b));
3. Challenge the constitutional legitimacy of the PCAOB; and
4. A House of Representatives committee vote to exempt the 6,000 'smaller reporting companies' (i.e., market cap. < $75 million) from complying with S-OX 404(b).

If I had been writing a blog back in 2002 as S-OX was being rushed to a vote in spasms and fits of self-righteous bipartisanship (did blogs actually exist?), I would have predicted something like this would be happening about now. Having nothing whatsoever to do with the philosophical leanings of the party in the majority, such is the formula by which U.S. political dramas are scripted. Declarations of war (figuratively and literally) through zealous and hastily enacted statutes are inevitably followed within just a few years by reversals to more moderate positions. Regarding the securities laws (and holding the frightening prospect of IFRS adoption aside), we are clearly in a period of moderation, albeit more misguided than usual.

While I echo Norris' sentiments on the first three items, I had only a few weeks ago expressed my glee that requiring smaller public companies to comply with S-OX 404(b) might soon be trashed. I had previously observed that S-OX 404(b) attestations have appeared to devolve into a go-through-the-motions exercise. Those suspicions are validated to some extent by a recent ruling against defendant Deloitte on a motion for summary judgment in a lawsuit alleging that Deloitte failed to adequately report on internal control deficiencies at WAMU. Jim Peterson of the Re: Balance blog avidly follows the solvency tightrope that each of the Big Four is walking as they try to fend off litigation arising out of 'traditional' public company audits. His view is that auditors should walk away from S-OX 404(b) work while they are still ahead. 

There Must be a Better Way

Even though S-OX could have, and should have, been more tightly focused on measures to prevent another Enron or WorldCom from happening, something was missing in the securities laws for providing reasonable assurance that management public companies, both large and small, are taking their financial reporting responsibilities seriously enough. I just don't agree that S-OX 404(b) was the right way to go about it.  Notwithstanding other merits of a financial reporting regulation, a windfall to gatekeepers, especially those sharing the blame for a lack of confidence in the system, is a reason for any reasonable person to be suspicious. 

Given that change is in the offing, now may be the time to bring back my old war horse, mandatory audit firm rotation. The resistance to mandatory audit firm rotation in the wake of Enron and WorldCom came from the AICPA, which couldn't bear the thought of auditors being audited by other auditors. Their main stated argument had been that switching costs would be too high, as audit efficiencies in the client's environment take a few years to be realized.

Even accepting the AICPA's excuse, which I absolutely do not, it is a fact that the vast majority of audits of smaller firms are much more straightforward. That should mean that the successor auditors can, relatively speaking, take over from predecessors without breaking stride. I would like to suggest to Mary Schapiro that, instead of pushing against the bipartisan will of Congress to let smaller reporting companies out of S-OX 404(b), she should promote mandatory audit firm rotation. There is nothing to suggest that it will impose anywhere near the scale of costs engendered by S-OX 404. With little at risk, it could actually transform audits from a make-the-client-happy exercise to one that moves the U.S. toward the forefront of global capital markets just in terms of basic integrity.

Let's pick 2,000 smaller reporting companies at random and require that they switch auditors within a year; another 2,000 next year, and 2,000 the year after that. If done right, there should be a wealth of data for the SEC and academics alike to analyze. For the next time we take a whirl on the regulate/moderate merry-go-round, we will at least have some hard evidence to take along.

(By the way, I recommend that you try Kevin LaCroix's D&O Diary blog for excellent non-technical summaries of current developments in securities litigation.)

And Our IFRS Survey Says…

This is the first of a series to discuss the results of our IFRS opinion survey. The idea for a survey originated with yours truly, and I was moved to do so (more like propellled with outrage) by the ersatz pro-IFRS "research" coming out of the Big Four and the AICPA propaganda machines. I also decided to seek a collaborator from the ranks of academia through the AECM listserv, and I consider myself very fortunate that Pat Walters, herself an IFRS proponent, volunteered to work with me. Pat's association with this effort should lend, at the absolute minimum, a semblance of balance; which is, ironically, completely absent from published views of the Big Four and their shills.

But, thankfully, I can report that not all CPAs have behaved like pigs at the trough. We owe a huge debt of gratitude to Gaylen Hansen, who has provided us with a clear-eyed compilation of the response letters to the SEC's Roadmap proposal; and to Grant Thornton for their survey, which was published as we were conducting ours. GT asked a question of import ("Ideally, who should set U.S. accounting standards?") properly, and received proper responses from CFOs and senior comptrollers in return. GT reports that only 18% of more than 800 respondents from public companies are of the opinion that the IASB should be setting accounting standards for U.S. companies.

Full Disclosure and Caveats

We received a total of 289 responses. We can't beat GT on sheer number of responses, but we did ask a broader set of questions regarding the perceived relationships between IFRS and GAAP: (1) quality differences; (2) costs and benefits of IFRS adoption; and (3) how the SEC should act on its Roadmap proposal. You can view all of our response data in a spreadsheet format here, and the text of the online questionnaire here. Twenty-seven responses came from non-U.S. residents and 13 from students. Our analysis excludes these two groups, and the tabulation at the end of this post breaks down the respondents we analyzed by all of their occupations.

Before we proceed to the major takeaways from our survey, two further caveats are in order.

First, we sure were hoping to generate a larger number of responses. GT excepted though, our level of participation is well within the range of other "studies" conducted by the IFRS proponents, including the number of comment letters received by the SEC in response to the Cox-instigated Roadmap Proposal. We left our survey open for three weeks; the SEC's comment period extended for months.  

Second, one should always take with a grain of salt unsolicited responses, as opposed to a random sample. But, no study that we are aware of has employed a more open self-selection process than ours. For example, I was solicited for Deloitte's survey apparently because I subscribed to one of their IFRS information services; if that was Deloitte's only method for soliciting responses, the self-selection bias therefrom is self-evident.

The Major Takeaways from Our Survey

As with GT, we asked for opinions regarding IFRS adoption; and our results were very similar to theirs:

My initial interpretation was that 71% of respondents do not agree with the proposition that IFRS should replace U.S. GAAP. Pat pointed out that this may be somewhat of an overstatement—since we don't know why 16% of respondents "neither agree nor disagree." Those respondents, according to Pat, could very well be indifferent to the prospect of IFRS adoption. My own take on that is: if one took the trouble to take the survey and to answer the question, then indifference would not be the most likely sentiment being expressed. Nevertheless, Pat and I agree to this interpretation:  respondents who disagreed with the proposition outnumbered those who agreed by a margin of about 5:3. Anyway you look at it, especially in light of GT's results, it should give the SEC pause before proposing to supplant the FASB with the IASB.  That's as mildly as I can put it.

When I took a closer look at the answers to this question, I was not surprised to see that the frequency distribution of responses from Fortune 500 companies and the Big Four appeared to be negatively correlated with all of the other occupations. To evaluate their impact on the full results, I decided to disaggregate each question by three subgroups: (1) Fortune 500 + Big 4; (2) academics; and (3) everyone else. The chart below repeats the results from above and adds these subgroups:

 

See that tall blue bar on the left? That's Big 4 and Fortune 500 money talking. Notice also that academics (the ascetic purists J), are the least inclined to adopt IFRS (as indicated by the short green bar on the left).

Given these results, it should come as no surprise that a significant majority of respondents do not believe that the benefits to investors of IFRS adoption would exceed the costs of conversion:

77% of all US respondents do not believe that benefits to investors will exceed the cost of conversion. Indeed, although a majority of the Fortune 500 accountants and Big Four auditors believe that the SEC should adopt IFRS, only 44% believe that the benefits to investors would exceed the cost of adoption. Figure that one out.

The bottom-line question we asked pertain to how the US should approach adoption of, or convergence, to IFRS:

These results are, admittedly, somewhat difficult to interpret with precision, but they clearly indicate that few respondents would like to see IFRS adopted before 2014. Moreover, 54% of respondents (including the Fortune 500 and Big 4) would either prefer not to adopt IFRS, or to adopt it starting with 2020 at the earliest. Although an in-depth analysis of the "other" category of responses was not undertaken, my brief analysis strongly indicates that a comfortable majority of the "other" responses more closely resemble those who stated a specific preference to either delay in IFRS adoption beyond 2020, or to abandon IFRS altogether.  If you don't believe me, you can look at the data for yourself.

And, as one might expect, the Fortune 500 accountants and Big Four auditors were strongly in favor of relatively fast-paced IFRS adoption, although it must be said that less than 10% favored adoption by 2012-2013. But, take those folks out, and you have even less interest among respondents for adopting IFRS anytime soon … or ever.

Act II

Thus far, I have discussed the results of only three of the ten questions that we asked about IFRS vs. U.S. GAAP. I promise you, more drama is to come. Also, Pat has agreed to write a guest post with the working title, "How the Survey Result Informs an IFRS Proponent." I'm sincerely looking forward to that.

The Speak-No-Evil FASB

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My previous post lambasted the FASB for shilling the SEC's whacky proposal to measure the year-end value of oil and gas reserves at average prices for the year – instead of the year-end price. Since then, I had two follow-on thoughts; the first one I'll mention is not related to the cheeky title of today's post, but it leads into the one that is.

A More Reasonable Way to 'Modernize' Oil and Gas Disclosures

A week ago, I forgot to mention that there really is a reasonable way to enhance the measurements of year-end values of oil and gas reserves, the ostensible goal of the SEC's recent actions.   But, it has nothing at all in common with the SEC/FASB approach of using averages.  What I have in mind is 'sensitivity analysis.'

Investors can use information about the current value of reserves today, but they also can use information concerning risk of changes in value. Financial reporting rarely reports that kind of information, but there have been movements in that direction of late, and by the SEC no less. Most prominently, Item 305 of Regulation S-K requires quantitative measures of market risk sensitive financial instruments, which often takes the form of some version of a sensitivty analysis.  In addition, Financial Reporting Release No. 60, urges companies to provide a sensitivity analysis covering assumptions underlying critical accounting policies.

So why not provide a sensitivity analysis regarding the value of oil and gas reserves? It doesn't have to be complicated, and the resulting disclosure could be as clear and simple as the following:

Using end-of-year energy prices, the present value of proven reserves is $100 million as of December 31, 20x0. Energy prices during the year ranged from 80 to 130 percent of the year-end prices. If the lowest (highest) energy prices during the year were substituted in our year-end present value calcultions, the lower end of the range would result in a $50 million valuation, and the higher end of the range would result in a $130 million valuation. The range of valuations is not proportional to the range of prices for the following reasons: [would be listed here.]

Sensitivity analysis of valuations can always be informative, but particularly so in the extractive industries. A significant portion of the value of the investment in a project can be traced to 'real options'; e.g., to invest in additional development if prices rise, or to shut down operations until such time as commodity prices recover. In fact, in the three decades since the SEC came out with its original version of oil and gas disclosures, the topic of 'real options' has gone from esoteric to an essential component of any capital budgeting decision by the larger players in the extractive industries. By the same token, investors are in a better position to value options (especially those that are not recognized on the balance sheet) if they can more reliably estimate the volatility of a project's value.

Covering Ears, Eyes and Mouths

Maybe you like my suggestion to add sensitivity analysis to the present value of reserves disclosures, or maybe you don't. Whatever your opinion, you should definitely be incredulous that the FASB appears unwilling to give any alternative to the SEC's hatchet job so much as lip service.

Now that the ball is in the FASB's court, one must ask whether all of them have truly put their brains in neutral, or whether they have even considered alternatives to the SEC's approach.  If they have chosen to put their brains in gear, we certainly can't tell from their proposing document or any other public comments. At least at the SEC, dissenting board members give speeches that reveal their own preferences and reasoning. It appears that FASB members, perhaps as a matter of basic economic incentives (i.e., money), don't dare to do the same. Based on the way the last investor representative on the board was treated, it's pretty safe to assume that, if you are not a go-with-the-flow sort of chap, chances of getting your $500,000/year position renewed for a second five-year term are slim to none.

Here's my prediction as to what is going to happen with the ED. The Board is going to vote 3 -2 in favor of measuring the value of proven reserves at average prices. Two board members, Linsmeier and Siegel, are going to furnish compelling dissents, and maybe another financial columnist will celebrate the dynamic duo for the strength of character they displayed while others around them were busy shilling. But in the final analysis, after-the-fact minority dissents will have no effect on anything real or important. As my father too-often said, "If all you have to stand on are your principles, then you may as well remain seated."

Yes, minutes of open meetings report board members' comments leading up to exposure documents, but who reads them? I might if I were to have trouble falling asleep at night. Why aren't formal dissents registered in exposure drafts? Why don't board members, as SEC commissioners often do, provide their individual views when they go around making speeches? For true 'due process' to occur, we need more open public debate on the issues. Commenters on FASB proposals need to have some idea of the level of consensus within the board.

I suspect that every single FASB member thinks that measuring the value of proven reserves by average, instead of current, prices is a significant step in the opposite direction from quality financial reporting. So, perhaps I am being unfair in calling on only Tom Linsmeier and Marc Siegel to carry the flag of reason and investors' interests. But, no good deed goes unpunished. That's what they deserve for taking principled stands in the past – even if, thus far, they have amounted to little more than empty gestures.

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FASB Proposed Changes to Oil and Gas Disclosures: A Crude Sham

Before I discuss the sordid details of a recent FASB proposal, please take a moment to read this hypothetical: 

What if the FASB were to issue a proposal to require companies holding marketable equity securities of oil companies to calculate and report their investment as the number of shares owned multipled by the average share price over the past year.  The average share price would be calculated from the closing share prices on the first day of each of the past twelve months.  (In other words, changes to share prices over the last month of the year would not be counted.)

Assume that the FASB issued its proposal to respond to concerns of financial statement issuers with significant holdings of oil and gas shares that reporting full year-to-year fluctuations in investment values would not constitute "meaningful" information to investors. 

Incredible?  Yes.  Impossible?  No. As I am about to describe, something very close to my hypothetical scenario has left the station and is unlikely to be stopped before pooping on the financial statements of oil and gas producers.

In an earlier post, I imparted the common-sense view that the historical-cost based financial statements of oil and gas producers bear almost no relation to a firm's value; because, the historic cost of a producing field, however measured, bears no relation to the value of that field.  There are a number of reasons for this, having to do with the luck of the draw or the price for the output that will be obtained from extracting the field's reserves over ensuing decades. To make a long story short, that's why disclosures are critical in the oil and gas industry. 

In particular, two disclosures are critical, and it should come as no surprise that oil and gas companies go to great lengths to 'manage' them: (1) the quantities of oil and gas that can't be seen, but are estimated to be in the ground; and (2) a standarized calculation of the amount that the "proved" portion of those in-the-ground reserves are worth.  The former is technically an SEC-required disclosure, and the latter, which I will refer to as the  "present value of proved reserves" is to be found in the FASB's rules.

"Modernizing" Oil and Gas Disclosures

In December of last year, the SEC issued a final rulemaking release to update the three-decades-old oil and gas disclosure requirements for current practices and changes in technology.  As I described in two previous posts (here and here), numerous important and overdue changes to the disclosure rules were made.  But there were also numerous sops to the oil and gas industry.  Among the biggest gifts was the SEC's statement of intention to get the FASB to muddy up oil and gas valuations -- pretty much in the manner I described in my hypothetical scenario -- by substituting a crude estimation of averages prices for year-end energy prices. The only differences from my scenario are that the measurements are made in disclosures of reserve values, and that they affect the investee's financial reporting (as opposed to the investor's in my hypothetical). 

Just as they were commanded, the FASB did indeed issue with great alacrity its own proposal to alter the net present value calculation along the dubious lines specified by the SEC.  The FASB's "basis for conclusions"?  Here ya go: 

"After taking into consideration more than 70 comment letters from financial statement users, preparers, auditors and other constitutents, the SEC refined its proosed rule on oil and gas reporting and issued the Final Rule on December 31, 2008."

There is some brief discussion of other specifics, but with respect to the change in measuring the net present value of proved reserves, there is absolutely nothing more.   And even what is provided is grossly misleading.  Of the 70 comment letters, virtually all came from oil and gas producers, lawyers representing oil and gas producers, engineers working for oil and gas producers, auditors whose largest clients are oil and gas producers, and consultants whose clients are oil and gas producers. 

I could not find a single comment from an investor (even notice the weasel term "financial statement users" in the above quotation) among the list of comment letters posted on the SEC's website.  A more accurate description from the FASB of their thinking (or lack thereof) would have been something like this: "The Cox-led SEC did their thing, and that's good enough fer us. Cuz they're the SEC.  We got nuthin else to say about 'due process' or any other process."

But in case you are wondering what the FASB is proposing to swallow -- hook, line and sinker -- here it is from the SEC's proposing release:

"Some believed that reliance on a single-day spot price is subject to significant volatility and results in frequent adjustment of reserves. [footnote omitted] These commenters expressed the view that variations in single-day prices provide temporary alterations in reserve quantities that are not meaningful or may lead investors to incorrect conclusions, do not represent the general price trend, and do not provide a meaningful basis for determination of reserve or enterprise value." [italics supplied by me]

Some Unsolicited Advice to the FASB

And, so, FASB, I'm going to pretend that you have not switched off your brains on this, and provide you with some unsolicited advice.

First, your job is not to help financial statement users predict a "general price trend."  If future prices of oil could be predicted by past prices, then any person who can perform that trick is in the wrong business—unless they are already oil speculators. I have vivid memories of consulting for an oil and gas producer during a year in which they sold their entire production forward, because they speculated that prices would go down. Unfortunately for everyone involved in their ostensible "hedge," oil prices rose -- a lot. The operations managers I was working with, whose bonuses and shareholdings depended on oil revenues, were not pleased with the 'economists' at corporate headquarters who conjured that one up.  And, those guys were privy to the best public and non-public information money could buy.

Second, beware of the use of the term "meaningful."  To put it as gently as I can, the fundamental attributes of financial information are its relevance and reliability.  For example, subsitute either: (1) "relevant," or (2) "reliable," or (3) "relevant and reliable" in the above quotation for "meaningful" and see if it makes any sense.  It doesn't, of course.  More bluntly, you should treat "meaningful" as if it doesn't exist when discussing the properties of accounting information.  I suspect that "meaningful" owes its popularity to the fuzzy psycho-babble of the hippie generation (that would be me). SEC literature is already infested with "meaningful," and you need to put a stop to it before it infects accounting standards.

Finally, FASB, you should stiffen your backbone, clear your conscience and earn a gold star for bucking the single-minded, monied special interests.  You omitted any reason for concluding that an average price should be substituted for the period-end price, because there is none possible.  There is nothing you have ever done, and nothing that you could now say to rationalize the product of an SEC administration that would have babbled and blurted anything for the benefit of its political backers. 

If the new SEC honchos are still intent on mucking up oil and gas disclosures, they have the statutory authority to do it without any assistance from the FASB.  Gratuitous shilling shouldn't have to cost investors $500,000 per vote.

S-OX 404(b) for Non-Accelerated Filers: A Political Crime Waiting to Happen

Section 404(a) of the Sarbanes-Oxley Act, together with SEC rules implementing the provisions of the Act, require management to assess and report on the effectiveness of internal control over financial reporting (ICFR). It took a few years for the SEC to phase everybody in, but all public companies, large and small, are now subject to the requirement.

As pretty much everyone knows, however, S-0X 404 doesn't stop with a management report. Auditors get in on the action in Section 404(b). Therein is the lucrative requirement that an independent auditor attest to management's assessment regarding the effectiveness of their internal controls over financial reporting (ICFR). One person testifying before Congress has called the provisions of S-OX 404(b) the largest windfall to audit firm partners in history, and as I will soon describe, 6,000 more public companies await a new 'service' for which the benefits are, to be charitable, unclear.

Why S-OX 404(b) is Little More than Chicken Salad for Auditors

The corporate corruption scandals that got politicians moving on the Sarbanes-Oxley Act of 2002 were the result of fraud by CEOs and CFOs. ICFR can have little to no impact on the actions of the top executives, because they always possess the power to override internal controls, or sometimes to orchestrate collusive schemes that circumvent those controls. Thus, Section 404 cannot possibly do much to mitigate these particular sources of fraud risk; and there is no better example of that than Enron itself. I have been told (but have not verified) that Enron was the only public company to disclose with much pride and pomp that it paid its world-class, independent auditor to perform a separate evaluation of internal controls. Andersen's report was, of course, clean as a whistle.  

No one should doubt as well, that Enron's relationship with its auditors wasn't much cozier than the norm, either. No matter who the client is, and especially if it is a big one, material weakness are generally only reported after an error has occurred; i.e., after a control has obviously failed. Thus, all the machinations to test ICFR, and prevent a control from failing, don't add much beyond the testing of account balances that occurs as part of the regular financial statement audit.

So, it remains questionable at best, that S-OX 404(b) has created a safer environment for investors to trade their shares. Auditors, on the other hand have been champing at their bits, waiting for the SEC to throw them some fresh meat: the 6,000-odd smaller public firms (technically, "non-accelerated filers) who are not yet required to pay for an ICFR report.

Chicken Salad Days Appear on the Horizon

The auditors received some good news on that front a few days ago when the SEC announced that the stay of execution for non-accelerated filers would be extended only until their annual reports for fiscal years ending on or after June 15, 2010. Chair Schapiro and one other commissioner also issued statements to 'assure investors' that no further extensions would be granted.

Indeed, the SEC's Office of Economic Analysis has completed the last of the SEC's go-through-the-motions machinations to steer S-OX 404(b) through the gauntlet of thousands of irate registrants who resent the additional audit fees imposed upon them -- and the additional hoops they must jump through. And, what did OEA's report have to say? As it turns out, not much at all. Although changes to SEC and PCAOB guidance may have reduced the cost of S-OX 404(b) implementation for companies that currently must comply, OEA did not even address the key question: whether the costs of complying with S-0X 404(b) has been less than the benefits, or whether benefits can be expected to exceed the costs of compliance for the 6,000 companies in line to be plucked. It must surely be the case for non-accelerated filers that initial implementation costs are most onerous, especially in an economic down cycle. But nothing so obvious and significant was to be found in the OEA's report.

The Skinny on the Costs and Benefits of Section 404(b)

If I were writing OEA's report, I might have begun and ended with the following modest, albeit virtually dispositive, back-of-the envelope calculation: The total value of all public traded equities in the U.S. is very approximately $14 trillion, based on information available from indexes published by Wilshire Associates. Let's conservatively assume that each and every non-accelerated filer has a total market cap of $75 million, which is the maximum market cap for a non-accelerated filer. Even under that very conservative assumption, 6,000 non-accelerated filers comprise (at the very most) only 3.2% of aggregate equity values.

In the best of worlds (i.e., assuming that there is real information in an auditor's attestation report) can the new fees that auditors will charge these 6,000 smaller companies provide loss protection that will cover the billions of dollars in aggregate fees? Don't bet on it.

In fairness, the SEC would say that their hands are tied; S-OX directs the SEC to require ICFR attestation reports from all public companies. So, what should really happen is for Congress to wake up and amend S-OX to permanently exempt non-accelerated filers from the requirements of Section 404(b). Will it happen? Don't bet on that one, either.

What upsets me the most is that chair Schapiro is once again catering to the wishes of the Big Four instead of affecting much needed reform, as she has pledged to do. Schapiro should use her bully pulpit to inform Congress that they have created an obvious case of excess regulation. Notwithstanding the sorry fact that S-OX 404(b) has devolved into a waste of time for all issuers, to extend it to non-accelerated filers would be nothing less than criminal.

Instead, of rushing to require ICFR audits, why don't we just sit back and wait to see how many non-accelerated filers will voluntarily submit to an examination of their ICFR – just like Enron did. 

 

IFRS Adoption Critics: More Silent Majority than Vocal Minority

Given my public record of opposition to IFRS adoption, you might be surprised to know that I have taught courses on IFRS for over ten years, beginning in Switzerland and the UK. If anybody is interested, I will be presenting a two-day IFRS/GAAP comparison courses in Chicago and Vegas this November; and I gladly collaborate on the delivery of those courses with representatives of two Big Four firms.

I try to stay away from blatant self-promotion in the body of a blog post, but I wanted to make the point that I am not an IFRS newbie, and have thought about the problems of which I blog for years. I also strongly believe that certain aspects of IFRS are much stronger than U.S. GAAP.

The larger point, however, is that I actually do have a significant stake in IFRS adoption; yet, for reasons only a psychiatrist might be capable of explaining, I persist in my financially self-destructive rants.

Imagine you're my shrink. As I lie on your couch, I tell you that my attitudes toward IFRS adoption are rooted in my childhood. (Surprise!) Both my parents fled from Nazi Germany, but my Dad was involuntarily detoured in a Nuremberg prison and Dachau concentration camp before managing to finally extricate himself from miscreants' clutches.

After immigrating via the UK to the USA, Dad soon thereafter entered the military (he was drafted after first volunteering and being turned away). He was returned to Germany on D-Day +30 as a POW interrogator. It's a long and unique story, which late in life he wrote about in a book that I posted on line.

Obviously (I try not to use that word very much), my dad's perspectives on life were shaped by these experiences. As to their effect on me, his bitterness rarely came to the surface, except indirectly when he was motivated to speak out against some proximate injustice. Dad was non-violent in actions and manner, but his words were sharp and he didn't give a hoot what others thought of his pithiness and directness. He was only self-conscious about his thick German accent (think Henry Kissinger). Also, I'm sure that his "attitude" and accent did not help his career aspirations at AT&T. Anyway, I think that is the font of my self-destructive outspokenness.

I bring this up now, as I am about to present you with a quote from a kindred spirit, and former Big Four auditor, who shall remain nameless; his nom de email is SuperHeater, and I have no idea what that is supposed to mean, but I have a pretty good idea that his brief turn as a Big Four auditor shaped his perspectives. Here's an excerpt from one of his war stories:

"I knew I needed to leave [the Big Four firm I was working for] after about three months. I had questioned a client (politely) about how they arrived at a $90,000 bad debt reserve on an A/R balance of $10,000,000 for unsecured receivables where the aging detail showed items 500 days old. I was told by the assistant controller that the 'CFO knows our customers, and knows what invoices they'll pay.'

The in-charge senior associate told me, 'I don't care if it's adequate, I care that it's there'- so much for adequate audit evidence and professional skepticism.

The following day I was summoned to meet with the partner on the job (who happened to be the HR partner) in order to be told 'the client had a complaint,' but offered no details. As the client was a trucking company that financed their equipment and was surely trying not to violate the current asset requirement of their debt instruments I suppose that's not hard to figure out. I'd like to say that was my only eye-opening experience, but it wasn't. There were screaming 'seniors' and days when testing exceptions were explained away with 'this appears to be a one-off transaction, P/f/p' rather than expanding the test sample as indicated by the audit plan."

I don't receive many substantive comments on my posts, (roughly two per post), but they are about 95 percent supportive. (BTW, those who have chosen to express their disagreement with my points of view are invariably respectful.) Thus, I want to at least surmise that SuperHeater's sentiments (with certain colorful features omitted) are generally in the same direction as those of a large proportion of my readers. In addition, the comments about how the market for auditing staff will shift after IFRS adoption is a fresh perspective for me.

"Having spent an unpleasant year at KPMG as an older, nontraditional hire and observed their methods and now currently employed at an enterprise where Deloitte is an IT contractor, I remain convinced that the only people who think IFRS adoption (either wholesale, convergence or some other method) is desirable are the Big 4, major transnational corporations and the SEC.

Additionally, the cheerleaders' affection for IFRS has absolutely nothing to do with any intrinsic superior quality, simplicity, brevity or any other (supposed but immeasurable) attribute of IFRS; it's about the ease and profitability of the cheerleaders' enterprises. The transnationals have a similar perspective; the SEC is a study in "regulatory capture", with its bureaucrats giving speeches and missing the likes of Enron, Worldcom, Adelphia & Madoff.

However, the leader of the pack is the Big Four. Like most modern propagandists, they furiously release marketing information disguised as objective technical analysis. I personally think the IFRS' "ordained clergy" are easily identified by the use of the word "robust." We are supposed defer to the presumed expertise of Big 4 partners and senior managers about the arcana of accountancy-especially when they use nebulous language and speak with the authority of historicity with constant references to IFRS as "inevitable."

For years the Big 4 have envied their clients who outsource their production to places like India, China, and other lands, where there's plenty of high intellects looking for opportunity. As the birthrate has fallen in America, it has been harder to represent the typical associate's position as something more glamorous than the fraternity hazing it resembles. The Big 4 have copied the outsourcing on their IT side, where there's no credentialing impediments; but on the attest side – well, that's different. Sure, you can staff an office full of staff and senior associates from other countries; language barriers don't matter that much when you don't speak to the client that much. Also, we know they'll work like the dickens because they're working for permanent US residency and having family half a world away creates less desire for time off.

However, when you get to be a manager, you need to have that CPA-and the exam is hard. Harder still, when you don't speak English, let alone when you have to learn a new book of rules. Do away with GAAP, you do away with the need to comb among potential US born associates with their tender egos, high debt loads and social and esteem needs. Once we're on IFRS, the Big Four becomes a truly global enterprise; picking off bright minds from lands of less opportunity-obtaining a deep inventory of intellectual capital at distress sale prices. Perhaps at the Big Four, the "A" in CPA stands for arbitrageur. I suppose it's a losing battle, because in the end, some very deep and mercenary pockets are driving this surrender of US commercial sovereignty. Now we know why Mr. Niemeier was passed over for the CA job."

The supporters of IFRS adoption have long-dismissed detractors like myself, Charles Niemeier and SuperHeater as comprising nothing more than a "vocal minority." The tepid-to-hostile feedback on the Roadmap should have put that libel to bed, but the recent remarks of chief accountant Kroeker and SEC chair Schapiro indicate that they are willing and able to follow Christopher Cox's oft-repeated example of plowing straight through reasoning critics behind nothing more than a blast of hot air.

I'll soon be posting a link to an online survey of attitudes towards IFRS adoption. Whatever the truth is, I want it to be more clearly evident.

First Missive from the New Chief Accountant: Get Ready to Roll with IFRS

It came as no surprise that SEC Chief Accountant James Kroeker's first public foray, since Mary Schapiro deigned to remove "Acting" from his title, was to announce that the IFRS Roadmap has once again become a priority at the SEC. That should please his former employer, Deloitte, one of the Big Four IFRS Cheerleaders. To give you some indication of the goal-oriented culture from whence Kroeker came, here's a couple of examples from recent "surveys" Deloitte has been peddling.

In 2008, Deloitte asked financial professional what they thought were the benefits and costs of IFRS adoption. That sounds reasonable, but the next logical question appears to have been intentionally left off: which was whether respondents perceived that the benefits of IFRS adoption might not exceed the costs.

And, here's a sample question from a survey I received in my email this month:

In your view, what should the IASB's and FASB's approach be to convergence?

• Extend a comprehensive convergence plan over the next 5-10 years
• Achieve as much convergence as possible between now and 2011, and then focus on IFRS conversion at that point
• Wind down convergence efforts at this time, and support IFRS conversion
• Not sure

"Not sure"? What if you're "sure" or just pretty "sure"; but your answer is not one of the three that Deloitte is willing to tabulate? What if, heaven forefend, you are really "sure" that further convergence efforts would be a waste of time and money?

Answer to my questions: Should you dare opine that IFRS adoption is of no benefit, Deloitte doesn't want to have to acknowledge that gazillions of other like you perchance exist amongst the public, whose interests Deloitte has an ethical obligation to serve. These were not surveys; they were charades. They were put together to serve special interests – at the expense of the investors that Mr. Kroeker now is supposed to be working to protect.

Thus far, the text of Kroeker's remarks have yet to appear, as is customarily the case, on the SEC's website. Consequently, my comments will be based on press coverage from the following sources: CFO.com, Reuters and WebCPA.

Be Very Afraid … of a "Race to the Bottom"

Some people took IFRS adoption for dead, but Kroeker came to say that it has returned to becoming a priority at the SEC, in part because the financial crisis may have underscored its importance. It appears, for example, that without a single authority over standards, the U.S. and Europe may get caught up in a "race to the bottom" to set accounting standards most favorable to banks and to the detriment of investors.

While it is true that the EU has made its fears that lower-quality accounting standards in the U.S. will cause its banks competitive harm, more recent events don't comport with a race-to-the-bottom scenario. The FASB (as I have written here) is proposing that all loans should be fair valued. The FASB is clearing saying to the IASB, 'You can take the low road if you want, but we'll take the high road.' (By the way, there's no way that the IASB will follow the FASB's lead on this. If Sir David Tweedy so much as dreamed of requiring fair value for loans, he'd call up Charlie McCreevy the very next morning to apologize.)

Nonetheless, I do concede that, in the absence of SEC intervention, a race to the bottom is at least theoretically possible. But, for at least two pretty obvious reasons, that possibility is remote, if not downright silly to contemplate.

First, as a general matter, it is not clear that competition among jurisdictions inevitably results in a race to the bottom. As one of many possible counterexamples, consider the development of the state laws governing corporations. The Delaware laws are regarded by many to be least restrictive; however, many corporations choose to register elsewhere. There are two lessons from this that I can think of: (1) there is not necessarily one set of rules to suit all tastes; and (2) the stability and longevity of our system of corporate laws indicates that multiple law givers are preferable to giving the federal government a monopoly on that role. Thus, notwithstanding the 99 other reasons (okay, 10) I can think of, it is far from clear that granting a worldwide monopoly to the IASB is the most efficient thing to do.

Second, and this is the biggie, whatever Kroeker might fear about incentives of standard setters to debase their own coinage, his job, whether he likes it or not, is fundamentally to prevent a race to the bottom from even getting past the starting line. Various securities laws clearly state the authority of the SEC to set accounting standards for public companies. It must be said, however, that the SEC has published its policy that, for the most part, has left standard setting to the FASB. (For the rule wonks amongst you, that would be Section 101 of the codified Financial Reporting Releases.) Kroeker weakly assures us that the SEC will always be active in interpreting accounting standards adopted by SEC registrants, but the SEC historically has done much more than that – by judiciously picking its moments to pre-empt or outright reject FASB pronouncements.

Given Kroeker's own stated preference for uniformity in bank accounting and his own view of its significance in the global financial order, no opportunity could be more ripe than for the SEC to take the initiative on loan accounting. All Kroeker need simply do is to endorse the FASB's proposal to measure all loans at fair value, and counsel the IASB that they should get with the program. That oughta eliminate any fears of an accounting standards race-to-the-bottom.

But, alas, world peace is a more likely scenario; fair value for loans doesn't fly in the EU, so it surely cannot fly with Kroeker's former colleagues at Deloitte. Who wouldn't prefer to know what Kroeker's thinks about loan accounting than the Roadmap? But it's a steady diet of Roadmap that we will surely be force fed in the months to come.

Saying So Doesn't Make it So

As was sadly the case when Christopher Cox was SEC chair, I found nothing in Kroeker's remarks to indicate that he cares much about citing evidence in support of his ideology. Take these accounts:

• Reuters – "Kroeker … said … that in the more than 200 comment letters the SEC has received on the proposal, it was 'resoundingly clear' that people agree there should be a single set of global high-quality accounting standards…"
  
• WebCPA – A single set of global accounting standards is "…like motherhood and apple pie."

Given, as I reported here, that the overwhelming majority of investor responses to the Roadmap proposal want to tear it up, I don't know where he comes up with this stuff. And, don't forget about Deloitte's paranoia about even broaching the question in its "surveys." (By the way, Wayne Carnall, former PwC partner, and chief accountant of the Division of Corporation Finance had characterized the response rate as a pittance, and now Kroeker is spinning 180 degrees away from that.)

Ironically, Kroeker delivered his remarks before a meeting convened by the New York State Society of CPAs. It was there that another candidate for chief accountant, Charles Niemeier, trashed the whole notion of IFRS adoption for what it was: a full-employment act for the current chief accountants' former colleagues.

Not only were Kroeker's and Niemeier's positions as different as black and white, but the quality of their inputs and reasoning couldn't be more starkly contrasted. Niemeier's inspiration clearly sprang from a foundation of cited broad-based analyses produced by published rigorous, peer-reviewed, independent research. The source of Kroeker's remarks apparently came from nothing more than his own wishful thinking.

The Lease Accounting Proposal: What Investors Say

In this post, I'll be reviewing two comment letters submitted to the FASB in response to its Discussion Paper (DP) on lease accounting* by the Investors Technical Advisory Committee (ITAC) of the FASB, and the CFA Institute Centre for Financial Market Integrity (CFA).   My original comments are here. 

The lease accounting project is a strong test of the proposition that accounting standards are capable of cutting through the camouflage of legal form to get at the underlying economics of an arrangement. In that respect, FAS 13 has been a dismal failure, with untold amounts of shareholder value being destroyed by management machinations aiming to exploit complex accounting loopholes and bright line rules lacking no conceptual basis.

Almost any new standard will be a significant improvement over FAS 13, so one of the dangers we face is setting the bar too low. For example, since FAS 13 was promulgated over 30 years ago, the field of financial management has progressed well beyond the point where precise measurement of lease value drivers is on the frontier of our knowledge. I'm not just talking about academic theorizing, either. According to the book, Real Options: A Practitioner's Guide, economic valuation of complex lease terms was first undertaken by executives at Airbus, who needed to know the true cost of the flexibility they were writing into their leases to accommodate their customers' risk preferences. That was over twenty years ago! I'm certainly don't consider myself to be at the cutting edge of financial modeling, but give me about a week, and I should be able to write a spreadsheet to value leased assets and lease obligations that can capture 100% of a lease's complexity for more than 90% of the leases out there.

So, given the state of the art of leasing and finance, we should be expecting a lot more from the FASB than the usual medley of incremental piecemeal improvements they are proposing. We should not just expect that: (1) the assets and liabilities arising from leasing arrangements are appropriately measured on the balance sheet; but (2) that they should also be appropriately measured. As I will be describing, below, ITAC and CFA are pressing for (1), but are aiming far too low on (2). Ironically, given the prominence and reputation for integrity of ITAC and CFA groups, one thing that you can take to the bank is that their positions will be regarded as the upper bound on the concessions to investors that will make it into the final standard. Thus, the most to be had is recognition of leases on the balance sheet; but they will be reported as arbitrary numbers based on calculations that hearken back to the relative stone ages of financial management.

I'll now discuss some of the specific issues starting with the ones I have the least qualms about, and ending with the stuff that gets my goat.

Overall Approach to Lease Accounting

The DP proposes to eliminate operating lease accounting, with the exception of "non-core" and short-term leases. While both ITAC and CFA strongly support the elimination of operating lease accounting, they are both against the notion of a "non-core leases" category. Nobody would ever expect that lease capitalization would have to be applied to immaterial items; but whatever "non-core" is supposed to mean, it doesn't always correspond to "immaterial." It's a ridiculously silly notion, but I'll nonetheless award points to both groups for pointing that out—and doing it much more tactfully than I would have.

ITAC further adds that exempting short-term leases would be an open invitation to gaming, which surely must have been obvious to the FASB but somebody needed to mention it.

Scope of a Forthcoming Standard

Without calling out the FASB for the real reason that lessor accounting issues were deferred, CFA reluctantly accepts the FASB's decision to defer consideration of lessor accounting. The real reason for the limited scope goes something like this: 'We're already taking too much heat from financial institutions on loan accounting, so let's not mess with them any more than we have to.' ITAC, for my tastes, is being too conciliatory (perhaps trying to rebuild the bridges it has burned on IFRS and fair value?) when they state that they are content for now to focus on lessee accounting.

My own two cents — If there is any area in which balance sheet accounting standards can (and should be) symmetrical, leasing is it. If the FASB is serious about its commitment to an asset/liability view of recognition and measurement, then the only real revenue recognition issue in leasing is nothing more than how to present the changes in lease-related assets and liabilities on the income statement. I would not object to deferral of income statement presentation issues from the scope of the next major accounting standard on leases, but I'm disappointed that ITAC and CFA are not exhorting the FASB to get everyone's balance sheet right. Let the big boy lessors present their income statement any old way they want; and let's require detailed roll-forward disclosures of the changes in balance sheet amounts.

Measurement

Everything I have written to this point has been little more than caviling, compared to my consternation on the groups' positions regarding measurement. CFA states that discounting at the incremental borrowing rate would yield a reasonable approximation of fair value, even when there is "significant uncertainty." That's the great unsupported statement of their comment letter—probably because no support is possible.

In the years since FAS 13, alternatives to discounted cash flow (DCF) analysis have been sought and developed because one eventually had to acknowledge a truth that is exactly the opposite of what CFA claims to believe: the truth is that picking the discount rate to value contingent cash flows, and coming up with a reliable measure of the fair value** of those cash flows, is nothing more than a guessing game. Ad hoc adaptations of DCF modeling to option-ladened arrangements is so yesterday. That the FASB proposes to go back to the stone ages of financial theory is less surprising to me than learning that both CFA and ITAC are cool with it.

Here's a much more robust way to think about lease valuation. There are three categories of cash flows in leasing arrangements: (1) the unconditional rental payments to be made, (2) required payments whose amount is determined by reference to uncertain future events, and (3) optional payments. We should require that a preparer document and disaggregate the fair value of their leases by each of these components. This can only mean that options must be valued using option pricing models—i.e., nails should be driven with a hammer. Yes, not all of the cash flow elements of a lease are mutually exclusive, but modern valuation models take care of that. Disaggregation in disclosure of interrelated items is challenging, but reasonable assumptions can be made and disclosed.

As to separate measurement of options, the FASB suggests, and both CFA and ITAC don't object to, a version of DCF that truncates the expected cash flows at the "most likely lease term." Given the financial technology nearly everyone has at their disposal, it's a ludicrous suggestion. Therefore, I expect it will be embraced universally by issuers. That alone should cause CFA and ITAC to reconsider their positions.

ITAC supports the most likely lease term rule of thumb (incredibly, they elevate it to "principle" status in their comments), because it seems that everybody should be able to do it. So, not only are they proposing to pound nails with rocks instead of hammers, they don't think it's worth the effort to drive the nail flush. Who are we writing standards for? FASB ought to be thinking first of the Fortune 500, because that's the bulk of the U.S. economy. Simplistic models to accommodate smaller companies no longer make sense from a cost-benefit perspective.

CFA states that one reason they support the expected lease term approach is out of expediency: "…an acceptable alternative in the interim until the use of fair value for non-financial assets is addressed by standard setters." And when will fair value for non-financial assets be addressed by standard setters? Given the glacial pace of standard setting, and the priorities that standard setters seem to have set for themselves, I'm giving even money that we won't have a general standard on that for at least another 20 years; and 2:1 odds that it won't happen before hell freezes over.  Is that really how long the CFA is willing to wait?

The bottom line on the measurement issue is that if the FASB requires some ad hoc discounted cash flow model for measuring leases on financial statements, then one of two things are going to happen: either companies will have to measure leases twice – the approach they use for internal decision-making, and again with the FASB's stone-age approach – or companies will throw out the approach they use for internal decision making and base their decision entirely on how a lease will be portrayed in the financial statements. Neither alternative should be acceptable to CFA or ITAC.

And that brings me to my bottom line on the CFA and ITAC comment letters. Both groups are legitimately concerned about the quality of information that investors will get from a new lease accounting standard, and they evidently believe that getting leases on the balance sheet at any number is as much as they dare hope for without rocking the boat too much. However, both groups virtually ignore the potentially huge value that investors will realize if the new leasing standard leads to better decision making by managers. Assets that should be leased will be leased, and assets that should be bought will be bought. That vision can only be fully realized if lease accounting gets both recognition and measurement as right as it can be. CFA and ITAC need to hold the FASB's feet to the fire, because nobody will do it for them.

Finally, here's my message for the FASB. Elimination of operating lease accounting is a good thing; it will certainly cut into the book of business of financial engineers and lawyers who accomplish little more than helping management mwwt their financial reporting objectives by skirting the edges of arbitrary bright lines. But, if you choose to catapult lease measurement back to the stone ages, all you will accomplish is to invite those same advisors to adapt to a new game at shareholders' expense. You will not be pleased to eventually discover that, once again and forevermore, you will find yourself chasing your own tail to issue fresh interpretations of unprincipled rules, so as to put a stop to some of more egregious ploys; and worse, you will be pressured to issue new interpretations to widen some of the inherent loopholes in stone age valuation. In the process, your policy choices will surely destroy value for shareholders (although you will strenuously deny it).

Alternatively, you can craft a principled and perforce simple standard requiring economic valuation of leases. There will be some work to do in specifying the objectives of the measurement process, but you will actually be able to afford flexibility in the choice of models and parameter selection. If you do that, some managers will pay consultants, but it will be for honest advice from valuation experts; they could also eschew that advice by negotiating less complex lease terms that they can understand and value straightforwardly.  Honest advice is geared toward discovering the underlying economics of an arrangement, and it will cost a small fraction of the FAS 13-style advice. In the process of all this, your policy choices will create value for shareholders.  

But, don't just take my word for this. Credit Suisse analysts recently issued a report entitled, What if All Financial Instruments Were at Fair Value?" [I can't find it on the web, so I don't dare post a link to my own electronic copy]. In it, I discovered a refreshing message that I hope ITAC, CFA and FASB will take to heart:

"With companies paying more attention to the fair values of their financial instruments, behavior could change. The controls that would need to be put in place and the due diligence involved could force companies to better understand their assets and liabilities. If that were to result in better management, companies could be rewarded with a lower cost of capital." [emphasis supplied]

 

Shalom, and L'shana Tovah (Happy New Year!)

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*The IASB also has a DP out on the topic that is about 90% similar to the FASB's. So for simplicity, I just refer to the FASB's version from here on out.

**I am an ardent supporter of replacement cost measurements, especially for leases. For example, I haven't the slightest idea how the FASB is going to come up with an exit price concept for non-transferable leases. But, to avoid distractions from other points, I am going to presume solely for the sake of sidestepping this issue that all leases are transferable. It doesn't cause replacement cost and fair value to converge, but it gets us close enough for my purposes in this post.

A Sampling of What Lurks at the Bottom of the Goodwill Garbage Heap

I have already reported stumbling upon a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one struck me right in one of my biggest pet peeves:

"In the process of recording ... [a business combination transaction] ... they discovered, by golly, that in a $300,000,000 acquisition, $100,000,000 of assets they thought they had didn't exist. And so the company tromped in with their auditors and said, the rules say the difference between what we got and what we paid is goodwill. I simply wasn't able to accept the fact that there should be $100,000,000 goodwill on their books, which didn't exist, and we told them to write it off."

I have explained in a previous post many months ago why I think the process of measuring goodwill and periodically testing it for impairment is a shameful waste of time and money. I would be hard pressed to think of a better example than Clarence's story to back that up. But, I also want to explain why Clarence's story is more than merely an interesting anomaly.

Goodwill (I despise the term, but will use it here for the sake of clarity and with the understanding that it's meaning as a term of art bears no relation whatsoever to what regular folks think it means) arises from two sources. One source is genuine assets that have been acquired, but for various and sundry good reasons those assets are never separately recognized under GAAP. Even the management that bought those assets probably can't adequately explain to you what those assets actually are in anything but very general and vague terms. Yet, in a business combination, we recognize them all together (and mixing them in with liabilities of a similar ilk as part of the process) as 'goodwill.'

The second source of goodwill are 'mistakes.' In other words, paying a price to acquire a company greater than its value. Although the amounts of money in Clarence's story are extreme, the fact of the matter is that mistakes happen all the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down after they have proudly announced their plans to acquire another company. During my part-time career as litigation consultant, I can recall at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or those assets were worth less than they were represented to be worth by acquirees. In all of those cases I was involved in, how did a mistake get accounted for? Capitalized as goodwill, of course! No Clarence Sampson or auditor suggested they do otherwise.

I suppose that one could justify initial capitalization of mistakes as goodwill, because they are impossible to detect at the time a transaction takes place; if they could have been detected, then the purchase price presumably would have been adjusted. But, don't business combination accounting rules give one a full year to adjust the values of assets acquired and liabilities assumed? Sometimes they do, but the rules don't mention that mistakes aren't supposed to go to goodwill; so that's where they go.

But, won't impairment testing eventually catch the mistakes and chase them out of goodwill? Not usually. If it ever should happen that a mistake pops out as an impairment charge, it's usually years after the mistake has become known to management. The goodwill impairment tests allow companies to aggregate subsidiaries into 'reporting units,' which are usually large enough to allow any mistakes to be offset by goodwill from other acquisitions that have accumulated a successful enough track record over time to protect their own goodwill, plus the goodwill generated by any recent mistakes.

At least the big mistakes will get caught by the Chief Accountant, right? Ironically, I doubt whether the current chief accountant or his predecessor would have the gumption Clarence did to stand up to a registrant and its auditor like that. Unlike Clarence, who spent decades coming up through the ranks of the SEC, these guys spent their distinguished careers chest bumping their fellow Big Four partners. When an erstwhile comrade-in-arms "tromps" into the SEC as his client's Doberman Pincer, will he be welcome with the secret Big Four handshake? But to be fair, today's SEC staff may not have the technical ammunition Clarence did; the FASB's sausage factory has created a new line of business combinations rules; their literal application has come to be the generally accepted method for leveling the M&A playing field…

… as opposed to Clarence Sampson's application of common sense principles:

"And that's the kind of thing that the Commission can say - look that's just too far; you can't look at the written words and try to apply them to a situation where it just doesn't make sense. And as a matter of fact there's some language, and I'll bet you can tell me where it is, which says if it doesn't make sense, you can't do it."

Those "written words" (principles-based rules?) Clarence couldn't specifically recall are still in the cupboard (see Exchange Act Rule 12b-20, and AICPA Ethics Rule 203-1), but they haven't been taken off the shelf in a real long time.

Anyway, I hope you enjoyed Clarence's story as much as I did.