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?

Going to School on Revenue Recognition

I'm a night owl, but once I hit the sack, I'm out like a light for 8-9 hours. In fact, the two things I would say that I do best are type fast and sleep like a log. One recent night was a rare exception, though. I woke up only about two hours into my hibernation and couldn't fall back asleep. After about another hour, I gave up. It was too late to have a toodle, so I decamped to my office and turned on the computer.

The first thing on the web to catch my eye was a blurb in the Chronicle of Higher Education, in which it was reported that the revenue recognition policies of the Apollo Group Inc., the parent company of the University of Phoenix, were the subject of an "informal inquiry" by the SEC's Division of Enforcement. Apollo has declined to provide any further specifics, but their share price declined about 18% around the time of the announcement. Hmm.

I decided to look further into this for three reasons: (1) I thought it might help me get to sleep; (2) I was in the midst of preparing to lead a one-day workshop on revenue recognition, so I could actually benefit by a review of some of the rules; and (3) Apollo's headquarters are in Phoenix, where I live.

What I Found – Before I Went Back to Bed

The first thing I did was to download Apollo's most recent 10-K and to read their description of critical accounting policies on revenue recognition. I also pulled 15 years worth of financial statements in spreadsheet format from a data service.

Here is what I found after a few minutes of perusal:

• Students are billed on a course-by-course basis. But, judging by the ratio of the allowance for doubtful accounts to gross student accounts receivable, 29%, it appears that a significant number of student accounts are eventually written off as uncollectible.
• Upon the first day of attendance, Apollo records a receivable and deferred revenue in the amount of the billing. As I will explain later, I was surprised to learn this; 'executory contracts' are usually not recognized (with the notable exception of capital lease accounting).
• Tuition revenue is recognized pro rata over the duration of the course, which is generally 6 - 9 weeks. As we say in the trade, it appears that Apollo has adopted a 'proportional performance' revenue recognition model. A more conservative choice would be a 'completed performance' model.
• Apollo recently changed its refund policy whereby students who attend 60% or less of a course are eligible for a refund for the portion of the course they did not attend.
• Apollo prepared its statement of cash flows under the direct method through 1997. They switched to the indirect method in 1998. I would have thought that a 'preferability letter' for such a change would have been included in the 1998 10-K, but I was unable to locate one.

What Could the SEC Be Looking At?

It appears that the SEC Enforcement Division received a referral from the Division of Corporation Finance, which reviewed Apollo's most recently filed 10-K, issued a comment letter, and received a reply from Apollo. Corp Fin's comments addressed, among other things, Apollo's revenue recognition policy for refunds, and whether bad debt expense and revenue were both overstated (i.e., certain amounts of bad debt expense should have been treated as reductions in revenue).

My own questions start at a much more basic level than Corp Fin's comments: when, if ever, it would be appropriate for Apollo to recognize revenue prior to the receipt of payment?

Accounting for the Students Who Pay in Arrears

The general rule in GAAP is that revenue cannot be recognized until it is earned, and realized or realizable (see Statement of Financial Accounting Concepts No. 5). The SEC staff has interpreted this general rule in Topic 13 of the Codification of Staff Accounting Bulletins (SAB Topic 13) to mean that four criteria must be met in order for revenue to be recognized. I won't go into all of them, but the last criteria is that "collectibility is reasonably assured." If the probability is 29% that a student won't pay Apollo, can it be said that collectibility is reasonably assured?

Apollo and its auditors might respond by stating that 71% of the billings to students are reasonably assured; moreover, Apollo has accumulated an extensive history of course delivery that enables them to reliably estimate the allowance at 29%.

But, there is no language in SAB Topic 13 that specifically allows Apollo to combine similar arrangements for the purpose of determining whether collectability is reasonably assured. SAB Topic 13 does provides that one can estimate future liabilities for warranties and returns by aggregating similar customer arrangements and estimating an average for the group; however, it did not specifically provide that those procedures were available for non-payments of enforceable claims. Notwithstanding, historic experience may not be all that helpful in determining the non-payment rate in the current economic environment. For companies with low non-payment rates, maybe, but for companies with a 29% payment rate, perhaps not.

I suppose it would have been clearer if SAB Topic 13 stated what was to be accomplished by providing that collectibility must be reasonably assured; and/or had specifically prohibited combining accounts when evaluating the criteria. Nonetheless, the following example may serve to illuminate the SEC's intent.

Take two companies, A and B; they are equally profitable and differ principally in collectibility rate of accounts receivable. Company A estimates its allowance for doubtful accounts to be 2% of gross accounts receivable, and B's allowance is 30%. Both companies discover, after the fact, that the real allowance was only two-thirds of what it should have been: that is, 3% for A and 45% for B. The premature recognition of earnings by Company A may or may not be material, but for B, it will be as cataclysmic to the income statement as was the AZ Cardinals loss last Sunday on a final-play touchdown pass to my son. It could be permissible to estimate an allowance for doubtful accounts for a group of similar arrangements, but it does not seem appropriate to determine that collectibility is reasonably assured on the same basis.

When is Revenue from a Course Earned?

While collectability may be an issue for some arrangements with students, many of Apollo's students pay in advance. The comment in this section apply to all arrangements, regardless of the timing and/or uncertainty of cash flows.

SAB Topic 13 provides that revenue should not be recognized for "delivered elements" (i.e., classes in Apollo's vernacular) if remaining elements to be delivered to the customer are "…essential to the functionality of the delivered … services." The staff created an exception to this rule for undelivered elements that are "inconsequential" or "perfunctory," but it is not applicable if failure to complete the activities would result in the customer receiving a full or partial refund … (or a right to a refund…)." Stated from a balance sheet perspective, the underlying principle is that one is generally precluded from recognizing a receivable that is not backed by an enforceable right to collect it.

I am unfamiliar with the way courses are conducted by Apollo, but I assume that they all end with an evaluation leading to a final grade. In my experience, students will not pay for a course that doesn't provide them with a grade. Grading is an essential function of the service provided; therefore, it would seem that SEC guidance would require Apollo to defer revenue related to a course until a grade is given to the student.

But, to be fair, I did check the revenue recognition policies of a number of other public companies in the same industry as Apollo, and they all recognize revenue in some ratable fashion as courses progress. For me, that is just one more reason why the SEC's investigation of Apollo's revenue recognition practice is significant. It could better the practices of an entire industry.  (And, by the way, numerous competitors have non-collectibility rates that are roughly the same as Apollo's.)

Accounting for Students Who Drop a Course

The question that the SEC seems to be homing in on is whether Apollo has properly allowed for refunds to students who may drop the course before the 60% point. That also happens to be the only revenue recognition issue that analysts were asking about in Apollo's fourth quarter earnings conference call.

It could be that the analysts and the SEC are both missing the boat. The SEC may believe that Apollo should allocate a portion of the deferred revenue to an estimated liability for refunds. That would initially affect balance sheet classification of liabilities, and it may affect the pattern by which revenue hits the income statement; but it doesn't seem to be that big a deal to me. Yet, it must be said that Apollo's stock price did take an 18% hit around the time of the announcement of the SEC investigation.  If the accounting for the new refund policy is the reason for the stock price drop, then so be it.   

Other Red Flags

I have two final thoughts regarding items that I noticed in my relatively brief perusal of the financial statements. First, even though the ratio of the allowance for doubtful accounts to accounts receivable is around 30%, the ratio of the allowance to receivables for which Apollo actually has enforceable rights could be significantly higher.

That's because Apollo has a practice of recognizing receivables for which it has no enforceable rights. Recall that Apollo recognizes a receivable and deferred revenue for the price of a course when the student shows up for the first day of class. I suppose Apollo is reasoning that both parties have gone down the road somewhat, but it pretty much looks like an executory contract to me. Be that as it may, the SEC should be asking whether the allowance for doubtful accounts is based on the total reported balance of accounts receivable, or just the portion representing enforceable rights. It makes no sense to me to create an allowance for doubtful accounts (and an offset to bad debt expense) on a 'receivable' that is not owed, and may never become owed if the student drops the course. If Apollo sees it the same way, the ratio of doubtful accounts to enforceable student receivables could be significantly higher than even the 29% reported.

Second, regarding the change in the method of presenting cash flows, it would be a pretty big stretch for an auditor to maintain that the switch in accounting was to a preferable method; the FASB has stated in SFAS 95 that the direct method is the approach they encourage issuers to employ as "the more comprehensive and presumably useful." (para. 119) I sure would like to see the SEC ask Apollo and their auditors about that one.

And, perhaps, here is a Hanukah present to the FASB: Apollo could be their poster child for why the direct method for presentation of cash flows should be required. Would 18% of total shareholder value have been destroyed in one fell swoop, had Apollo reported cash flows to investors using the direct method? Perhaps not, because trends in the amount of cash collected from customers would have been disclosed.  The direct method of presenting the statement of cash flows reduces the criticality that investors accurately evaluate the quality of an issuer's revenue recognition policies.  

Winding Up

My goal for this posting was simply to raise interesting questions about Apollo's revenue recognition policies. I want to explicitly state that my intention is not to pass judgment on any of Apollo's choices, even though the market may have spoken to that effect by devaluing Apollo's shares.

Indeed, there are many more questions suggested by this case, and they go beyond the specific effects on Apollo. For example, one could consider whether the revenue recognition rules applicable to Apollo's arrangements with students are themselves representationally faithful or appropriate. We might also ask whether a different result would obtain if the revenue recognition rules under IFRS were applied. Finally, and perhaps most interesting, we could ask how the revenue recognition project being undertaken by the FASB and the IASB jointly has the potential to improve the quality of financial reporting by companies like Apollo. Unfortunately, I am not confident that the proposed approach would be an improvement, but that's for another post.

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.)

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. 

 

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!)

-------------------------------

*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.

Ten Reasons Against Mark-to-Market for Loans – and the Reasons Why They are Wrong (Part 2 of 2)

Continuing my previous post, here's reasons 6 – 10 with my responses.

6. There are also hedge accounting considerations. Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief. Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

Inflation is a real risk, and it is independent of management's free choice in their accounting for that investment. Ironically, the risk of greater-than-expected inflation is greatest in the presence of such a pledge to hold to maturity, yet through existing hedge accounting rules management is discouraged from entering into a hedge to reduce the risk of excess inflation on the purchasing power of its future cash inflows. This is because the gains and losses on the hedging instrument would actually increase the volatility of accounting earnings, while the effect of the hedge would be to reduce the volatility of economic earnings!

If all investments in debt instruments were marked-to-market, then management would choose the economic hedge that best fits the circumstances of the enterprise; they could choose to hedge default risk, inflation risk, prepayment risk, or whatever other risk that concerns them without worrying about silly rules regarding arcane accounting definitions for "macro hedging," "hedge effectiveness," documentation requirements and more. Management would also not feel a push one way or the other toward a particular brand of "hedging instrument."

7. The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory. Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem.

Actually, agency costs can occur because one party, usually the agent, is able to observe economic earnings (and take for itself an undeserved share of those earnings) because the principal cannot measure economic earnings as precisely and completely as the agent. Thus, accounting rules that deliberately distort economic earnings create agency costs, and not vice versa.

Exhibit A for the case that historical cost is the real purveyor of agency costs is the thankfully defunct SFAS 76 and related literature on accounting for an "in-substance defeasance" of debt. Basically, managers wanted to report gains upon early retirement of their bonds, which of course were measured at historic proceeds instead of being marked to market. (Obviously, the yield to maturity of those bonds had increased subsequent to issuance for whatever reason.) Those managers were prevented, either practically or contractually, in many circumstances, from retiring those bonds.

So, special interests did whatever they needed to do to get the FASB to permit in-substance defeasance accounting even if the bonds were not actually retired. The process was pretty straightforward: if enough dough were transferred into essentially riskless, irrevocable trusts whose funds could only be used to make payments to the bondholders, management could get their gain accounting upon funding the trust.

The economics, however, effectively transferred wealth from shareholders to bondholders for no other apparent reason, except to juice reported earnings. Essentially, the bondholders received a windfall gain, because their risky bonds on which they were earning a risk premium, all of a sudden were backed by a fully funded, risk-free trust account. In other words, they were still earning a risk premium without being exposed to any risk! Of course, after the FASB rescinded SFAS 76 et. al., the in-substance defeasance game became a lot less interesting.

My point is that agency costs are minimized when accounting reports economic income. Management can use the opportunity to report fictitious earnings to screw anyone they can: bondholders, employees, shareholders, whomever. Other examples include retiree healthcare costs (mentioned earlier) and compensation via stock options. In all of the cases I can think of when bad accounting became less bad, abuses lessened significantly.

8. We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.

It is quite possible that this "purchase contract" could become a derivative within the scope of FAS 133, and thus measured at fair value, if net cash settlement were required or permitted on each delivery date, instead of physical delivery of paper. In other words, it is currently required (and noncontroversial) to report "fiction" for complex derivatives, but not for other complex (and even less complex) debt instruments, or lease contracts, or purchase contracts, etc.

I am not proposing that we abandon FAS 133's requirements to measure complex derivatives at a current value, but rather to say that if we can tolerate "fiction" for derivatives, I'd like to know why we shouldn't tolerate it for other contracts.

Furthermore, I can only conjecture that the two parties to this transaction would not have entered into it, or at least modified it significantly if it actually did fall within the scope of FAS 133 or some other requirement to measure it at current values. Maybe, instead of Regis providing Dow Jones insurance that the price of paper won't go to high, a more appropriate arrangement would be made with a properly funded financial institution.

The only way to fix this sort of agency problem is to require current valuation of all legal obligations to make future deliveries of goods or services. I know it sounds drastic, but I believe it's necessary, and at least in the arena of lease contracts, the FASB is finally acknowledging that ignoring such contracts by calling them "operating leases" has benefitted only management and its "financial consultants."

9. Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted. One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.

Again, my response to the valuation problem of the debtor/obligor is to mirror the replacement cost measurement exercise of its counterparty.

10. Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees --- that's the ultimate loss.

Actually, on an aggregate basis, I am not sure that clients are actually paying audit fees even today. Each year, the increase in the Big Four's liability exposure (including interest) may be outstripping the fees that they are supposedly earning with audits that do little more than provide legal cover for corporate executives to lay claim to as much of the shareholders' money as they can get away with. Shareholder suits are threatening to bankrupt every single one of the Big Four, and ironically, a more stable (albeit less lucrative) future for audit firms can be found in mark-to-market accounting. This may be a stretch, but I read a wonderful quote of Upton Sinclair (courtesy of Paul Krugman) just today: "It is difficult to get a man to understand something when his salary [or, Krugman adds, his campaign contributions] depends upon his not understanding it."

Even in the absence of a change in measurement attribute, the SEC needs to radically think about the kind of assurance services auditors should be providing on financial statements. As just one example, what is the quantum of investor protection that is added when an auditor documents in its workpapers that the management of Bank XYZ has made an estimate of its loan loss reserves that "appears reasonable"? In place of a rubber stamp from auditors who, despite what any law might provide, can be fired by management virtually at will, I would prefer to be furnished with an independent appraisal of the replacement cost of the loan portfolio, prepared without the involvement of management. Auditors should go back to what they most often do well: count cash: test calculations; confirm receivables, payables, debt amounts and inventory counts; and little else.

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That's all, folks. Here's hoping that whatever the outcome of the debate on loan valuation, it will consist of more than pure politics. As the anecdote from Clarence Sampson indicates, capital markets regulators have been pushing for improvements to bank accounting for ages, with improvements being grudgingly conceded in decades-spaced drips and drabs. Now, finally, the FASB is aiming higher. Let's see whether they can score a hit somewhere in the vicinity of the bulls eye.

Ten Arguments Against Mark-to-Market for Loans – and 10 Reasons Why They're Wrong (Part 1 of 2)

In my previous post, I argued that the FASB should require accounting for investments in loans at inflation-adjusted replacement cost.  I have not been flooded with reactions from readers, but I did ignite a lively discussion on the AECM listserv, composed mainly of academics, and which included a pretty comprehensive analysis from Emeritus Professor Bob Jensen of Trinity University. It's hard to say how most of the 700-odd members felt, but I did receive some hard jabs.  That indicates to me that there are some legitimate and broad concerns -- as opposed to merely selfish preferences of big money special interests.   

In this post, I have taken their comments (mostly those of Bob Jensen, but there were others who contributed their own, thoughtful two cents) to synthesize ten comments that I can respond to in an organized fashion.  Well, there are actually two posts, because the whole enchilada is just too much too swallow in one gulp without putting everyone to sleep.  I'll cover five issues today, and five tomorrow. There will shortly follow another post in which I will present a T-account derivation of the financial statements I provided, accompanied by calculational notes.

Why have I decided to make such a big deal out of this? I predict this topic will be debated as vigorously by capital market participants in the coming year as healthcare is being debated by the general public. Also, just as with the healthcare debate, there will be spillover to other issues: such as convergence with IFRS and adoption; measurement of all liabilities; measurement of real assets; and most important, the objectives of financial reporting. Thus, reasonable professionals, academics and students will probably have to do a lot of thinking to distill all the rhetoric and to feel comfortable with their positions on the issues.

As to my own views, it is no secret that am in favor of comprehensive inflation-adjusted replacement cost accounting.  Here’s my fantasy:  put me in a room for a year and pay me my consulting rates.  When the year is up, I will emerge with a set of comprehensive accounting standards based on constant-dollar replacement costs that will cover everything that GAAP now covers—in about 100 pages.  The basis for conclusions might take 50 more, and worked out application examples might require another 100.  Not everybody will like them, but everybody will come to understand them.  After that, I’ll re-write Article 2 of Regulation S-X to specify the roles of auditors and other experts in SEC-filed financial statements.

But getting back to reality and the scope of this post, I am going to limit the scope to debt instruments and liabilities.  I am also going to ignore the effects that changes in financial reporting per se have on regulatory capital, instead assuming that regulators will develop metrics of capital adequacy that are independent of changes in accounting rules and policies.  Indeed, there are indications that this may finally be happening.

The First Five Arguments Against MTM for Loans -- and Why I Think They are Wrong

1.  Some argue that HTM fair value adjustments reflect opportunity gains and losses when evaluating management. But these opportunity gains and losses may be so inaccurate that they remain in the realm of total fiction. [The commenter, Bob Jensen, considers "fiction" in this context to be "something that is either intentionally or accidentally reported as fact when in reality it is entirely made up out of thin air and does not relate to anything in reality."]

We should not allow fiction that we are 99.999999% certain is fiction. Keep in mind that all the fair value ups and downs of earnings totally wash out over the lifetime of an HTM security. Interim value changes are pure fiction, especially under IFRS where the penalties are too severe to turn fiction into cash.

Sometimes in accounting, we have to choose among the lesser of two evils.  As I have written about in a previous post, until FAS 106 was promulgated in 1990, it would be fair to state that a more insidious "fiction" had been fed to investors: that retiree health care cost liabilities were zero, when it was far more likely that the amount was closer to a trillion dollars – plus or minus a few hundred million.  Indeed, the chicken salad accounting (so-called "pay-as-you-go") prior to FAS 106, which inappropriately delayed recognition of those costs until they were actually paid in cash, is in large part responsible for the demise of GM, just to name one of many casualties.  Thus, even when economic values are measured with huge error, unbiased estimates of changes in value are far better than presentations that pretend that such changes are zero.  Despite its flaws, I'm quite confident that most would aver that FAS 106 was a much-needed improvement to financial reporting.  So, if one is against reporting "fiction" as a matter of principle, how can one justify "fiction" in measuring retiree health care costs, but not for loans? 

One might argue that narrative disclosures of changes in market conditions and other factors are preferable to imprecise measurement, but history has proven conclusively that in both the notes to the financial statements and MD&A, little more is provided than boilerplate.  As Pat Walters (Fordham) indicated on the AECM listserv, it would be preferable to measure economic values on the financial statements, and disclose contractual amounts in the notes. 

I also wonder whether those who support HTM because of measurement limitations, also support HTM for investments in bonds with readily determinable market values?   In fact, the two FASB members who objected to HTM accounting when it was promulgated as an allowed alternative were Bob Swieringa and Clarence Sampson.  Swieringa is an academic (whom I'm proud to say was one of my teachers), and Sampson is a former SEC chief accountant who worked at the SEC for 28 years.  The other five came from the Big Six and/or industry, and would have been seen by Lawrence Revsine through his "selective measurement hypothesis" as having been "captured" by the regulatees. 

Speaking of Clarence Sampson, in an interview sponsored by the SEC Historical Society, he provided a gem of a story that could foreshadow the kind of 'feedback' (to put it mildly) the FASB will get to its forthcoming exposure draft.  Sampson was asked about the SEC's decades-long battle to improve the accounting for financial instruments by banks:

"[Accounting by banks] … was by today's standards horrendous back in the '60s … bad debts were not shown as an expense; they determined income before they took out the bad debt …[W]hen the Commission considered this question, the Chairman of the Federal Reserve came over and protested, dragging his feet all the way …" [italics supplied]

I am supposing that the banking industry's arguments against bad debt expense reporting was something like, "We should not allow fiction that we are 99.999999% certain is fiction."  If that kind of reasoning didn't wash then, it shouldn't now, which incidentally leads us to dealing with the second issue.

2.  Suppose a firm borrows $100 million by selling 10-year bonds at 5% with the holding that debt to maturity. Letting earnings fluctuate for 40 quarters for fictional gains and losses of value changes on those bonds is more misleading than helpful investors in my viewpoint. It may be especially fiction if there are cost-profit-volume considerations. Just because a few investors in those bonds are willing to sell at current market (thereby making a market) does not mean that all investors are willing to sell at current market rates. There are issues of blockage costs of trying to buy all the bonds back versus buying only $1 million of those bonds back.

It is indeed true that the earnings fluctuations will wash out IF there is no inflation, AND IF the loan is paid in full.   The problem, though, is that inflation is ALWAYS with us; my example conclusively demonstrates that, when properly measured, the holding gains and losses on debt don't wash out, even when the bond is repaid in full.  The reason for this is that inflation, even when it is low, can have a significant effect on economic earnings.  Thus, it's a pretty safe bet that, if inflation were properly taken into account, managers' preferences for long-term debt as opposed to equity financing would shift towards equity.  And as another consequence of the proper accounting, it would become more common for regulated financial institutions to hedge their exposures to unexpected inflation.  Currently, accounting standards discourage that, even though it may be in everyone's interests to do so.

But, since the FASB is not proposing to measure the changes to loan valuations at their inflation adjusted amounts, I support their proposal to relegate the fluctuations in fair value to other comprehensive income (OCI), and to exclude them from the EPS calculation.  That's because I'm fairly indifferent as to income statement presentation, especially with the prospect that XBRL will allow investors to tailor income statement presentation to their needs.

As to the problems attendant with the valuation of one's own debt, I believe in symmetrical measurement of financial transactions, i.e., transactions that only transfer wealth as opposed to create it (see this post).  This means that a debtor should report its obligation at the lender's replacement cost of its investment (except that the debtor would not include the transaction costs that the investor would incur to replace the investment).  Among the advantages of relative simplicity and clarity of principle, blockage factors would come into play only if there were investors holding relatively large blocks.

3.    But even if we can accurately measure the value of the $100 million in debt, value to financial reporting is not served by booking repeated gains and losses that automatically wash out over the year life of the bonds. This is especially the case in IFRS where severe penalties are incurred for firms that the IASB imposes on companies that renege on their held-to-maturity pledges. How can you adjust fair market value of HTM securities for the penalty clauses of the IASB for reneging on HTM pledges?

Refer to my answer to 2, above, regarding the washing out of gains and losses when measured in nominal dollars, i.e., when adding apples and oranges. 

As to the IFRS "penalties," that comment refers to a provision in IAS 39 (para. 46b) in which a company must essentially cease use of HTM accounting for the current and subsequent two years if they liquidate a bond investment before maturity.  Actually, U.S. GAAP is not significantly different; the two-year penalty provision has been a long-established policy of the SEC staff since virtually the effectiveness of SFAS 115.  The IASC, probably controversially, inserted it in IAS 39 as part of their hasty scheme to appease the SEC and be able to state that it completed  the momentous, five-year "core standards" project one year early (1999).  What a joke. 

As to whether there is a "severe penalty" for breaking the HTM "pledge," absent any regulatory effects that are neither the fault or responsibility of accounting standards setters, I fail to see how changing the location in the accounts of one's debits and credits penalizes shareholders in any real sense.  Call me old fashioned, but cosmetic accounting changes don't affect future cash flows unless they are factored into management's decision making processes.  For example, a change in accounting could affect that portion of management's compensation which is earnings-based, and management could react accordingly; but if the BOD thinks that would be a bad thing, they could certainly make the necessary adjustments.

4.    We might be able to estimate a reliable change in value of a HTM-designated asset or liability, but reneging on the HTM pledge will impact a raft of other past and future contracts that are almost impossible to factor into the damage caused by reneging on a single HTM pledge.

If we require current-cost accounting in any form, then HTM goes away; and absent HTM, I can't conceive of any reason why management would pledge to hold a security to maturity without adequate compensation for giving up their options.  So, let's say that management does make that pledge and debt securities must be valued at replacement cost.  Valuing the security by the replacement cost of the security as an asset to investors should handle this problem.

5.    Debtors could book debt at current call back values, but these call back values often have penalty clauses that make them poor surrogates of current value, especially when penalties are severe.

I don't see this to be a significant factor if, as I stated earlier, the measurement of debt is its replacement cost to the holder. 

That's all for now.  My next post will deal with issues related to derivatives, hedge accounting, what agency theory has to say about the controversy, and complex executory contracts.  I'll give you the issues I'll be responding to, and you can start thinking about your own responses now!

 

6.    There are also hedge accounting considerations.  Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief.  Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

7.    The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory.  Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem. 

8.    We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.

9.    Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted.  One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.

10.    Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees --- that’s ultimate loss.