The Accounting Onion

The Death and Transfiguration of "Substance Over Form" in U.S. GAAP

Over the years, the notion of accounting for "substance over form" has been trumpeted in IFRS circles as the apotheosis of principles-based accounting. From a practical standpoint, something like it is absolutely necessary for filling in the large gaps in specific guidance and the paucity of application examples.

This is what the IASB's Conceptual Framework said about "substance over form" until pretty recently (more on the change later):

"If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, an entity may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the entity continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction). [¶35, emphasis added]

In stark contrast, the FASB firmly rejected the notion more than 30 years ago:

"Substance over form is an idea that also has its proponents, but it is not included [in the hierarchy of accounting qualities] because it would be redundant. The quality of reliability and, in particular, of representational faithfulness leaves no room for accounting representations that subordinate substance to form. Substance over form is, in any case, a rather vague idea that defies precise definition." [Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, ¶160, 1980; emphasis added]

The example in the quotation from the IFRS concepts document, on legal ownership versus economic benefits, feeds right into an anecdote a good friend and trusted source related to me recently. I'll call him George.*

George was attending a conference where he asked a German accountant about the criteria that was used in his country for distinguishing between an operating and a capital lease under IAS 17. "If ze lease term ist greater than 70% of ze remaining economic life of ze asset, zen vee capitalize ze lease," said the German.

"Why 70 and not 75%?" asked George.

"Because 75% ist zee American standard," responded the German. He walked away without further explanation.

George asked a French accountant in attendance the same lease capitalization question. His answer was 90%; and when George asked him why, he too just shrugged and walked away.

That's the reality of the application of substance over form. Whatever "substance" might mean to the accounting standards setters, we all know that's not the way the pros play the game.

Under IFRS, "substance over form" can be more than a gap filler. It has even been used to trump specific accounting rules. In 2008, Société Générale chose to shove losses incurred on their account by a rogue trader into 2007's income statement, thus netting them with his gains of the previous year. There is no disputing that the losses occurred in 2008, yet the company's position is that application of specific IFRS rules (very simply, marking standalone derivatives to market with the result gains/losses going to income) would, for reasons unstated, result in a failure of the financial statements to present a "true and fair view" – i.e., substance over form. You might also be interested to know that the financial statements of French companies are opined on by not just one, but two, auditors. How could both be wrong about the "substance" of those losses? C'est imposible.

Bringing Back the Dead

If IFRS were to converge with U.S. GAAP, then it was imperative that "substance over form" be resurrected. The deed was done through the joint project to converge conceptual frameworks and hidden the basis for conclusion section in CON 8:

"Substance over form is not considered a separate component of faithful representation because it would be redundant. Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. Representing a legal form that differs from the economic substance of the underlying economic phenomenon could not result in a faithful representation." [¶BC3.26]

The positions of the IASB and FASB are now identical, because the same language was incorporated into the IASB's framework. The new language in CON 8 is eerily similar to old CON 2, but there are two important differences. First, the last sentence of CON 2 on the vagueness of the "substance over form" notion is conveniently omitted. Second and relatedly, the next two sentences make out "substance over form" and "faithful representation" (now one of the two "fundamental" qualitative characteristics of financial information). to be one and the same. That's pretty convenient since "representational faithfulness" doesn't seem to mean anything more or less than telling the truth. Effectively, CON 8 now says, 'The two fundamental qualitative characteristics of financial information are relevance and being truthful.' Wow, that's deep.

Does it matter that for U.S. GAAP "substance over form" has been resurrected and transfigured into "representational faithfulness"? Yes. If you are looking for example of the ways in which convergence with IFRS has diminsihed the quality of U.S. GAAP, I would make bringing back "substance over form" Case in Point No. 1. Three examples of recent consequence come to mind.

First, the AICPA has proposed to make "substance over form" a key component of its proposed accounting framework for SMEs:

"The substance of transactions and events may not always be consistent with the substance apparent from their legal or other form. To determine the substance of a transaction or event, it may be necessary to consider a group of related transactions and events as a whole. The determination of the substance of a transaction or event will be a matter of professional judgment in the circumstances." [¶1.13, emphasis added]

That last sentence is just another way of acknowledging the FASB's concern expressed in CON 2 (and which has magically disappeared): that no one knows what "substance over form" means. As a teacher, I anticipate explaining to students that a real professional knows substance is, and she knows it when she sees it. As a litigation consultant, I'm already salivating over the prospects for the extra work it promises: whenever "substance over form" is invoked to justify an accounting treatment, plaintiffs and defendants alike will arm themselves with experts swearing this "substance" and that "substance."

Is this really how the AICPA envisions it will make financial reporting less burdensome for SMEs?

Second, "substance over form" can be used by standard setters to justify almost anything. Most recently we see it being proposed to help lessees smooth lease expense. The same can also be said for the revenue recognition proposals that would permit recognition of so-called "constructive liabilities" as performance obligations.

Third, now that convergence is failed, the SEC is being pressured to adopt IFRS – if not wholesale, then to allow companies to elect IFRS instead of U.S. GAAP. Yet, whenever a particular wrinkle in a contract is not specifically addressed in an authoritative document, the IFRS accountant is charged with somehow being able to parse "substance" from "legal form" with "management's intent" thrown into the mix. And, somehow, the auditor is supposed to be able to determine whether its client's divine revelation is at least "reasonable."

* * * * * * *

IFRS adoption in any form would be an unmitigated disaster, with the ridiculous notion of "substance over form" playing a leading role. It's a concept that should have no place in U.S. GAAP, and convergence is to blame for bringing it back.

 

"Double Entry": A Tale of Two Books

If you are looking to buy a holiday present for an accountant, then you should consider Double Entry: How the Merchants of Venice Created Modern Finance. It's a pretty fast read – both for its moderate length (256 pages) and for Jane Gleeson-White's graceful and clear writing style.

Double Entry also covers a lot of ground. It begins with what little is known about the origins of accounting in ancient Mesopotamia, moving quickly to the first known treatise on the eponymous bookkeeping* system published in 1494, and then to its proliferation throughout Europe (largely owing to the near simultaneous invention of the printing press).

That takes us almost exactly half-way through. I am certainly not an accounting historian, and for that reason I found these earlier chapters the most edifying. My friend and SUNY Geneseo professor Harry Howe summarized it nicely:

"It's a good read - suffering in a few places from a lack of technical precision (it's popular rather than scholarly history), but strong in explaining Pacioli's [the author of the accounting treatise] life and the breadth of his contributions. [Jane Gleeson-White] does indeed acknowledge the earlier origins of [double-entry bookkeeping], and does a nice job of explaining how arithmetic practiced within the convention of Roman numerals left no audit trail. We don't often think of the development of accounting as part of the Renaissance, but, after reading the first half of this book, it seems clear to me that we should."

The main theme of the remainder of the book is that while double entry bookkeeping has endured, the gap between what it measures and what should be measured has grown wider. Like this blog, it hews close to a wisdom of what gets measured gets done; and more important to Ms. Gleeson-White, that which doesn't get measured doesn't get done. But, even though Ms. Gleeson-White and I share a common interest in producing variations on that theme from stories of audit and accounting failures, she also sets her sites on accounting-abetted mismanagement of economies (value-neutral systems of national accounts) and the environment (failure to account for externalities).

Pardon the pun, but Double Entry feels like two books in one. The first 'book' is a celebration of a simple and deceptively powerful system for recording and summarizing economic events that has endured for perhaps a millennium. The second 'book' wants us to ask ourselves whether slavish devotion to that same system will prove to be the undoing of humanity.

Is appreciation of the ancient history of double entry bookkeeping helpful for answering the question posed by the second book? I don't think so, but if you love and are fascinated by accounting, then the whole of Double Entry is well worth reading.

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 *Here's a fun bit of trivia that not everybody knows (and is not in the book): "bookkeeping" and "bookkeeper" are the only words in the English language with three repeated letters in a row.

Is Money Market Fund Accounting Fair to Investors?

The purpose of this post is to review a recently published monograph authored by former FASB Chair Dennis Beresford. To summarize, it supports the status quo for money market funds, and I want to explain why I think the reasoning and analysis leading to that conclusion is flawed, and hence potentially misleading.

With no disrespect intended, I'll be referring to my subject as Denny. And, without wishing to lay it on too thick, I want to state at the outset that I consider him to be a friend whom I greatly respect for both his intellect and integrity.

Speaking of which, Denny told me that he refused compensation from the monograph's publisher, the U.S. Chamber of Commerce, so as not to have to deal with anyone questioning his true motivations. I was not the least bit surprised to learn of his refusal to take nothing (except perhaps a couple dozen golf balls). However, it must be stated just the same that the Chamber is a conservative and large-scale lobbyist that raises millions in large chunks from anonymous donors, who themselves keep a low profile as the Chamber uses their millions to sway political elections and policy deliberations. To give you some idea as to the nature of the Chamber's 'support,' consider this from a New York Times investigation:

Prudential Financial sent in a $2 million donation last year as the U.S. Chamber of Commerce kicked off a national advertising campaign to weaken the historic rewrite of the nation's financial regulations.

I think it's safe to assume that if Denny's positions were not congruent with what some have referred to as the banking oligarchy, his monograph wouldn't have seen the light of day.

* * * * *

To understand the nature of the policy issues, and my misgivings, let's start with a couple of basic questions – having nothing whatsoever to do with accounting:

Question #1:

If someone had invested $1 million in a mutual fund yesterday, could she withdraw the full $1 million today – even if the fund's investments have declined in value? (For the purpose of your answer, ignore any dividends earned.)

Interpretive Response – No, unless said mutual fund is a "money market fund" conducting its business in accordance with SEC Rule 2a-7 under the Investment Company Act of 1940. Paragraph (c) of the rule provides that, with certain qualifications, a "…money market fund shall limit its portfolio investments to those United States Dollar-Denominated securities that the fund's board of directors determines [emphasis supplied] present minimal credit risks …" and the average maturity of the investment portfolio should not exceed 60 days.

Question #2:

Should money market funds, unlike other mutual funds, be allowed to redeem shares at $1/share (i.e., a constant net asset value, or NAV), even if the net market value of the fund is less than $1 per share?

This is the crux of the matter. The current legal response to this question is 'yes,' provided it is 'safe' to do so. It may be safe today, and revisions in 2010 to Rule 2a-7 have tightened things up somewhat; but not everyone believes it will be safe for long. Denny, however, avers that adequate security measures are already in place. Notwithstanding, kindly refer to the part about the BOD's discretion in the interpretive response to Question #1, above.

In contrast to Denny, SEC Chair Mary Schapiro certainly doesn't think it's safe. She has gone out on a limb to make money market fund reform a centerpiece of her legacy, but thus far has been frustrated – reportedly to the point of tears – by special interests.

And Ms. Schapiro is not alone. Arthur Levitt, the longest serving SEC chair in history and by my estimation a moderate not given to hyperbole, had this to say to Bloomberg Radio about the current status of money market funds:

"There's clearly a need to do something about money-market funds. Everything else [other mutual funds] is marked to the market. This should be marked to the market in the interest of investors. The fact that Mary Schapiro couldn't get her three members of the commission to support this is really a national disgrace….

"We've had a number of instances where funds have broken the buck, and the funds have made up for it because they know that the whole faith and confidence in the fund market would be damaged. Today, the margin of error is narrower than it's ever been."

The sponsors of money-market funds simply don't want this regulation." [bold italics supplied]

Question #2a:

As an aside, even if it is safe from a systemic perspective to maintain a constant NAV, does it do right by investors?

To answer that question, think about where the money comes from when the investor with the $1 million redeems her shares. If you happen to hold shares in the same fund, the difference between $1 and the market value per share has to come out of your pocket. And, what if she should invest her $1 million in another money market fund whose market value is greater than $1? If you're an investor in that fund as well, then more money comes out of your pocket.

On its face, a constant NAV is an open invitation to arbitrageurs.  Yet maybe, as Denny argues, the provisions of Rule 2a-7 ensure that these windfall transfers of wealth are insignificant when spread out over all of the investors in a fund; but couldn't the same be said about insider trading? And, over time and with automated trading strategies (perhaps yet to be invented) this kind of thing could run into real money.

Given that marking to market probably entails fewer record keeping costs than maintaining a constant NAV, I don't see how this constant barrage of individually small rounding errors can be ignored.

Question #3:

How should a money market fund account for and report the value of its investments: at 'amortized cost' or at 'market value'?

The title of Denny's monograph, Amortized Cost is "Fair" for Money Market Funds, clearly indicates that this is the accounting question he is answering. For one thing, placing "fair" in quotes can only indicate that Denny is simply referencing an accounting term of art, and not broader questions of fairness as commonly understood. If his monograph were entitled, "Is Money Market Fund Accounting Fair to Investors?," without the quotes surrounding "fair," then very little of Denny's analysis could have been salvaged.

The bulk of the monograph is an interpretive response to an accounting question that is derived from the consideration of accounting concepts, precedents and even accounting materiality. However, the questions for policy makers regarding money market funds are perforce grounded in economic considerations, and not the form of the accounting. Those policy questions are the ones I have already posed in this post.

As Arthur Levitt implies in his criticism of the status quo, how one answers the economic questions determines the answers to the accounting questions – and not the other way around. Stated another way, the answer to an accounting question should depend on the purpose an accounting purports to serve. Regarding money market funds, I believe there is broad consensus as to the predominant purpose of an accounting: to serve merely as the basis for determining how much money will be distributed to investors when they redeem their shares. Once the basis for distributions is determined, the accounting question solves itself.

I believe that Denny realizes this. Even though he emphasizes the accounting aspects, he must eventually come around to considering the economics. But with all due respect, Denny's background as an accounting standard setter does not particularly qualify him to address the potential economic consequences of Rule 2a-7 as it is currently written. My biggest gripe is that from a couple of pages of cursory analysis, Denny is willing to confidently state that money market funds are subject to sufficiently prudent regulation under Rule 2a-7; but Mary Schapiro and Arthur Levitt, who have lived and thought about these issues for much longer, say differently. I think Denny has stuck his neck out too far.

It also doesn't help that when Denny attempts to ameliorate concerns over the limitations of amortized cost accounting, they are hedged in practically every case with qualifying language. Here are three examples from just a single page (9) [italics supplied]:

• "The … restrictions in SEC Rule 2a-7 ensure that the difference between market value and amortized cost generally is immaterial."
• "Further, money market fund investments are often held to maturity and any discount or premium in the purchase price is realized by the fund."
• "Gains and losses tend to be immaterial."

Take out those qualifiers (which I have highlighted with italics), and were are left with unsupportable generalizations. But leave them in, and we have very little to take away from the analysis except for this: amortized cost as a basis of accounting and for administering money market funds works fine – except for when it doesn't.

Bigger than Loan Impairment – Adjusting Bank Profits for Inflation

We have been covering loan impairment for the past few weeks, and the FASB's proposals leave me with the feeling that we will be discussing it for a long time to come. Once the FASB shoves its post-WWI-Germany-derived "Current Expected Credit Loss Model" through the meat grinder that it refers to as "due process," the banking oligarchs will be mollified, and financial results will hum right along again … for maybe a decade. After the next tsunami of bank insolvencies will hit without warning; my best hope is that accounting standards setters (it might not be the FASB that far out) will finally adopt a credible process for marking bank loans to market.

Now that I'm finished with loan impairment, as long as we're on the topic of the accounting for banks, let's move on to another topic that could prove to be even more important between now and the next balance sheet bubble. In this post, I'll be discussing the accounting for inflation – or rather the lack of accounting for inflation. Only for the sake of whetting your interest, let me state that if you believe the conservative naysayers, imprudent monetary policy is raising the inflation specter. But, what I really want to show is that reflecting the effect of inflation on bank financial statements is important even now.

The Effect of Inflation on Accounting in a Nutshell

When a bank originates a fixed-rate loan, monetary inflation inevitably erodes the purchasing power of the contractual cash flows to be received in the future. Even if the bank were repaid in full at some point (i.e., setting aside all impairment concerns) the return of its principal is worth less 'today' than in the past, when the loan originated. Bankers realize this, of course, and should charge a rate of interest that is commensurate with the expected loss of purchasing power of its future cash inflows.

But, despite the straightforwardness of the problem, there is a huge accounting disconnect between economic reality and what is actually reported.  The lessons I intend to convey by a representative, yet simple example, are the following:

• Reported bank profits are always overstated by U.S. GAAP (or IFRS) by the absence of any rules requiring banks to recognize the declining purchasing power of the value of loan portfolios.
• Reported bank profits are always less volatile than their economic profits.
• If you believe, as I do that what gets measured gets done, then shareholder value destruction occurs: loans are mispriced because the full of effect of a manager's lending decisions are not reflected in management's scorecard, i.e., net income for the period; and dividends may unintentionally shrink a bank because they are greater than the banks true (economic) earnings.

Here's the example – and I hope you'll bear with me because I'm going to need more than a modicum of words, numbers and pictures to demonstrate the above points:

• NewBank was established on January 1, 20x0, on which date it engaged in the following transactions:
  • Shareholders contributed $20,000 in cash;
  • The bank borrowed $80,000 in the form of a bond paying interest at 4% at the end of each year for five years.
  • The bank originated a $100,000 loan with terms identical to the bond, except the interest rate charged was 5%.
• New Bank made its bond payments as scheduled, and its borrower did the same.
• Annual dividends were $1,800. (Note that this is the amount of net interest received each year. Also, since the bank has no other revenues or expenses, it is the amount of income reported in U.S. GAAP each year.)
• Inflation for each year was as follows: 2% in the first year, followed by 4%, 6%, 4% and 2% for each succeeding year.

Below are the financial statements for the each year, but I want to first focus on 20x1. (By the way, you can access my full spreadsheet here.  Among other things, it will show you to the purchasing power loss item is calculated.)

The first thing to notice is that the bank's inflation-adjusted income in the first year (and every other year), which henceforth I will refer to as economic income, is lower than its GAAP income. In the presence of inflation, this will almost always be the case, because there is nothing the bank can do about the fact that it holds more monetary assets that are exposed to inflation than monetary liabilities. I have displayed the effect of loss of purchasing power on economic income in a separate line item.

A couple other things to take note. First, that revenues and expenses were inflated. More generally, all measurements are made in "constant" units of purchasing power, which simply means that we are adjusting (i.e., remeasuring) past revenues, expenses, assets and liabilities to reflect their purchasing power as of the end of the most recent period.

But, for a bank, these remeasurements are not as consequential as for an industrial company that would, for example, have to remeasure depreciation expenses from long-ago capital expenditures in the dollars of today.

Second, the inflation adjustments made in the financial statements only require actual inflation as inputs; no assumptions about the difference between expected versus actual inflation are made. In fact, we have no way of directly knowing how much inflation was impounded in the interest rates charged by the bank as a lender, or to the bank as a borrower.

To get a sense of the long-run effects of remeasuring for inflation, the chart below displays the time series of GAAP income versus economic income over the full five-year terms of the loan and debt:

The biggest takeaway here is self-evident: that changes in inflation will add an element of volatility to reported earnings. Conversely, ignoring inflation makes reported earnings quite easy to predict. Even when inflation runs amok, NewBank's reported earnings misleadingly appear to be like a rock of consistency.

The $64-K Question

Should the FASB require banks to adjust for inflation? The reasons why they should are:

• Bankers can be expected to make better decisions if better information is provided to shareholders, i.e., their putative bosses. If you believe that adage 'what gets measured gets done' then you have to believe that shareholders are losing value every day that a clearly inferior accounting standard is in place.
• Making inflation adjustments to a bank's accounts is simple (I'm setting aside other industries here, also mainly for the cause of simplicity). As I demonstrated in my worksheet, inflation adjustments are not rocket science; they are easy to program, and are a lot easier to explain than, say, the CECL model or hedge accounting.
• When banks choose a dividend payout ratio based on GAAP earnings (the ratio is 100% in my example), it is impossible to tell whether the dividend exceeds economic earnings.  Stated another way, a portion of the dividend will be merely a return of investment, as opposed to a return on investment. Among the consequences are that bank executives own shares in their banks, so GAAP-based dividends risk that the executives will be receiving the invested monies of shareholders instead of an earned share of investment income. In the extreme case, when inflation is high, we can expect bank executives to seek a raise in their compensation – even while economic income is surely negative.

As far as I can tell, there is only one reason why inflation-adjusted financial statements shouldn't be required. You guessed it: bankers will throw a fit.

It will make their recent protestations to the FASB against marking loans to market feel like a book club debating 50 Shades of Grey.

What Do Accounting Standard Setting and Infrastructure Projects in Southern Italy Have in Common?

In my previous post, I committed to providing a statement of my own accounting principles with newer readers of this blog in mind. I am also adding a few observations about what the process of standard setting has come to be without guiding principles – i.e., standard setting at the FASB and IASB.

A Statement of Basic Accounting Principles

(I apologize for the dense formatting, but I couldn't figure out how to (or couldn't be bother) add spaces in lists with html commands.)

1. The purpose of financial statements issued by public companies (hereinafter, reporting entity) should be consistent with the SEC's mission to protect investors.
2. The present holders of the common stock (i.e., using the FASB's terminology from a defunct proposal from five years ago, "basic ownership interests") of the reporting entity should be viewed as the primary users of financial statements. This view of common shareholder primacy has the following implications:
   • Claims on reported wealth should be distinguished by non-owner claims (liabilities as defined in #6, below) and owner claims (owners' equity).
   • Determination of what constitutes revenues, expenses, gains and losses is from the perspective of the common shareholders.
   • The mission of investor protection is best accomplished when financial statements function as an external control over management. This role is sometimes referred to as "stewardship" – ensuring that the company's affairs are conducted for the benefit of the shareholders and within legal and ethical constraints.
   • Usage of financial statements for valuation purposes is a subordinate consideration when determining accounting policies.
3. This external control (or stewardship) view of financial reporting calls for providing shareholders with information that is relevant for assessing: (a) the amount of wealth under the control of the reporting entity and how it has been invested; (b) claims on wealth; and (c) a detailed summary of how wealth has changed over time. (However, and as discussed below in #8, it is assumed that users of financial statements understand that financial statements will not provide all of the information investors may desire for assessing these items.)
4. The needs of non-primary users of financial statements should not be considered when determining policies for the preparation and presentation of the primary financial statements (e.g., balance sheet, income statement, statement of cash flows). However, the informational needs of non-primary users may provide the basis for requiring certain disclosures outside of the financial statements. (A pragmatic justification for this principle is that it is generally taken as a given that the interests of others in the assets of the company (e.g., bondholders) are not sacrificed in any significant manner when common shareholders are viewed as the primary users of financial statements.)
5. If the reporting entity "controls", "jointly controls" or can exercise "significant influence" over its counterparty to a contractual arrangement, the reporting entity should consolidate the counterparty on a proportionate basis. (Note: I accept the existing definitions in U.S. GAAP of "control," "joint control" and "significant influence."
6. The balance sheet should report items of wealth (assets) and claims on wealth (liabilities).
   • An "asset" is an economic resource to the reporting entity that satisfies at least one of the following conditions: (a) the reporting entity holds legal title to the resource; (b) the reporting entity holds the legal right (conditional or unconditional) to receive the resource; or (c) the reporting entities holds the legal right (conditional or unconditional) to use the resource for some purpose (specified or unspecified).
   • Liabilities are legally enforceable obligations (conditional or unconditional) to either: (1) deliver an asset or the common stock of the reporting entity; or (2) permit another party to use an asset. Therefore, all liabilities of a reporting entity are assets of another entity or person.
   • A balance sheet may not violate the axioms of arithmetic (e.g., unlike measurements may not be summed).
   • The attribute of an asset to be measured for purposes of financial statement presentation should be the asset's economic utility to the reporting entity. In most cases, this is represented by the asset's replacement cost; however, in some circumstances measurement of utility is best captured by the asset's net realizable value through sale under current business conditions.
   • Since all liabilities are assets of another entity, a liability is measured at the replacement cost of the corresponding asset.
   • Comparisons of measurements at different points in time require adjustments for changes in price levels.
7. The income statement reports changes in assets and liabilities for a given period resulting from the following: (a) transactions between the reporting entity and persons that were not common shareholders (or were not acting in the capacity of common shareholders) during the period; and (b) other events that affect the measurement of assets and liabilities.
   • The income statement should clearly delineate the effects on reported net income of operating and financing activities.
8. Providing information about wealth is costly. Financial reporting standards setters must weigh the aggregate costs to be incurred in producing information against the benefits of making the information available. This weighing of costs and benefits, has, among other things, the following implications:
   • Not all assets and liabilities of the reporting entity may be recognized on the balance sheet.
   • The most accurate approach to measurement of some recognized assets and liabilities may not be economically justifiable. Therefore, financial reporting standards may require or permit alternative measures that are less accurate, but without sacrificing the objective of wealth measurement.
   • The needs of regulators, managers, or auditors are not directly germane to establishing financial reporting standards, except to the extent that their past and future actions cause the costs of producing information for investors to change.

 

The Effect of Standard Setting without a Statement of Principles

I cannot claim that application of these principles will automatically resolve every accounting policy question; however, I do claim that a comprehensive basis of accounting built on these principles – or making incremental changes to an established basis of accounting such as U.S. GAAP – would be much simpler, more transparent, consistent, and germane to the SEC's mission of investor protection.

In stark contrast, the FASB claims that its "conceptual framework" (note the absence of the term "principles") is supposed to serve as a guide to its mission to improve the quality of accounting standards. How has that been working out? IMHO, not very well at all.

If the FASB has no principles, then how do accounting issues get resolved? There is no simple answer to that question, but consider these facts:

• The members of the FASB, are appointed by the Financial Accounting Foundation (FAF) whose members in turn have strong ties with the reporting entities that the FASB is supposed to regulate through the promulgation of accounting standards. These ties can be direct, or indirect through the larger CPA firms with membership on the FAF's board of trustees.
• Board members often receive a salary that is significantly (2 – 3 times?) higher than what they were earning prior to becoming board members. (This was not always the case, by the way.) They are appointed for an initial term of five years, with the possibility of re-appointment by the FAF for a second term.

Given no principles to serve as constraints and the pecuniary value of FASB membership, the process of promulgating a new major accounting standard (e.g., leases, revenue recognition, or loan impairment) has come to look like a public infrastructure project in southern Italy: it goes on for decades, and the prospect of an outcome in the public interest is highly uncertain. Moreover, like the Italian construction workers, it can be argued that Board members take care to preserve their employment at above-market salaries; and like organized crime in Italy, the reporting entities want a big piece of the action – and they get that in exchange for "protection" of the Board and its members. Just to be sure, each FASB member is carefully chosen by a board composed largely of the representatives of the reporting entities and its friends (i.e., the FAF) so as to maximize the likelihood that they will 'play along.'

Don't shoot me! All I am doing is interpreting long-established and recognized economic rationale of "regulatory capture"; and I'm not the first academic accountant to do it. In 1991, Lawrence Revsine observed in an article published in Accounting Horizons (which I wrote about here), that, even though accounting is intended to protect investors, "…managers gradually learned that while events that affect performance often cannot be controlled, the way that people perceive these events can be controlled by distorting economic reality." To be sure, misrepresentations to benefit the regulatees cannot be too comprehensive lest a complete loss in the credibility of financial reporting should occur; hence, the importance of being "selective."

With respect to specific process of regulatory capture of standard setters, Revsine wrote:

"While it regrettably conjures a pejorative image, the phrase "regulatory capture" is not intended to impugn the integrity of standard setters. Instead, the point is that everyone is influenced by their background and becomes comfortable with familiar perspectives and experiences. This is inevitable and natural. Unfortunately, in the regulatory sphere, it is also antithetical to the intended purpose of regulation."

In other words, Revsine would not state in 1991 that standard setters were actually conscious of being captured. But now, more than 20 years later, I wonder if Revsine would continue to be as kind.

I would hope that Revsine would be more pointedly criticial of the FASB, for whatever the culture of the FASB 20 years ago, it is self-evident that regulatory capture of the FASB has devolved to a much more virulent form, and to a point where moneyed interests run roughshod over investor protection.

Pick a Number: Anything but Market for Loan Accounting (Part 2)

In response to my previous post, Edith Orenstein (author of the FEI blog and fellow Ohio State alum) asked me whether I preferred the status quo "incurred," or the proposed "expected" loan loss model (CECL).

Also in that post, I stated that I would have more to say about how the FASB defined "expected" in the CECL model. As it turns out Edith's question makes for a good lead in, so I'll take on both of these questions here.

The Expected Loss Model is a Move in the Wrong Direction

Actually, Edith, both models are terrible because they both require estimates of future cash flows over a loan term of 5, 10 or even 30 years out. It's ridiculous to presume that these numbers are much better than seat-of-the-pants guesses – even for the plainest vanilla loan contracts.

But, I'm not going to evade your question: the proposed "expected" loan loss model is worse.

CECL is worse because it violates basic economic logic and reasonable accounting conventions. How can the value of a loan at its inception be anything different than the net proceeds to the borrower? This was the logic for the incurred loss model; but under the CECL model not only can the carrying amount be different than economic reality from the get go, but it must be different – and that difference must be recorded as an expense on the income statement.

When a cash outflow does not give rise to an "asset" as defined by applicable accounting standards, it is perfectly understandable that a corresponding expense must be recognized. But, this CECL contrivance is different: the cash outflow to the borrower clearly gives rise to an "asset," and there is no precedent I can think of to justify recognizing only a part of that asset.

There is also the matter of discount rates in both models. I discussed in my previous post how the CECL approach is discounting numbers that aren't actually cash flows; at least the current model at least purports to discount cash flows, but with an arbitrary discount rate. What approach is worse? Let's just say that they're tied for last in a two horse race and we'll leave it at that.

So, on a scale of 1 to 10, I rate the CECL model a minus 3, and I give the incurred loss model a solid zero. As I am about to explain, the proposed CECL model will not provide relevant information to investors and regulators. It is merely another iteration of the "anything but market values" movement driven by bankers and auditors.

Pick a number … pretty much any number.

As Edith pointed out, I was pretty "acerbic" (her word) in my criticisms of the CECL model. But, I actually saved the most insidious aspect of the FASB's loan impairment proposal for last:

"The estimate of expected credit losses is neither a 'worst case' scenario nor a 'best case' scenario, but rather reflects management's current estimate of the contractual cash flows that the entity does not expect to collect.

That helps a lot; it's management's estimate, and just like that old accounting joke about two plus two, management can pick pretty much any number it wants.*

The FASB's boilerplate approach to defining expected losses will not fix the problem of overstated loan balances during a financial downturn. But, there is a method to the madness. To see what that could be, let's tryout a saner solution: how about requiring management to provide its best estimate of future uncollectibles – i.e., the number the bank CEO would bet her own house on instead of the shareholders' and taxpayers'?

The 'problem,' with this solution is that it would put even the best intentioned auditors on the hook to do something they are not qualified to do. If management must estimate in good faith the expected loan losses (i.e., the number that is just as likely to be too high than too low), then how is an auditor supposed to provide reasonable assurance that management actually did what was required of them? Perhaps the auditor could re-perform management's task, but given its complexity and the number of judgments required, it would be unlikely to come reasonably close to management's estimate. Then what?

Alternatively, the auditor could simply review management's estimation methods and parameters, check a few calculations, and then in their infinite wisdom pronounce to the world that management's estimate "appears reasonable." The problem with either of these audit approaches is that when then next financial crisis hits, auditors' judgments will be second-guessed – and if history is any guide, rightly so.

But, if the FASB's boilerplate is finalized, auditors' lives will be improved. For starters, they will finally be able to get those persnickety PCAOB inspectors off their backs. Management can throw out the number it wants investors to behold, and auditors can keep themselves relatively protected from litigation merely by devising some rote procedures that must inevitably find that the number management picked was neither the best nor the worst case.

My point, Edith, is that the question of an expected or incurred loss model is a distraction from the real issue. By whatever model, the numbers won't mean anything – and neither will the auditor's report.

There is a better way.

These are the reasons why I have repeatedly maintained that it is essential for the carrying amounts of loans to be estimated by independent third parties and not management – regardless of the measurement basis for those carrying amounts.

Neither auditors nor management are qualified to provide unbiased and reasonably tight estimates of loan loss allowances; but even if you want to dispute that, it is indisputable that auditors can much more reliably provide assurance as to whether a third party is independent, competent, and that it did what it was supposed to do.

Which brings me full circle back to market value. If an independent third party is going to measure the carrying amount for bank loans, why should it be estimating anything other than market value?

The real question is not incurred versus expected loss models. The real question is why the FASB, despite every common sense indicator, is sticking to its mantra of 'anything but market value.'

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*As an aside, I don't know what "current" is supposed to mean – as of the balance sheet date, or date of the issuance of the financial statements? It's an important distinction.

Taking the Measure of Lease Expense (Part 1 of 2)

The best thing to come out of the lease accounting project is that, except in very limited circumstances, 'operating lease' accounting will be jettisoned. At the inception of a lease contract, lessees will have to recognize a liability to make future lease payments and a corresponding asset for a right of use (ROU) of the leased asset during the lease term.

I do wish I had more positives to report, but such is not the case. For the past ten years, the boards have been beset at every turn by financial statement issuers; mostly to grind down recognition of lease obligations to some crudely calculated and arbitrary amount they might grudgingly accept. I have had much to say about this in earlier posts, here and here.

The latest lobbying efforts have been focused on stamping out income statement variability derived from the subsequent measurement of the ROU asset and the lease obligation. I imagine that most of my readers are familiar with how capital lease accounting, as set forth in current GAAP and IFRS, results in higher(lower) lease expense in earlier(later) periods, but kindly bear with me as I demonstrate this phenomena via the rudimentary example, below. You should take a little time to examine it if only because a close variation will serve to make my main points.

Example 1

• Paul the pumpkin farmer trucks a portion of his harvest each year to the nearest city, where he rents a vacant lot and sells pumpkins to residents on Halloween.
• Today, exactly one year before the next Halloween, Paul signed a lease contract with Larry the landowner. The contract conveys to Paul the right to use Larry's land for one day each year in exchange for rent of $1,086 per year.
• The appropriate rate of interest is 10%.

Under existing U.S. GAAP and IFRS (assuming capital lease accounting), the following amounts would be reported over the life of the lease contract:

Companies who enjoyed the cosmetic benefits of operating lease accounting, including reporting level amounts of lease expense, objected to the boards continuation of this pattern of lease expense in the 2010 lease accounting exposure draft. Among other things, they observed that land does not depreciate; therefore, they argued, the pattern of expense recognition corresponding to purchasing a depreciable the asset and financing that purchase with debt doesn't always make sense.

The Latest Capitulation

Evidently, the boards were either persuaded by some version of this argument, or given the absence of a reasoned explanation from the boards, they just caved in response to the incessant pressure. A recent press release announced that they recently agreed to permit level recognition of lease expense under the following circumstances:

• In a lease of property (land, building or both) – the lease term is for a major part of the economic life of the underlying asset, or the present value of fixed lease payments accounts for "substantially" (whatever that means) all of the fair value of the underlying asset.
• Leases of assets other than property – the lease term is an insignificant portion of the economic life of the underlying asset, or the present value of the fixed lease payments is "insignificant" (see "substantially," supra) relative to the fair value of the asset.

After reading the press release, I retrieved the minutes of the meeting in which the boards came to this consensus in search of their reasoning, or some indications of what transpired during their 3.5 hour discussion. The "minutes" were totally unhelpful: only one page of narrative, and giving no indication as to how the boards were persuaded to essentially permit a choice of methods for measuring periodic lease expense. The only hint came from the press release wherein FASB chair Leslie Seidman was quoted: "…we decided that leases that convey a relatively small percentage of the life or value of the leased asset should be recognized evenly over the lease term."

Since the board now (correctly) views a lease as conveying the contractual right to use an asset for a period of time, as opposed to conveying the asset itself, the logic of Ms. Seidman's comment totally escapes me. Accounting for the ROU should render irrelevant any information about the economic life of the asset after lease expires -- which I will more formally illustrate with another simple example.

Towards a Principles-Based Approach to Lease Accounting: Example 2

To demonstrate how lease expense attribution should be approached by the boards, I'm going to tweak the first example somewhat (my tweaks are in italics):

• Paul the pumpkin farmer trucks a portion of his harvest each year to the city where he rents a vacant lot, and sells pumpkins to residents on Halloween.
• Today, exactly one year before the next Halloween, Paul signed three forward contracts with Larry the landowner. The first(second)[third] of these forward contracts will provide Paul with the right to use Larry's land for one day exactly one(two)[three] years from today in exchange $1,086 per contract at time of delivery.
• Today, Larry could rent his land for the day for $900.
• The appropriate rate of interest for all three contracts is 10%.

The journal entries below are the result of accounting for these forward contracts at 'hypothetical' fair value – i.e., assuming constant interest rates and spot rate of the underlying. (Note that even though there are three forward contracts, there is only one underlying, which is the rental today for one day.) Also, consistent with the presentation of a capital lease, I have grossed up the presentation of the forward contracts on the balance sheet such that their asset and liability legs are presented separately.

Below are the amounts related to the forward contracts that would be reported over the three years. Note that with the exception of captions, they are the same as the first example.

At this point, I hope you are now asking yourself, "what happens to lease expense when the underlying asset depreciates?" I'm saving that for the next post, which I hope to spring on you in a day or so. In the meantime, here is what I see are the logical implications of my analysis to this point:

• A plain vanilla lease is, in economic substance, a series of forward contracts. My example is somewhat stylized, but continuous "delivery" does not alter the fundamental economics.
• It is not a coincidence that the pattern of lease expense corresponds exactly to what would have been obtained by applying current US GAAP or IFRS under capital lease treatment. One the other hand, it would be purely coincidental for the economics to yield a level lease expense pattern.
• The "underlying" to a lease contract is not the asset itself, but the right to use the asset. This is consistent with the boards' right of use approach.
• Since the leased asset did not depreciate, its depreciation is not the factor that determines the pattern of lease expense. Instead, the decline in the economic value of the right to use the leased asset is one of the two drivers of lease expense. (The timing of the lease payments and its effect on the interest component is the other factor.)
• To account for a lease as a forward contract, I had to have the spot price for the underlying. For a non-depreciating asset only one spot price is needed. For a depreciating asset, multiple spot prices are needed (and I will show how this affects the results in my next post).

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Critics of my conceptualization of a lease as a series of forward contracts will point to numerous obvious implementation problems. In response, I would point out that the boards have spent the last 10 years and counting discussing implementation problems of their rules-based solution; and many loose ends still remain before a revised exposure draft can be issued. Unlike the boards, at least I have economic principles for dealing with implementation issues as I begin to consider them.

If the boards would practice what the IASB preaches – that substance trumps legal form – then leases should be treated as forward contracts. But, that's not what I want to be the main take-away from this post; which is that the boards' criteria for permitting level lease expense attribution are, if Ms. Seidman's statement in the press release is an indication, purely arbitrary and have no basis in economic logic.

I wonder whether I will laugh or cry as I read the basis for conclusions in the final standard.

CLICK HERE FOR PART 2

Securitization Accounting and Grand Theft Auto

Many books and articles have been written to describe the mishaps that led to the Great Recession of 2008, but few have done so while putting the role of accounting standards and auditing in context. I reported back in January 2010 that Paul Krugman at least was cognizant enough of accounting to acknowledge that we do not presently have honest financial reporting standards that let investors make good decisions and that "… forces management to behave responsibly." But, other than changing the name on the sausage packaging from GAAP to IFRS, detailed suggestions for achieving fundamental change have been exceeding rare.

NC State accounting professor Paul Williams also drew inspiration from Krugman's column and the financial crisis for a brief paper entitled The Wrong Metaphor, which I recently heard him present to the Public Interest Section of the American Accounting Association. Much as I have (but certainly with some important differences that you should read for yourself), Williams has come to the conclusion that a paradigm shift is needed for accounting to re-assume its proper role in society. I wish we could have much more from Williams reagrding what he thinks should be changed and how to make change happen.

A recent paper by S.P. Kothari and Rebecca Lester of MIT, The Role of Accounting in the Financial Crisis: Lessons for the Future, is very strong in its description of flawed accounting and its potential role in the past crisis. These are some of the basic messages:

• The accounting rules provided originators of subprime mortgages (SFAS 140) the opportunity to record economically specious gains on securitization transactions.
• The accounting rules also permitted regulated financial institutions that invested in financial instruments created out of subprime mortgages (MBOs and CDOs) to delay recognition of likely losses; which, in turn, distorted measures of capital adequacy.
• Estimation errors, most significantly estimates of fair value, committed by issuers of financial statements and their auditors exacerbated the accounting misstatements inherent in the accounting rules.

Although, like Williams, the Kothari/Lester did not provide much in the way of "lessons for the future," I would still highly recommend it. Accounting students could, and should, read it if only for its lucid examples and explanations of the arcane and flawed accounting rules that are applicable to securitizations.

The purpose of this post is to distill the analysis of Kothari/Lester so as to further discuss "lessons for the future." Before I do that, however, I want to tell you about an email correspondence I had with S.P. Kothari after I read their paper. Since I was preparing my own remarks for academics on the topic of IFRS adoption and the future of U.S. accounting, I asked him whether he thought it more or less likely that promulgation of more appropriate fair value or securitization standards would occur if the SEC continues to pursue convergence with IFRS. This was the response:

"…I think convergence will harm promulgation of more appropriate standards because a converged standard setting body would become a monopoly that would be pulled in all different directions by its constituencies."

Clearly, whatever the "lessons for the future" may be, adoption of IFRS is not one that he had in mind.

 

Securitization Accounting as Grand Theft Auto (not the video game)?

The process of securitization reminds me of large-scale car theft ring.* To obscure the link to the illegal 'acquisition' of cars, much like subprime mortgage loans, the cars are almost immediately chopped up into parts and re-sold. As a business model, stealing cars works only because the cost of obtaining a car is low; but let's ignore that for the moment and assume that someone actually establishes a legit buy/chop auto parts business – in other words, cars are bought for full price and chopped up for the sale of parts. Here is a representative sent of journal entries:

Day One – buy a car:

Dr. Car (at cost)                               30,000
      Cr. Cash                                                   30,000

Days Subsequent – chop up the car and sell its parts:

Dr. Cash (from sale of parts)            25,000
Dr. Engine (at estimated fair value)   7,000
     Cr. Gain on sale of parts                            2,000
     Cr. Car**                                                    30,000

I readily acknowledge that second entry does not comport with current GAAP.  I am using to illustrate securitization accounting in the context of a highly simplified example.  Having stated that, however, I don't see any reason (although others might) that the accounting for a chopped car should be different than the accounting for a chopped subprime mortgage.  I can't abide mixed-attribute accounting systems, and believe that college-educated professionals should not be adding apples and oranges, much less elevating the error with misleading names like "statement of financial position."

If you can set aside any cavils you might have with respect to my violation of current GAAP, please answer this question for me:  Would you invest in a business whose financial statements were based on journal entries like these? They sure do look legitimate, but common economic sense would dictate that the second journal entry must overstate the real profit on the resale transactions. First, as Kothari and Lester observe in the securitization context, "how is it possible that the sale of an asset originally recorded at one value could generate income and higher asset balances upon merely transferring this asset to another entity?" I suppose one could say that butchering a chicken should add value such that the sum of the parts is greater than the whole chicken. But that's because there's only one way to one way to obtain chicken parts – first, you gotta grow a chicken. However, one doesn't have to manufacture a car just to obtain a spark plug; or to originate a subprime mortgage loan just to create contracts containing a particular pattern of future cash flows.

The second reason indicating that the second journal entry is misleading is that the flawed business model would not be able to earn an economic profit over a full cash-out-cash-in cycle (i.e., buy car Þ chop Þ sell Þ reimburse for defects under warranty). If the engine could actually be sold for $7,000 (and generating an overall profit of at least $2,000), then I'll be a monkey's uncle!

The Lessons for the Future

In order to determine whether a better accounting is feasible, we need to be able to identify the sources of overstated income. With respect to both the car parts example and securitizations, overstated income could be the result of any of the following:

1. Kothari/Lester do not refer to this explicitly, but the most subtle and important aspect of the problem, in my view, is the unavoidable change in the 'unit of account' from the original asset (e.g., car, subprime loan) to the retained portions (e.g., engine; or in the case of securitizations, a servicing asset, and the right to residual cash flows). For example, erroneous accounting will occur because the values of the components of the car will not exactly sum to the pre-chopped value of the car itself; it doesn't matter how one chooses to measure value.
2. The appropriateness of the basis of measurement for the retained assets: such as historic cost, fair value or replacement cost.
3. Given a basis of measurement, biased measurement of the assets retained (which auditors fail to correct). Kothari/Lester surmise that this is the most significant source of overstated income.
4. Unrecognized or understated liabilities (e.g., a warranty obligation on the car parts, or a written put option for underperforming loans).

As to mitigating these sources, I have provided my two cents on #3, the biased estimate problem in a number of posts, the latest of which is here. Regulators have tried over and over again to make incremental improvements to auditing standards, with no perceived help in increasing the public's confidence that auditors can play a significant role in averting a large-scale financial crisis. It is time to abandon any notion that: management can provide unbiased estimates of value; and/or that auditors are intellectually capable or even inclined to provide a independent and knowledgeable assessments of management's estimates.

Therefore, when financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – i.e., neither management, nor the auditor. The auditor's role should be limited to:

• Verification of the components of financial statements that can be verified.
• Verification of the inputs to current valuations that can be objectively measured, and hence, verified.
• Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

As to #2, above, the conventional wisdom is that historic cost accounting is fact-based, objective, understandable, and even verifiable. We have learned the hard way that this is a fiction; however historic cost accounting has been practiced. To get to a point where financial reporting can be freed from perverse incentives for management to produce biased estimates, standard setters must dedicate themselves to the establishment of accounting standards that yield financial statements capable of being audited and understood by auditors, investors, credit rating agencies and the like. Securitization/loan accounting standards clearly indicate that historic cost "principles" when applied to financial instruments create nothing but a big mess.

Saving the worst for last, the unit of account issue (#1, above) may defy a principles-based solution, but I still want to take a stab at it. Referring to the sample journal entries, the higher the values assigned to the assets retained, the higher will be the reported gain. This suggests, once again, replacement cost is the most appropriate basis of accounting, for it would require measurement based on the least costly way to replace the asset subject to being measured. For the car example, the business model indicates that the most economical way for the entity to acquire an engine would be to buy a car, chop it up, and sell all of its parts except for the engine. Thus, the marginal cost of an engine might be essentially zero – and the result would essentially eliminate the gain recognized in the second journal entry. Indeed, the loss recognized in the second journal entry by this logic would be the telltale sign of a flawed business model.

The same logic used to measure the replacement cost of the engine could easily apply to securitization assets such as servicing rights and residual interests, and leads to an analogous question: Did the subprime loan origination/securitization business model only work, or appear to work, because of favorable accounting treatment? These are questions worthy of further research, but if the accounting for securitizations had been more reasonable, we would already have reasonable answers.

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*Kothar/Lester address both the accounting for securitizations by the originators of subprime loans and the subsequent accounting by investors in the financial instruments created by securitization. I am only looking at the former in this post.

**I am assuming that costs of chopping the car are negligible or are expensed in a journal entry not displayed. Capitalization of these destruction costs would affect the form of the journal entries, but it would not affect my conclusions.

Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False (Part Three of Three)

Click here for Part One of this Three-Part Series.

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False Claim # 6:    Costs of conversion to IFRS can be spread out over a long transition period.

All I can do here is to point out the obvious: merely spreading out the costs doesn't lessen them, nor lessen opportunity costs. What cost spreading does, however, is unduly prolong the time until financial reporting will reach a stable environment. If proponents of IFRS adoption are still playing that misleading comparability card as a primary benefit of IFRS adoption, then they should also explain why prolonging the transition, and the resulting lack of comparability, benefits investors.

Especially in light of the feedback the SEC has already received and the current economic climate, what is the benefit for a small public company of incurring the transition costs to IFRS? These companies could care less about how they stack up against the financial statements of a foreign company, and neither could their banker or venture capitalist.

We know from the European and Canadian experiences that transition costs were not trivial – to say the least – and it put a lot of shareholders' money into the pockets of auditors. If any member of Congress that voted for the Jumpstart our Business Startups (JOBS) Act believes that companies with $1 billion in sales or less have been unduly burdened in their capital raising by SEC rules, then they should act now to prohibit the SEC and FASB from changing accounting standards primarily for the sake of convergence with IFRS.

 

False Claim #7:    The U.S. will not experience any loss of sovereignty over its ability to set accounting standards.

There could be mechanisms to assure that the U.S. will always be heard, but the absolute very best the U.S. can expect is to have a significant influence over IASB decision making. That's a far cry from sovereignty; and frankly, any efforts to minimize this issue are disingenuous.

Added to the fact that the EU will continue to do its level best to control all aspects of the IASB, there are other formidable forces that may be working to mitigate the U.S. voice in IFRS. Let's take one case that has recently been in the news – India. From reading an interview with India's Chairman of its National Advisory Committee on Accounting Standards, the mindset of India's accounting establishment reminds me more of the reserve-oriented income statement smoothing approach developed by the Germans. The interview mentions four (of a total of 65) major carve-outs from IFRS; but one in particular, on deferral of gains and losses on foreign currency-denominated debt, best reflects the great divide that still exists after years of negotiations with the IASB. Indian issuers, who rely on foreign debt more heavily than their U.S. or European counterparts, are unwilling to tolerate the income statement volatility of FX gains and losses on that debt. Hence, an exception to IFRS in India permits an issuer to spread any foreign exchange gain or loss over the life of the loan.

This is just one of many examples of an irreconcilable difference in financial reporting mindsets. It is inconceivable that such differences can be bridged by a single set of global accounting standards. It's just not realistic to expect that the U.S. will be the winner in every case when there is a difference in mindset, regulatory, political or legal circumstance; or not even in the majority of cases.

Indeed, history suggests that the U.S. will lose most of these battles. The numerous failed convergence projects alone attest to how many battles the U.S. stands to lose if it incorporates IFRS into U.S. GAAP. None of these issues – R&D, inventories, pensions, borrowing costs, business combinations, impairment of long-lived assets, financial instruments, hedge accounting, to name the ones that quickly come to mind – are trivial. For, if any of these, or any of the other differences between U.S. GAAP and IFRS were small differences, surely they would have been converged by now.

It is not unreasonable to expect, even, that a country like India might form a coalition with other countries against the U.S. Here's just one scenario: India makes a deal with the EU, and together they push a new standard that permits the deferral of unhedged foreign exchange gains and losses on foreign currency denominated debt. How will condorsement work? Will we carve out that particular deferral option? If so, the goal of comparability would be irretrievably lost.

I should add that what we are seeing now in the United Nations is not all that different from my hypothetical. It seems that numerous smaller nations have learned to use the United Nations to advance agendas that are making citizens of wealthier nations question their own willingness to continue belonging to and funding these efforts. Thus far we do not have a similar problem arising with the uniting of smaller nations to dominate standard setting in the IASB. However, once the U.S., Japan, India, and China become committed to IFRS, smaller nations could begin to rise up in the IASB. Their incentives would come from the fact that international accounting standards are not necessarily neutral when it comes to global capital flows and economic development.

 

False Claim #8: Bad things will happen to the rest of the world if the U.S. does not adopt IFRS

Harvey Goldschmid speculates that, without IFRS adoption, the so-called coalition of IFRS members would break apart. However, history strongly suggests otherwise. As I have already mentioned, much of IASB's growth was driven by the desire to insulate Europe and other jurisdictions with less developed standards, like China, from the influence of U.S. GAAP. So, maybe the only thing that could possibly break up the IASB would be for the U.S. to join it.

The IASB was created in 1973. It was reconstituted in 2001. In all those years, it has not been the sole creator of accounting standards. Yet it has grown and done well. Without the U.S. in the coalition, the IASB will continue to have the degrees of freedom events have shown that it needs to do what it takes to bring everyone currently in the coalition even closer together. That will mean giving the EU the financial instruments and hedge accounting standards it wants, giving India the foreign exchange standards it wants, and giving China the watered down related party disclosure standards that it wants – and so on and so forth, and all in the form of free choices that are in opposition to the goal of comparability and the mindset of U.S. GAAP. None of that would be possible if the U.S were to adopt IFRS.

I find it difficult to imagine that the U.S. could ultimately justify subsequent endorsement of the IASB's standards from the numerous failed convergence projects without significant modification – and what if the EU likes those standards just the way they are now? Just recently, for example, the Financial Times reported that there was a "real risk" that the European Commission would reject the IASB's new consolidation and joint venture accounting rules, developed jointly with the FASB, and which were due to become effective for 2013. Indeed, it is entirely possible that, as the EU has threatened before, they could cut their support for the IASB, establish aggressive new carve-outs, or even promulgate its own standards.

 

False Claim # 9: Bad things will happen in the U.S. if the U.S. does not adopt IFRS

Mr. Goldschmid also predicts that if the coalition does not break apart, it will leave the U.S. to fend for itself when it comes to accounting standards. According to Mr. Goldschmid, this is would be the worst of all possible worlds.

Again, history would suggest otherwise; and moreover, if it did occur, many believe that it would be a good thing, not a bad thing. As the AAA's Financial Accounting Standards Committee concluded, standards competition is desirable, and monopolies can have dire consequences. I find it extremely ironic that individuals and organizations such as the AICPA that normally speak out for free markets for goods and services somehow think that granting a monopoly on accounting standards is preferable to accounting standards produced in a competitive environment. Even if, and this is certainly not true at present, IFRS could be regarded as higher quality at some point, granting IFRS a monopoly would risk stagnancy – and in place of innovation toward higher quality accounting standards, we could be racing to the bottom. It is a great understatement to say that there is still plenty of room for improvement in both IFRS and U.S. GAAP, and a monopoly would virtually assure that not enough of that improvement would happen.

And, perhaps the monopoly effect explains the many failures to progress on convergence in the past ten years. If one were to accept that execution of the convergence projects and the results of that work to-date are the most important factors for the SEC to consider when deciding the future status of IFRS in the U.S., one would have no choice but to conclude that continuation by whatever means – condorsement or anything else – will be a monumental waste of time. That should also make it apparent that the FASB's time would have been much better spent on efforts to improve the quality of U.S. GAAP, instead of on convergence with IFRS.

It's hard not to be amazed at how much time has been devoted since 2002 to debating accounting issues and to see how so little of the convergence objectives have actually been accomplished.

Going back just two years to the time of the SEC's February 24, 2010 Statement on IFRS, the FASB and IASB had nearly a dozen joint projects planned for completion by both boards by mid-2011. The Commission was hopeful that at least some of those projects would be completed by now; but even IFRS adoption skeptics (like me!) could not have imagined that we would actually be further from convergence today than we were back in February 2010. Progress has been made toward partial convergence of some trivial matters – like the way that the components of dirty surplus (so-called "other comprehensive income") are presented, and the IASB has finally agreed to adopt the FASB's fair value measurement standards for the few items that are measured at fair value. But, almost everything else seems to be heading in reverse.

The US could lose its seat at the IFRS table, as Harvey Goldschmid warns, but this doesn't mean it will lose its voice. Even before convergence projects began, it was obvious that IFRS owed its form, and a great deal of its substance, to U.S. GAAP. It is very clear that IFRS wouldn't be what it is today without U.S. GAAP to serve at least as a point of reference, and whatever U.S. accounting standards will become in the future, they will always make the rest of the world at least stop and think – if not do.

 

False Claim #10: All nations have the same goals for financial statements.

I suppose that one could take the position that although there may be differences in objectives for financial statements, they are not enough to abandon efforts to establish a single set of accounting standards suitable for use by companies worldwide. Yet, who could in all seriousness state that the financial reporting objectives of the SEC and Chinese regulators are anywhere near the same?

Even more significant at the present time, the history of the EU's efforts to monitor and steer the IASB clearly indicate its regulators believe that a legitimate role for accounting standards is to support the agendas of politicians and key industrial powers. It is undeniable that when it comes to bank accounting, EU regulators clearly see nothing wrong with investor protection taking a back seat. I know the Greek bond problem remains extremely serious, but I have to admit that it amused me last fall to see heads of state Angela Merkel and Nicolas Sarkozy arguing on television, for all to see, over an accounting issue: the size of the balance sheet haircut that banks should take on their Greek bonds. Surely, their constituencies must have been asking themselves, 'what are they talking about'?

If IFRS were high quality, as Messrs. Hoogervorst and Goldschmid claim, then politicians wouldn't have to get involved in accounting debates, and could instead turn their attention to the real problems. The EU could continue to muddle along using the same approach to financial problem solving long after the Greek bond crisis is behind it. But, that doesn't mean the SEC has to muddle along with them. By adopting IFRS, the SEC will essentially be telling U.S. investors that it is willing to tolerate insurmountable barriers – such as the EU's obdurateness – to high-quality, investor-purposed accounting standards.

* * * * *

So, here today we sit with the awareness that IFRS adoption is still laden with many problems and issues. There is seemingly overwhelming opposition to IFRS adoption, but many fear that the decision to proceed with some form of condorsement is soon at hand.

I would like to thank the following people who have provided comments on drafts of my speeches, and on which this series of posts is based: former SEC Chief Accountants Walter Schuetze and Lynn Turner; Gaylen Hansen; my colleagues, Jim Noel and Ray Stephens; and Bob Jensen, retired professor and current lifeblood of the AECM listserv.

I can only speak for myself, but I am confident that everyone whom I have just named all agree with me on this: for the sake of investor protection and the public interest, the SEC should have long ago made a U-turn on its Roadmap to IFRS adoption.

Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False (Part Two of Three)

Click here for Part One of this Three-Part Series.

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False Claim #2: A move to IFRS would restore the public trust in accounting standards.

I'm going to present three examples – one from 2007 and two from 2011 – that directly challenge this claim.

The 2007 case is one of my pet peeves. It has to do with the revisions to IAS 23, Borrowing Costs, ostensibly to further convergence of US GAAP and IFRS. I say "ostensibly" because there are still significant differences between IFRS and its U.S. GAAP counterpart. The bottom line is that IFRS rules still give management more latitude to manage earnings than the corresponding U.S. guidance.

Be that as it may, I'm am very confident that if you were trained in accounting or finance, one of the basic principles you were taught is that asset acquisition decisions are separate from the decision of how to finance them. And, prior to the 2007 revisions to IAS 23, that was the IASB's principled position as well.

Under IAS 23, prior to the 2007 amendments, two accounting treatments were permitted for self-constructed assets: the treatment designated as the "benchmark" treatment was to expense borrowing costs; but the "allowed alternative" permitted rules-based capitalization: a senseless alternative, unless one values opportunities to manipulate earnings.

Incredibly, the IASB in 2007, the supposed principles-based system of accounting, blithely rejected the sound and long-ago-established principles it had embraced earlier, by requiring the capitalization of interest on self-constructed assets. In other words, it threw out the principles-based benchmark and now permits only the management-friendly erstwhile allowed alternative. There can be no basis, other than politics, for this change, but that did not seem to bother all but two of the IASB's members. This is what was stated in the basis for conclusions of the revised standard:

1. Eliminating a difference between IFRS and GAAP is always progress. (In other words, two wrongs can make a right.)
2. Allowing only one method will enhance comparability. (This is not true, because companies with different financing policies will generate non-comparable results from business operations. It is more accurate to state the irony that the IASB's rules-based standard actually defeats comparability since initial asset values and subsequent depreciation charges will depend on the timing and type of financing employed.)
3. It will improve financial reporting (for reasons unstated).
4. This reason is so ludicrous and outrageous that I have to quote it verbatim:

   "The Board further noted that both IAS 23 and SFAS 34 Capitalization of Interest Cost were developed some years ago. Consequently, neither set of specific provisions may be regarded as being of a clearly higher quality than the other. [Nonsensical] Therefore, the Board concluded that it should not spend time and resources considering aspects of IAS 23 beyond the choice between capitalisation and immediate recognition as an expense." [bold italics supplied]

I chose this example because it demonstrates that the IASB cannot be trusted to adhere to its own due process policies, or to provide a legitimate basis for conclusions. Yes, the FASB is also susceptible to pressure, but the way that the IASB went about revision to IAS 23 was untrustworthy and made a mockery of its own "due process" policies.

There can be little question that big-issuer interests drove the revisions to IAS 23; both investors and smaller issuers were cast aside without so much as a nod to the real reasons for the adoption of a rules-based accounting standard. Any issuers that formerly elected the benchmark treatment were forced to change their accounting to a lower quality and costlier-to-implement alternative. The unavoidable conclusion is that the IASB caused significant wealth destruction, and it continues today under the guise of "convergence" of accounting for borrowing costs, even though it has no hope of enhancing comparability.

The second example is the IASB's revisions to its pension accounting standards, which incidentally were not undertaken as part of any convergence project – and I shudder to think that the FASB might actually be called upon to incorporate these changes into U.S. GAAP. I wrote a rather lengthy description of the revisions to IAS 19, Employee Benefits, in my blog this past October, and the bottom line is the same as for the first example: the revisions foster more income smoothing and earnings management; they indicate that the IASB cannot be trusted to tell the truth or to put investors' priorities first. Again, and just a few months ago, to accommodate special interests, the IASB shows its willingness to promulgate accounting standards that surely result in shareholder value destruction.

My third example is the secret letter sent by Mr. Hoogervorst to the European Securities and Markets Authority this past August, in which he expressed concern at the inappropriately high valuations produced by specific EU banks on their holdings of Greek sovereign bonds classified as 'available for sale.' Setting aside the accounting implications of that letter, and there are many, the subsequent revelation that the letter was kept secret – until the IASB was forced to make it public once news of its existence was leaked to the Financial Times – raises trust issues that can be directly traced to the current head of the IASB.

Hans Hoogervorst, as a former regulator, surely knew that sunlight would have been the best disinfectant, yet he chose secrecy. The numbers in financial statements are cyphers, and pronouncements of accounting standards are the principal means by which they are de-encrypted. If one is not concerned that investors fully understand the basis under which the financial statements were prepared, then one might have no qualms about withholding part of the de-encryption key. Evidently, the IASB wanted to be certain that European regulators fully understood the financial statements, and for the regulators to have that knowledge without letting investors in on the secret. It leaves a strong impression, to say the least, that EU regulators are currently the IASB's primary constituency.

False Claim #3:    U.S. GAAP is not superior to IFRS

Mr. Hoogervorst stated that quality of the actual accounting standards should be the most important consideration for the SEC as it formulates its IFRS policies, but he is "not convinced by the arguments that one set of standards is clearly superior to the other."

Moreover, he stated that "academic studies have concluded that both IFRSs and US GAAP are high quality standards." A vaguely-worded footnote to that statement reads as follows:

American Accounting Association Financial Accounting Standards Committee, 2008 ‐ Karim Jamal

That footnote leads me to believe that Mr. Hoogervorst was referring to a paper published in Accounting Horizons [Vol. 22, No. 2, 2008, pp. 241-248] by the AAA's Financial Accounting Standards Committee.

Let's take a closer look at that paper. That committee did indeed cite evidence from academic research that IFRS and U.S. GAAP were substantially similar; but, crucially, it added that it had no basis to state that either set of standards were "high quality." Furthermore, that same committee stated in a subsequent comment letter to the SEC that high quality depends on a number of factors that are specific to each environment: legal systems, securities enforcement, taxation and incentives of preparers, for example.

Taken as a whole, the paper from which Mr. Hoogervorst took one supportive nugget out of context clearly would not provide academic support for IFRS adoption in the U.S. Rather, I took the committee's remarks as an endorsement of a standard setting system that supported where standard setters were in competition with each other. And indeed, in the comment letter I mentioned, the Committee stated:

[A]cademic research indicates that using a single set of uniform accounting standards will not lead to the production of comparable and consistent financial reports that are desirable to regulators [citation omitted]. The promise that adoption of IFRS will deliver comparability and consistency in accounting reports is false and misleading. [bolding and italics supplied]

There are two more quick points I want to make about what academic research has to say about the relative merits of IFRS versus GAAP. In the same issue of Accounting Horizons, another AAA committee of academics, the Financial Accounting and Reporting Section of the Financial Reporting Policy Committee, took the opposite position on the relative attributes of the IFRS versus U.S. GAAP: empirical evidence suggested that analysts actually preferred working with GAAP financial statements instead of IFRS. Consequently, the elimination of the SEC requirement to provide reconciliations of differences between IFRS and U.S. GAAP was premature.

But, whatever these papers stated at the time they were published, time has elapsed, and both IFRS and GAAP have changed. Has IFRS been improved? The SEC needs to acknowledge that IFRS has taken a number of steps in the wrong direction: to name just a few, there are the borrowing costs and pension accounting issues that I already mentioned; there is also the free choice in accounting for non-controlling interests, and most recently, there is the proposed hedge accounting revisions that would broaden and liberalize the application of hedge accounting. I wonder if a single investor has called for any of these changes that will permit preparers to further manipulate earnings?

False Claim #4: IFRS is already widely adopted elsewhere

The IASB has been successful in achieving various degrees of acceptance of IFRS in many jurisdictions, and notwithstanding one significant carve-out, the EU should be regarded as the IASB's greatest success. But, if proponents of IFRS adoption are claiming that the U.S. should be following the EU to IFRS, the reasons why the EU adopted IFRS must be examined – for they are as different from legitimate regulatory goals for the U.S. as north is from south.

The impetus for IFRS adoption in the EU has its roots in events that were triggered by the NYSE listing of Daimler-Benz in 1993. At that time, German GAAP was known for the availability of so-called "hidden reserves," which permitted a high degree of non-transparent income smoothing. The SEC was under significant pressure to waive the reconciliation to GAAP requirement, but the SEC held firm; and the financial results reported by Daimler backed them up. For its latest reporting period disclosed in its initial registration statement, Daimler showed a small profit under German GAAP, but a significant loss under US GAAP. The difference was due to Daimler releasing reserves that were accrued in prior periods under German GAAP.

For similar reasons, the Daimler-Benz listing incited a debate in Germany about whether its own accounting standards were adequate. In 1998, German law was changed to allow listed companies a choice between German GAAP, IFRS or US GAAP. The end result was that many companies switched away from German GAAP, and about half of those switchers picked US GAAP.

Just as today, where the EU fears that the US could end up with too much influence on the IASB, the US GAAP switchers seem to have caused great concern throughout Europe; both governments and large banks feared the loss of their power to establish accounting standards, and especially feared inflexible standards that were rigorously interpreted and zealously enforced by the SEC. Stated bluntly, there was great concern that US GAAP could take over Europe; so, in 2002, the European Commission acted swiftly and decisively to mandate IFRS for all listed companies in the EU.

My point is that the SEC is now being urged to give up its prerogative to set accounting standards for U.S. issuers – not for the greater good as is generally thought, but solely because members of the EU feared their own loss of sovereignty. Without adoption of IFRS by the EU, we wouldn't be discussing whether the US should be adopting IFRS in any manner, shape or form; and anybody who doesn't think that the EU won't push back hard if it finds that the U.S. is limiting the EU's ability to influence, if not control, the IASB is kidding herself.

If the shoe were on the other foot – in other words, if the U.S. were part of the IFRS coalition along with the rest of the world – would the EU be inclined to join the coalition if it couldn't control the outcomes? Of course not.

False Claim #5: Even though IFRS may not be consistently applied elsewhere, the SEC can enforce compliance with IFRS as it sees fit.

It's hard to imagine that SEC enforcement of IFRS can take place without SEC-quality enforcement in the EU at a minimum. More likely, one of two scenarios will come to pass: SEC enforcement will raise the quality of IFRS worldwide, or the SEC will be pressured to join in a race to the bottom. I fear, and would expect, the race to the bottom scenario.

Here's an example of how the race to the bottom could take place: a questionable interpretation of IFRS is the basis of a loan loss allowance methodology adopted by, say, a French bank; and that treatment is approved by its French auditors and regulators. The race to the bottom begins when SEC registrants facing similar facts and circumstances argue to the SEC that if they were forced to comply with the SEC's stricter interpretation of IFRS, then they would be placed at an economic disadvantage – it could create competitive pressures, or perhaps affect compliance with banking regulations.

Consequently, even though the SEC may find no merit in the registrant's position, it might have to yield to pressure from registrants and sacrifice investor protections. The pressure could also come from an outside source: Congress, lobbyists for special interest groups, other foreign governments, and maybe even the United Nations. Even if the SEC manages to keep the high ground, the scenario is not pleasant to contemplate, and arises from the fundamental problem of a single set of global accounting standards: the present and likely future reality is that one size doesn't fit all. The relatively low degree of detail in IFRS also creates opportunities for this type of race to the bottom scenario to occur, and the higher detail present in U.S. GAAP may explain why it rarely occurs in the U.S.

I think there is also a technical problem that has not yet been the subject of much discussion and could easily start that race to the bottom rolling. If the SEC were to implement the so-called 'condorsement' approach, U.S. GAAP would continue to survive with IFRS rules incorporated into it. Ignoring whether such an approach is actually practicable or even feasible, U.S. GAAP provides that when an authoritative source does not specify an accounting treatment, an issuer would eventually be allowed to adopt a "practice that is widely recognized and prevalent either generally or in the industry." U.S. registrants could validly claim that they are permitted to adopt industry practices that developed globally among any critical mass of IFRS issuers, and not just in the U.S.

 CLICK HERE FOR PART THREE OF THIS ESSAY.

Stock Compensation, Tax Law, Financial Reporting and Facebook's IPO

Last August, I wrote a post in which I expressed my dismay that Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio) are trying to make tax law based on the premise that FASB rules for stock options are caviar -- when the stark reality is that they are chopped liver (or worse). The senators are oblivious to the fact that the evils they decry lie in the financial reporting rules (hewn from decades of political wrangling, grandstanding and backroom dealing), and not the income tax rules; and worse, their proposal to reduce the deductions available to corporations while keeping the same taxable income for the individual who would exercise options has no precedent in tax policy, logic or fairness.

This current post is in response to Senator Levin's recent speech on the Senate floor in which he pressed the same dubious points. But, the really interesting part are the circumstances he relates regarding Facebook's upcoming initial public offering of its shares:

"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.

Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see Footnote.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …

Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades." [italics supplied]

To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.

When the Levin and Sherrod approach to taxation is compared to other forms of compensation to executives, rank and file employees, vendors and lenders, it makes no sense whatsoever. If the senators want to make stock options more costly to corporations than other forms of compensation, then so be it – but they should just come out and say so, and explain why it's a good idea.

But, most of what I have just written reprises my earlier post (and if you want even more background on the depressing politicis of the accounting question, see Jon Weil's article, here.) I'm covering this topic anew because Levin's Facebook IPO story raises some other interesting questions with implications for financial reporting.

My first question is this: If U.S. GAAP for stock compensation expense were based on the value realized upon exercise, just like the tax rules, how would that have affected Facebook's financial statements?

The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.

Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?

My inclination is to say "no," but I can only speculate. So, I all answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?

If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.

Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.

But, methinks that Facebook would still be Facebook.

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Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.

 

 

An Accounting Parable for Our Time

As told to me by a faculty member at Ohio State, who heard it in a presentation by Eugene Flegm, former general auditor for General Motors:

Some years after the end of World War II, GM was negotiating a new contract with the United Auto Workers. The labor union proposed that GM should pay an additional amount per hour to its unionized employees, which the UAW would take and invest in a pension fund. Pension payments to retirees would eventually become the full responsibility of the UAW.

The CEO of GM consulted with his economist, who advised that the proposal was a good deal for GM: the expected cost of funding the pensions would remain the same, but the risk of funding unanticipated losses would be borne entirely by the union.

The CEO next consulted with his accountant, who informed him that current profits would suffer if the union's offer were accepted: the additional wages called for would be reflected in expense immediately. On the other hand, if GM were to keep the responsibility (and risk) of paying the pensions, recognition of the associated expense under extant GAAP would be delayed for decades – until retirees were actually paid.

The CEO chose to disregard the economist's advice and to decline the UAW's offer.

Postscript: Following similar decisions of subsequent CEOs and questionable funding decisions, GM's underfunded liability for retirement benefits grew to $50 billion as of December 31, 2008. In December 2008, under President Bush, GM received $13 billion of TARP funding, and another $39 billion under the Obama administration.

 

The 'Moral of the Story'

This tale of GM wealth destruction is just one of many that can be told that begins with a bad accounting rule. It's a relatively dated story, but if the first twelve years of this millennium are any indication, the problem of perverse accounting incentives has been getting much worse – despite the putative best efforts of standard setters to enhance financial reporting "quality."

Either the problem is seen by accounting standard setters to be in the "not my job" category, or if they are sensitive to it at all, then history suggests they are going about it the wrong way. That's just one reason why convergence hasn't been worth a hill of beans, and any forthcoming statement from the SEC about continuing on with IFRS adoption in one form or another is dross. I'll have more to say about that at the end of this post.

The wrong way that the Boards have been pursuing is predicated on the explicit assumption in their respective conceptual frameworks that the fundamental purpose for financial statements is to provide information to help interested parties value an entity. But, a major problem with this approach is that it doesn't provide any consistent answer as to how the recorded assets and liabilities of the entity should be valued. Instead, the approach is used as a justification for the kinds of accounting that managers can manage.

To illustrate, one of the most recent contributions to the valuation perspective for accounting standards is a new book by Columbia professor Stephen Penman, Accounting for Value. In many respects it is an excellent book and I highly recommend it; however, I take exception with his line of reasoning that rejects current values as the basis for asset and liability measurement.

Without wishing to oversimplify, there are two sources of equity value from Penman's perspective: things that we know; and things we can only speculate about. If accounting restricts itself to measuring things we know (such as the historic cost of land), then the amount of speculative value in the current stock price can be deduced from the difference between it and the book value per share. Penman argues that speculation should be left to investors, for if accountants were to engage in too much speculation, then it will be difficult to avoid paying a market price that could over value a company.

I do have questions about Penman's analytics that lead to a conclusion that historic cost accounting is to be preferred to current value accounting; but, if valuation is not the primary objective for financial statements, then it doesn't matter whether he is right or not. My intent is solely to point out that a rigorous defense of historic cost accounting depends on whether one maintains that it is appropriate to prepare financial statements under the presumption that valuation analysts are the primary user group. My position is that to determine that this assumption is inappropriate, it should be sufficient to have enough stories like GM, where transaction-based financial statements clearly caused massive value destruction. Based on my own experience and study, I would estimate that there are thousands of examples out there just like it – albeit few that are as overtly laden with societal consequences.

The right way to select a basis of measurement should begin with the assumption that financial statements exist to guard the interests of investors in an entity. Indeed, I would think that this "stewardship" function was the original intent of double-entry accounting in the first place. It entails a high level of accountability from managers to owners for the manner in which business was conducted. Normally, this should mean that managers have an obligation to utilize the (net) assets of a business in a manner that appropriately balances risk with return on the owners' investment.

Of course, neither stewardship nor any other financial reporting system is foolproof. But, if accounting has any hope of bringing perverse incentives to manipulate financial statements down to a tolerable level, the implication of a stewardship perspective is that accounting must focus, to the extent practicable, on measuring the effect of managerial decisions on wealth and changes in wealth.

While some argue that estimating current values injects too much subjective judgment into accounting, I suggest that no matter what system of accounting is proposed, judgment is an unavoidable reality; and therefore, quibbling about which approach to valuation requires larger doses of judgment is largely irrelevant. A stewardship role for accounting also implies that it is not "management's view" that should count, for that would be circular logic indeed. The only view that should matter is the view of a disinterested economist, taking into consideration current business conditions.

Getting back to that annoying IFRS question, which most of us wish would just go away, the SEC's Chief Accountant, James Kroeker, spread the word last week that he will be preparing a proposal to the Commission for moving forward on IFRS. I don't know what will happen here, particularly since not a single Commissioner has delivered a major speech on accounting standard setting – despite the fact that it is one of the most critical regulatory functions within the SEC's purview. If any of the five sitting Commissioners has a reasonably complete understanding of accounting standards and policy, I haven't seen it demonstrated.

Obviously, I'm not going to go into all of the reasons why the SEC should finally move away from IFRS in this blog post, but I do hope the Commissioners will ask themselves this one question:

If accounting standards can either create or eliminate perverse incentives for the managers of public companies – with potentially profound consequences for the U.S. economy – how can we set a goal of convergence with standards that cater to "management's view" instead of a goal of reflecting economic reality?

Accounting without Rules -- or Principles

Ted's Accounting Question

My friend, Ted (not his real name), is the ex-treasurer of a very large public company where he acquired extensive experience in solving accounting problems. He departed a few years ago to run a business that he and his brother had purchased. Business had been humming along nicely until the economy took a dive.

Ted recently came to me with a question about the accounting for a renegotiated payable to a long-time supplier, ABC Printing. While the negotiations were underway, Ted discovered that recent prices being charged by ABC were much higher than he could have obtained elsewhere. Eventually, the parties agreed to the following terms (more or less): (1) reduce the amount currently owed by 40%; (2) the remainder of the trade payable would be converted to a non-interest bearing note payable with equal monthly payments over the next three years; and (3) ABC would continue to be the exclusive printer for Ted's company for the next three years -- at a 5% discount to prevailing market prices, so long as new billings were paid within 30 days of their invoice dates.

Solely for the sake of discussion, let's assume the following additional facts:

• The change to the terms of the payable would result in a $90,000 write-down, such that the remaining balance of the payable would represent the discounted present value – or equivalently, the fair value – of the 36 monthly payments over the next three years.
• The amortization schedule for the note payable results in changes to its balance that correspond to changes in its current value.
• The current value of the future purchases at discounted prices is $114,000.

Based on our collective knowledge (i.e., winging it without any formal research), Ted and I identified two potentially permissible accounting treatments:

Treatment #1 – Reduce the payable by $90,000; record a gain of $90,000; no recognition of the purchase commitment.

Treatment #2 – Reduce the payable by $90,000; record a deferred gain of $90,000; no recognition of the purchase commitment. In subsequent periods, amortize the deferred gain to income over the term of the purchase agreement.

Ted tells me that his former employer had engaged in similar deals, and it had accounted for them along the lines of Treatment #2 because it produced a smoother stream of earnings. That comes as no surprise, but it would seem to me that an auditor could find Treatment #2 to be inappropriate (even though it is more "conservative") because the deferred gain does not meet the conceptual definition of a liability, and there is no specific rule that permits it. So much for principles.

Moreover, whichever of these two treatments is elected, the parties will be able to manipulate the accounting results to their preferences by manipulating the monetary parameters of the agreement – i.e., the amount of the payable forgiveness and the amount of the discount on future purchases are interdependent. Consequently, should the executive compensation packages for either company have an earnings-based component, it's easy to see how the absence of neither rules nor principles creates perverse incentives for management that end up destroying value for shareholders. The only form of accounting that would prevent such value destruction would entail recognition of all of the assets and liabilities – including the purchase agreement – and measurement at their current values.

This is Also an Interesting Revenue Recognition Problem

I chose to blog about my conversation with Ted because the accounting issues for ABC Printing (the supplier) is even more interesting than the accounting for Ted's company. Mostly, it's a good example for thinking about how the exposure draft, Revenue Recognition (Topic 605): Revenue from Contracts with Customers, would fail to provide answers to many issues that are sure to arise if finalized in its present form.

Before considering the exposure draft, however, let's start with existing accounting standards; because ABC has an opportunity to manage its earnings in two respects. First, the writeoff of the receivable from Ted's company might not have an impact on current earnings if ABC can conclude that the allowance for bad debts is sufficient to absorb it without a charge to bad debt expense. Second, if ABC was concerned with maintaining its future profit margins, then they might be willing (and could "afford") to grant a larger forgiveness of their current receivable in order to minimize the amount of the discount on future sales in order to keep Ted's business.

None of this weirdness would be corrected by, or particularly affect the accounting under the exposure draft, without my adding one more twist to the problem: let's assume that a portion of the re-negotiated amount owed by Ted would be payable in a lump sum at the inception of the new arrangement. The exposure draft would require separate accounting for the forgiveness of the indebtedness (a financial instruments contract) and the contract to supply goods; yet, it is impossible to determine whether the lump sum payment is a partial settlement of the receivable or a prepayment for future goods. To the extent that it is seen as a prepayment, then the resulting "performance obligation" would be accounted for like a deferred gain.

It would seem that this is an issue that the FASB could resolve before finalizing the exposure draft, but my sense is that it is only one of many gaping holes in the standard. Again, the only principles-based way of accounting for this transaction would involve recognition of all assets and liabilities, and measurement at current values, as follows (for ABC):

Reduce the receivable by $90,000 and any cash received at the inception of the new arrangement; recognize a purchase agreement liability of $114,000 (to be netted against the receivable); record a gain/loss to balance the journal entry. In subsequent periods, recognize changes to the current values of the purchase agreement and receivable directly in earnings.

In addition to providing the most complete picture of the legal rights and obligations created, there would be need for highly stylized and vague accounting standards like the revenue recognition exposure draft, and no perverse incentives to manage earnings via exploitation of the gaps in GAAP.

What I Mean by "Replacement Cost" is not Literally Replacement Cost

I get a lot of questions – and yes, some criticism – of my support for measurement of assets and liabilities at "replacement cost" (with comparative periods adjusted for the effects of inflation). My views are derived in large part from three conclusions. First, replacement cost measures are the only possible way for accounting to reflect wealth invested by shareholders in an enterprise; and consequently, changes in invested wealth. In a post and working paper that are already more than four years old, I demonstrated the truth of this proposition using a simple example.

The second conclusion is derived from the first: namely, that principles-based accounting must be primarily concerned with measurement of wealth and changes in wealth. I can think of no other principle that is more fundamental to accounting – and no way to be faithful to that principle without replacement costs. Financial reporting under complex and inconsistent rules, without principles to bind them, has been a losing proposition.

Third, I go back to the maxim that accounting affects decision making; or, "what gets measured gets done." If management is supposed to maximize wealth, then accounting must endeavor to measure the effects of management decisions on wealth. I have tried to say this in different ways over the years, but Walter Schuetze nailed it for me this weekend over lunch in San Antonio:

"Accounting cannot stop management from doing dumb things. But, we can report it as soon as possible so the world can see the results."

The FASB has succeeded in ignoring this self-evident maxim throughout its entire history. In doing so, it has enabled a national tragedy at many levels: obscene levels of compensation awarded to management, impairment of U.S. competitiveness, mass disruptions of financial markets, shareholder value destruction – not to mention the chaos and misery inflicted on honest, hardworking and capable individuals.

"Replacement Cost" in the Real World

However, I don't deny that there are a lot of implementation issues that should be addressed. Perhaps the most persistent and fundamental criticism of replacement cost measures is the lack of relevance when there is little or no prospect that the existing assets will be replaced with identical, or even similar, assets. A commonly invoked scenario is when an existing asset lacks some of the desirable characteristics of later versions that are available to be purchased – say, an aging airliner.

The conceptualization of "replacement cost" that I advocate can handle this situation simply and reasonably. To begin, let's set aside the airliner for a moment and consider inventory held for sale. For such assets, there is already a replacement-cost-based accounting treatment in U.S. GAAP (though not in IFRS), which has stood without challenge for more than 60 years.

Every accounting major will be familiar with U.S. GAAP measurement of inventories at its lower of cost or "market." For the sake of compactness, but without loss of generality, here is the essence of the protocol:

"A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost … the difference shall be recognized as a loss of the current period.

… [market] provides a practical means of measuring utility.

As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. … [However] … replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility." [Accounting Standards Codification 330-10-35-1 through 4 (emphasis supplied)]

In essence, a measure of the utility of inventory (i.e., wealth invested) should be capped by the amount it could be sold for, less incremental costs of disposal. This is because it is hard to imagine a situation where replacement would be economically justified if, once replaced, the inventory could not be sold for more than its replacement cost.

Having established the concept in existing US GAAP, let's turn back to the problem of the aging airplane. Following similar logic as for inventory, the owner should first determine whether there is an active market for airplanes of similar vintage and features. If so, then the replacement cost can be objectively based on recent transactions. But if there is no active market, then my operationalization of "replacement cost" would cap the reported amount at what could be received from sale (under current conditions), less estimated out-of-pocket costs.

Thus, there is no need to determine whether inventory is "obsolete", or even how management intends to use and/or dispose of the asset. Moreover, the resulting measure of "market," "current cost," "replacement cost," or whatever it may be called happens to be conservative because it is likely that the utility of the investment to shareholder interests is greater. This logic is buttressed by the fact that the airplane is still owned as of the balance sheet date, providing some indication that greater utility was expected from use rather than sale.

Simple Solutions to Contentious Problems of the Day

I know we are a long way from applying replacement cost or market to airplanes, but I want to conclude by pointing out that the concept of replacement cost provides for very different solutions to a number of current controversial accounting topics. Below are two very different examples.

Leases – Speaking of airplanes, many operators access them via non-transferable leases. When the right to use an asset is not transferable, "fair value" (i.e., exit price) makes no sense whatsoever; and neither does the crude and arbitrary calculations for leased assets and liabilities that the FASB and IASB are currently proposing.

The only relevant measurement attribute of non-transferable rights and obligations arising from lease contracts is replacement cost. In fact, if you believe that non-transferable rights should be recognized as assets, I can think of no better example to show why replacement cost is preferable to fair value as a comprehensive basis of measurement.

Going concern evaluations – Just yesterday, after years of rumination, the FASB announced that it has decided it will not issue a standard that would require management to disclose its going concern evaluation (instead of auditors), even though IFRS requires it of management. If all assets and liabilities were measured under the concept of replacement cost that I have described here, this would be a non issue.

A Practical Way Forward

Although I am for comprehensive use of "replacement cost" measurements, I don't want to be seen as rigidly ideological. As the forgoing example illustrates, there are plenty of ways to significantly improve GAAP without full adoption of replacement cost measurements. By far, the most important are those inflation adjustments I mentioned in passing at the top of this posting.

In that regard, I'll leave you with two closing thoughts: (1) a bank has not earned a profit on a loan of $10,000 when it collects a total of $10,001 over the five-year term; and (2) inflation-adjusted historic costs do a pretty good job of surrogating for actual replacement costs in most circumstances.

IFRS Convergence: Let's Play 'Chief Accountant for a Day'!

When I was at the SEC (1992 – 93), one of the senior staff members whom I admired greatly for his competence and integrity was Robert Bayless, the Chief Accountant for the Division of Corporation Finance. ("Corp Fin" is the branch of the SEC that reviews and comments on financial statement filings.) Sometime after I had left the Commission and the position of "Chief Accountant to the Commission" had opened up, it was rumored that Bayless would be in line for the promotion. But, the chatter quickly died down after Bayless was supposed to have responded, "Why would I want to drink battery acid?"

The point of my story is that the Accounting Establishment can always make life miserable for the Chief Accountant to the Commission – especially one who, like Bayless, would have made investor protection his sole priority. I thought of him recently as I read James Kroeker's (the current Chief Accountant to the Commission) remarks at the AICPA's annual conference on SEC and PCAOB developments. Mr. Kroeker did concede that the planned imminent policy statement from the SEC on International Financial Reporting Standards could not possibly happen for at least several months. But, in all other respects, he once again demonstrated his abilities and willingness to be the implacable Chief Spinmeister for the Accounting Establishment. If nothing else, it's a way to keep battery acid out of one's diet.

Rather than criticize Kroeker point by point, I'd like to imagine that I could take his place as Chief Accountant for one day – the day of that speech. This is what I would have said:

Good morning. It's an honor and a privilege to be the Chief Accountant to the Commission for a day.

Let me begin with a discussion of the current state of the IASB/FASB convergence agenda. If I were to start with the premise that execution of the convergence projects and the results of that work are important as the staff considers the issue of incorporation of IFRS, I would have no choice but to conclude that further efforts at convergence will be a monumental waste of time. Moreover, it is clear to me that the time and efforts of this office and the FASB over the past 10 years could have been much better spent on efforts to improve the quality of U.S. GAAP, instead of on convergence with IFRS.

As all of you certainly are well aware, the work of the two Boards on convergence has been at the top of their respective agendas since 2002. It's hard not to be amazed at how many hours have been spent debating accounting issues over those ten years while so little has actually been accomplished. I am stunned that the SEC staff has not given more direction and constructive criticism to both Boards. But, as my kids would say, "I'm not gonna lie. It is what it is." (I hate both of those expressions!)

Let's go back just a little bit to see how bad things have become. At the time of the February 24, 2010 Commission Statement on IFRS, the FASB and IASB had nearly a dozen joint projects planned for completion by both boards by mid-2011. The SEC was hopeful that at least some of those projects would be completed by now, and even IFRS adoption skeptics, like me, could not have imagined that we would actually be further from convergence today than we were back in February 2010. Progress has been made toward partial convergence of some trivial matters – like the way that components of dirty surplus (so-called "other comprehensive income") are formatted, and the IASB has finally agreed to adopt the FASB's fair value measurement standards for the few items that are measured at fair value. But, everything else seems to be heading in reverse.

We have come to the point where the SEC is placing all of its hopes for any indication of significant progress toward convergence on the revenue recognition and leasing projects. However, the best that can be said of these projects is that two watered-down standards could become finalized by the end of 2012. I do not consider this to be progress, as I believe that the FASB would have been capable of creating higher quality standards without being forced to collaborate with the IASB. We do have our politics here in the U.S., but recent years have shown that it is nothing compared to the political pressures exerted on the IASB by its many "stakeholders."

The major project that seems most likely to be finalized in 2012 is revenue recognition. In the revised exposure draft issued just last month, the Boards have abandoned any semblance of a principled position on the asset/liability view – supposedly one of the prime reasons the project was begun almost 10 years ago. If finalized as currently proposed, all sorts of deferred costs will populate the balance sheet. 

Overall, I think it is fair to say that this project has devolved into a desperate quest to somehow quell criticisms by preserving current practice while at the same time replacing the rules from 200 separate pronouncements and interpretations with one cohesive document. The unsurprising result is a draft standard that is so vague and lacking in robust illustrative examples, I wouldn't be surprised that we will soon have 200 new interpretations to deal with before an effective date finally comes to pass – which I expect to be no earlier than January 2017.

I should also mention that the prospects for a high-quality lease accounting standard are even more dismal. The Boards are being pushed to whittle down recognition of lease obligations to some crudely calculated minimum amount that lessees might grudgingly accept. Lessor accounting, after years of vacillation and improvisation, is still in flux.

Ironically, if my predecessors had been completely honest with the public, they would have admitted long ago that the greatest progress made on convergence has been to point out where convergence has no chance of succeeding in our lifetimes.

Take financial instruments. Please. Given the 2008 financial crisis, the impending implosion of bank balance sheets in Europe and the recent embarrassment in the U.S. of MF Global, this is the one area where the Boards could provide an immediate service to investors. Yet, the SEC stood idly by as one FASB Chairman was fired by the Financial Accounting Foundation for daring to insist that convergence result in high quality financial instrument standards, and while the FAF stacked the Board with three more reliable IFRS shills. But, it seems that nothing less than a return to post-WWI hidden-reserve accounting will satisfy the German and French bureaucrats. (At least we can thank the current members of the FASB for resisting at least that much.)

Even as the SEC's arguments for continuing with convergence have been pounded to dust by the vast majority of SEC registrants and independent-thinking investors, the staff has been blithely proceeding (albeit at a snail's pace) with its work program – exploring whether and, if so, how the Commission could or should proceed with a decision to incorporate IFRS for U.S. issuers. In truth, the scope of that work plan is woefully inadequate. I have absolutely no idea how the staff will produce a rigorous analysis of the costs and benefits of incorporating IFRS into U.S. GAAP that meets the standards set by a recent court ruling against the SEC.

My skepticism in this regard is further reinforced by the two progress reports that the staff has recently issued in the form of Staff Papers. The first is a comparison of the differences between U.S. GAAP and IFRS. Although revenue recognition, leasing, and financial instruments were excluded, it's amazing how many significant differences still exist! First, there are all of those convergence projects that have been abandoned or indefinitely postponed; second, there are the significant differences that remain from projects that the staff is counting as converged; and third, there are the differences that are so fundamental, the boards didn't even bother to put them on any convergence agenda.

Yet, it appears that the staff has attempted to downplay the sheer impossibility of bridging these differences, mainly by providing a document that no Commissioner would find any reason to actually read, except perhaps as a natural and highly effective cure for insomnia. The bulk of the report is a turgid regurgitation of differences between IFRS and U.S. GAAP that could have easily been lifted from a pamphlet written by any one of the Big Four. The staff also made sure to leave out any summary, takeaways, or any indication whatsoever of the dim prospects for, and herculean efforts that convergence will continue to entail. If the authors' intention was to provide no new information or guidance, then they succeeded admirably – and they should also be quite ashamed of themselves for the dismal quality of their work.

The second Staff Paper is an analysis of the use of IFRS in practice by the subset of Global Fortune 500 companies that claimed to comply with IFRS in their financial statements. This paper was actually well done (and it should be noted that it was not written under the direct supervision of the Chief Accountant to the Commission). The number of apparent departures from IFRS noted, and the inconsistent ways that IFRS has been interpreted by the largest companies, should explode the myth that worldwide adoption of IFRS will result in more comparable financial statements. The unavoidable conclusion is that even if a single set of global accounting standards were possible, the paper leaves no reason to believe that effective global enforcement would occur. A single set of standards without a single, consistent and rigorous enforcement mechanism will fail to deliver on the promise of comparability.

In summary, as I reflect on the negative feedback from the July Roundtable and these two staff papers, I see absolutely no reason to continue consideration of IFRS adoption in any manner shape or form. But, I'm only the Chief Accountant for today, and James Kroeker returns tomorrow. You should expect that he will continue to display his singular talents to spin convergence whilst the SEC's project spins ever more rapidly out of control (or down the toilet, if you will).

Thank you for listening. If only the Commission would do the same for once.