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After having just written a post on HP’s massive write-off of goodwill, I am reluctant to keep on banging the drum of how bad goodwill accounting can be.  But, I can’t resist following up on Bloomberg columnist Jonathan Weil’s coverage of yet another recent acquisition by a big-time company that went sour practically out of the box. 

Mr. Weil’s main motivation was to express annoyance at companies that are wont to characterize asset impairment charges as being “non-cash” in nature -- as if it could mute the impact of the largest single accounting entry by the company in recent memory. ‘If mistakes were made, they’re history. So just fuggedaboutit.’ 

But, in Caterpillar's case, I think it goes deeper than merely choosing the words for best (or least bad) effect: it's misleading.

The sad story began last June, when Caterpillar Inc. acquired ERA Mining Machinery Limited (ERA), including its wholly owned Chinese subsidiary Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd., commonly known as “Siwei.”  According to Caterpillar’s 10-Q for its second quarter, tangible assets acquired and recorded at fair value totaled $671 million, customer relationships and trade names were valued at $105 million, liabilities assumed were $592 million and goodwill in the amount of $461 million was recognized. 

"Goodwill … represents the estimated future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. … Factors that contributed to a purchase price resulting in the recognition of goodwill include expected cost savings primarily from increased purchasing power for raw materials and a reduction in other manufacturing input costs, expanded underground mining equipment sales opportunities in China and internationally, along with the acquired assembled workforce [many of whom were later fired because it was believed that they conspired to inflate the purchase price]."

One would have hoped that Caterpillar’s audit committee and due diligence team would have seen the large amount of goodwill for a manufacturing company to be a red flag – plus: key intangible assets were separately accounted for; ERA had recently obtained a backdoor listing on the Hong Kong stock exchange; and combined with all the other news we have heard about audits in China, there should have been a legitimate concern that the audit report should not be relied upon.

 As it turns out, such was the case.  From the 8-K announcing the impending goodwill impairment charge:

"Caterpillar first became concerned about an issue when discrepancies were identified in November 2012 between the inventory recorded in Siwei’s accounting records and the company’s actual physical inventory. This was determined by a physical inventory count conducted at Siwei as part of Caterpillar’s integration process. [whatever that is, and why ever it took so long] Caterpillar promptly launched a comprehensive review and investigation into the nature and source of this discrepancy. This extensive review has identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition."

For a company that strongly desires to project an image of adherence to high ethical standards, the above is not very forthcoming.  Caterpillar has not even deigned to tell us whether the inventory count was higher or lower than what was on the books.  And, what does inventory count have to do with “cost allocation”?

 We also know that, even though the investigation is not complete, Caterpillar is going to record a $580 million charge to goodwill, which as Jonathan Weil has observed is even more than the goodwill originally recognized and is almost as much as the original purchase price.  I can think of some scenarios under which the goodwill write-off is actually more than the goodwill originally recognized, but I shouldn’t have to speculate.* 

Although other account balances are clearly implicated, the company has not even deigned to tell us whether other assets (like the aforementioned inventory and customer receivables, or the finite-lived intangibles) will be adjusted.  In this regard, another factor to consider is that US GAAP allows for a period of time to adjust so-called “provisional” valuations of assets acquired and liabilities assumed as new information that the company is seeking becomes available.

But, surely Caterpillar’s valuations were not provisional until it could ascertain whether or not it was the victim of fraud.  Moreover, public companies have to be pretty careful when they adjust provisional amounts, especially if those amounts were previously filed in an annual or quarterly report; that’s because retrospective adjustments to amounts previous filed (and any impact on earnings) are required along with disclosures of the amounts of the adjustments.  If anything like that is going to happen, and I don’t think it will, Caterpillar is not talking about it.

 In summary, there is enough evidence to strongly suspect that the accounting entry to record the Siwei acquisition was incorrect.  It also seems to be the case that Caterpillar had adequate opportunity to become aware of its errors (and that it was the victim of an apparent fraudulent scheme) before it filed its 10-Q for the second quarter of 2012. From Caterpillar’s recent disclosures, we can be confident that inventories were misstated (over or under, we don’t know), customer receivables were recorded that did not exist, and goodwill was recorded that did not exist.   It could very well also be that other assets, including the values assigned to customer relationships and trade names were misstated as well.

US GAAP is quite clear as to the remedy for an accounting error: go back and restate all the prior periods presented.  So among other things, even if previous quarterly financial statements are not re-filed, when Caterpillar files its Form 10-K for 2012, it should have to report a loss of a few hundred million dollars from having been defrauded.  That’s not anything that can be waved away as a non-cash impairment charge.

Another interesting question to contemplate is whether Caterpillar has violated the securities laws.  Filing materially incorrect information to the SEC is, in and of itself, a violation, but that’s not what I’m thinking about:

• All companies have an obligation to keep adequate books and records, and the possibility exists that Caterpillar’s due diligence procedures did not adequately respond to the consequences of misstating the assets acquired and liabilities assumed from ERA. 

• On the filing of the Form 8-K itself onJanuary 18th, since Caterpillar admitted to having discovered material irregularities already in November, surely they must have come to the conclusion that a goodwill impairment charge in some amount would be necessary much sooner than mid-January.  Wasn’t the requirement to file an 8-K triggered long before Caterpillar’s actual filing date? 

* * * * *

The moral of the story is that fraud is not an asset.  Whatever you think about goodwill accounting, I hope you don’t think that the appropriate way for a company like Caterpillar to report that it has been the victim of a fraud is simply by a "non-cash" charge to goodwill.

 

 

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*One possibility has to do with the “unit of account” when testing for goodwill impairment.  As soon as a company is acquired, it is assigned to a “reporting unit” (roughly speaking, one level below a reportable business segment), and the goodwill assigned by some magical formula to that reporting unit (perhaps from other Caterpillar acquisitions in China) is what is tested for impairment – not the goodwill solely from purchasing ERA.  In fact, it is entirely possible that a portion of the goodwill from the ERA acquisition wasn’t tested, because it could have been assigned to another reporting unit.  (Yes, the rules are that loosey goosey.) 

HP's Autonomy Debacle: Mistakes were Made -- and Capitalized?

Companies overpay to acquire other companies all the time; but Hewlett Packard Co. just might be the new record holder for getting fleeced. I don't have the exact amount, but let's say that the goodwill HP initially recorded from the E.D.S. and the Autonomy acquisitions combined was on the order of $20 billion. Given the subsequent goodwill impairment charges for most of it, and the revelations that surrounded those charges, it should come as no surprise that investors have expressed dissatisfaction with everyone – management and the board, their outside financial advisors and auditors – associated with the decision making and the accounting for these ill-fated investments.

One very compelling expression of dissatisfaction came recently in a letter from the CtW Investment Group to Rajiv Gupta, HP's lead director and chair of its corporate governance committee. CtW works with pension funds, which in the aggregate are substantial HP shareholders. Supported by a detailed nine-page analysis, CtW has called for nothing less than "…a comprehensive overhaul of the board's oversight of the audit process and the replacement of long-time outside auditor, Ernst & Young."

Highlights of the claims made by CtW against EY are as follows:

• Large amounts of non-audit fees paid to EY in recent years, although not technically prohibited, challenge the presumption of its independence from HP.
• However, HP was a lobbying client of Washington Counsel, which was owned by EY: "We further note that it has been reported that the SEC is investigating Ernst & Young for allowing its … subsidiary to lobby for audit clients."
• The timing of the $8 billion goodwill impairment charge in 2012 relating to the 2008 acquisition of E.D.S. "reveals a significant performance failure on Ernst & Young's part." CtW's analysis of reported results indicate that significant goodwill impairment(s) should have been recognized in earlier years; and the delay in recognition resulted in misleading reported earnings for those years.

One of the motivations of this post was simply to bring to your attention this letter, which if substantiated, has important implications for EY and for financial reporting in general. But, a second motivation is to further discuss the accounting for goodwill, using the Autonomy debacle as a case study. This is the way that CtW teed up the issue I want to explore:

"Ernst & Young, as HP's independent auditor, had a duty to review HP goodwill accounting in its 2011 Form 10-K and for its 2012 financial statements. Ernst & Young did not discover any improper accounting practices [at Autonomy], nor does it appear to have objected to the amount of goodwill HP recorded in association with the Autonomy acquisition." [emphasis added]

Auditing Initial Goodwill is Not Necessarily about Goodwill

I'm sure that most readers already understand that goodwill is nothing more than the difference between the purchase price of the acquisition* and the opening measurements of all the identified assets acquired and liabilities assumed. Setting aside what goodwill on the balance actually means or doesn't mean, the CtW letter does not explicitly acknowledge that an auditor's responsibility for the initial amount of "goodwill" recognized actually begins with examining the non-goodwill amounts. In practice, goodwill itself would rarely be an object of scrutiny by the auditors; but more on that later.

The CtW letter does indicate a concern that EY missed something very important in its examination of Autonomy assets acquired and liabilities assumed. In this regard, it notes that a PwC forensic investigation of Autonomy's accounting uncovered "…a variety of inappropriate and arguably fraudulent accounting practices, including improper timing of revenue recognition…" But, while the PwC investigation doesn't bode well for EY it is not, as CtW seems to imply, because EY may have allowed initial goodwill to be overstated.

To illustrate this point, let's just focus on one particular asset acquired: customer accounts receivable. It has been alleged that Autonomy improperly recognized revenue from agreements to resellers of software licenses, even before a single license had been sold to an end user. Presumably, the improper revenue recognition would have caused customer receivables to be overstated.

But, if EY did not compel HP to back out any premature recognition of receivables, then the arithmetic business combination would not have been reflected in a misstatement of total assets. Even though customer receivables would have been overstated, it would have been offset by understated goodwill. That's why I wish CtW had framed its concerns in terms of the reported amounts for the non-goodwill assets acquired and liabilities assumed, instead of goodwill itself.

But, it is also possible that EY discovered a misstatement in, say again, customer receivables; and it compelled HP to reduce the receivables accordingly. If this had been the case, then EY looks better in one respect and worse in another; because, if EY had permitted HP to offset the downward adjustment in customer receivables with an increase in goodwill, then the issue that CtW raises is manifest: goodwill was artificially inflated, and EY might have noted that fact.

My sense is that if EY missed something it is more likely that they failed to note an overstatement of customer receivables. But, the reason I wanted to discuss this alternative scenario is because the accounting for 'mistakes' in a business combination is frequently problematic.

'Mistake' Capitalization Happens All the Time

I suppose that one could justify initial capitalization in goodwill of some mistakes – like overvaluing future prospects – because they are impossible to detect at the time a transaction takes place. For example, shortly after an acquisition is consummated in good faith by both parties, and before the first financial statements are issued, an acquiror might learn that its forecast of future profitability was too optimistic. But, if customer receivables are found to actually not exist at some point before the financial statements are issued, how should that be handled?

The FASB Accounting Standards Codification is silent on this point, but it turns out that the SEC took a position on a similar matter a number of years ago. I stumbled upon that position in a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one impressed me the most:

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

The amount of shareholder value destruction from the E.D.S. and Autonomy debacles were extreme, but the fact of the matter is that mistakes in major acquisitions happen with great frequency, if not most of the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down (i.e., shareholder value is destroyed) after plans to acquire another company are announced. During my part-time career as litigation consultant, I have been involved in at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or were worth much less than the amounts recorded on the balance sheet of the acquire.

In all of those cases how did a mistake get accounted for? Capitalized as goodwill, of course!

In a nutshell, Sampson stated the obvious: despite what the accounting rules say – or don't say – an asset that doesn't exist can't be goodwill. But, just so everyone should get the message, two things ought to happen:

First, no matter at what point subsequent to the acquisition date that the errors in Autonomy's financial statements were discovered, HP should not have capitalized them in goodwill; therefore, the SEC should require HP to correct its accounting error by restating all periods affect – and perhaps also by amending previously filed financial statements in which the erroneous amount of goodwill was reported.

Second, the FASB ought to use this case to echo that sentiment. It should amend U.S. GAAP to make it clear that when a company thought it bought it asset, but didn't, the asset that never existed is not goodwill.

I am not a supporter of recognizing goodwill as an asset under any circumstance, but if it is to be, then it should be clear that when it is discovered that an asset is overstated or does not exist, that's clearly not goodwill.

Perhaps, then, companies like HP will be more careful about: what they acquire; what they pay; and what the contracts state about what they are entitled to if assets that are purported to exist in fact do not.

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*To you accounting sticklers, I know that my description is technically accurate only if an acquiror purchases 100% of the outstanding shares of the acquiree. For the purposes of this post, that's close enough.

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.

* * * * *

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.

"Goodwill Impairment" Accounting Could Become Less Costly – and Earnings Management a Lot Easier

When you start with a bogus asset like goodwill (itself a misnomer), it's hard to find quality in the rules that govern its measurement. The root of the problem is that business combination accounting relies on a fantasy: that an utterly ineffable plug to balance the business combination journal entry must somehow be an asset. The initial measurement of that plug is, at its theoretical best (i.e., assuming that management did not overpay; and all other assets and liabilities are recognized and accurately measured), an amalgamation of assets and liabilities that (unlike every other asset on the balance sheet) can neither be separated from the rest of the entity nor measured directly. Among the broad panoply of misnomers in financial accounting, "goodwill" is among the least subtle.

If goodwill is a bogus asset, then testing it for impairment compounds the madness. But, there is at least some method to it. The propensity of management to overpay for corporate acquisitions is one of the most well-documented and uncontroverted phenomena in academic finance: with disturbing frequency, share price movements send a signal that investors believe that a corporate acquisition destroyed, rather than created, value. If goodwill were recognized as an asset, but not subject to either amortization or impairment, then management would be even more inclined to destroy shareholder value without having to worry that future earnings would suffer from its profligate spending. Since 2001 (see SFAS 142), impairment testing, albeit replete with opportunities for earnings management, has been seen as the less silly of two silly charades. As currently set forth in U.S. GAAP (ASC Topic 350), this is how it is choreographed:

• All of the goodwill currently on the balance sheet has to be assigned to "reporting units," another misnamed artifice, invented solely for the purpose of making the goodwill impairment test flexible and palatable.
• The fair value of each reporting unit has to be assessed at least once a year – a costly undertaking.
• The real mayhem begins if, heaven forbid, your estimate of the fair value of the reporting unit turns out to be less than its carrying amount. You must then estimate the "implied fair value" of goodwill, another artifice devised solely for goodwill impairment testing; and –
• Write goodwill down to the implied fair value, if its carrying amount is greater.

Recently, however, the FASB issued proposed Accounting Standards Update No. 2011-180, which if finalized would grant unfettered discretion to elect to avoid these processes altogether – so long as "qualitative factors" indicate that it is more likely than not (MLTN) that the fair value of a reporting unit is greater than its carrying amount. The option to consider qualitative factors applies to any year and any reporting unit.

The existing goodwill impairment ballet can be a very costly production. While I am sympathetic to cost issues, I have a number of concerns with the way the FASB is addressing them:

More management discretion means more earnings management – The Board ostensibly decided to give entities the discretion to skip any qualitative assessment at any time. The stated intention is to save entities the cost of performing the qualitative test in a period when breaching the MLTN threshold could be self-evident. Allow me to illustrate my skepticism for this explanation with a slight digression – an example of a similar impairment test that I got wind of just this week:

I was contacted by an analyst who was concerned about a foreign energy producer that prepares its financial statements under IFRS. In accounting for its oil and gas field development costs, the company capitalizes the development costs associated with both successful and unsuccessful wells. The question I was asked pertained to a very large reported impairment charge from writing off the capitalized costs allocated to one particular dry well, one component of a block of wells comprising a "cash generating unit." The write off took place even though every other well in the cash generating unit was performing well beyond original expectations.

I explained to the analyst that IFRS (see IAS 36) provides the option to assess impairment at the individual asset level at any time – ostensibly to allow an entity to provide more timely information regarding impairments. But, ulterior motives may have been at work: With oil prices (and revenues) so high lately, the entity likely had more than enough accounting profit to absorb impairment losses this year, and still meet earnings projections. Hence, the entity apparently elected to pave the way for higher future earnings by taking an impairment charge in the current year with the main effect being reduced future amortization of development costs.

One of my philosophies of financial reporting – and a major theme of this blog – is that discretion in financial reporting invariably leads to abuse. In criticizing the proposal that entities may use the qualitative assessment at their own discretion, am I being too cynical? Or, is the Board being disingenuous? As you decide these questions for yourself, consider that a qualitative assessment in no-brainer circumstances shouldn't cost that much in the first place. Also, while there are already plenty of opportunity for earnings management in the FASB's extant goodwill impairment standard, there will certainly be times when entities will want to write off goodwill before issuing its financials, but can't because the MLTN threshold prevents it.

The "more-likely-than-not" probability threshold is not auditable – I have conducted seminars on financial reporting to thousands of practicing accountants; and my own impression, which is corroborated by a colleague who has done even more of this kind of work than I, is that CPAs are not well-equipped, nor are they excited about, making probabilistic judgments. Yet, the latest fad among standards setters is to require them to do so (and in some cases – leases, loans, revenue recognition – to generate entire probability distributions). Again, my philosophy that discretion leads to abuse is directly applicable.

Moreover, who shall review the 'reasonableness' of these probabilistic judgments? In the most important cases, it will be the "independent" auditors of large public companies, who are paid millions of dollars via checks bearing the signature of the company's CEO. I can see it now: two weeks before the Form 10-K is due at the SEC, a newly-hired auditor who still takes his job too seriously will question the reasonableness of the MLTN determination. Should the auditor require a re-assessment, the company won't have enough time to conduct its goodwill impairment test. Guess who gets inserted between a rock and a hard place?

Non-existent cost-benefit analysis – Federal law requires the SEC to justify a new regulation with rigorous and transparent cost benefit analyses, generally with hard data and quantitative assessments. I find it strange that both the IASB and the FASB (essentially the SEC's agent when it comes to making accounting rules) can trumpet the rigor and extensiveness of their "due process" without the same. In ASU 2011-180, the FASB is proposing, without even acknowledging any potential negative consequences, to allow reporting entities to side-step a series of rules that clearly were intended to mitigate shareholder value destruction.

More convergence nonsense – The Board mentions that it considered a number of other alternatives for changing goodwill impairment accounting. I won't get into the details here, but some of those alternatives make a lot more sense that the proposed rule changes. Irritatingly, much of the Board's rationalizations are based on their concern that a revised goodwill impairment standard should move U.S. GAAP closer to IFRS. But in point of fact, the goodwill impairment rules under IFRS are already as different from U.S. GAAP (with no plans for convergence) as night is from day. Under U.S. GAAP, the last long-lived asset to be tested for impairment, and written down, is always goodwill; but under IFRS, all long-lived assets are tested together, and the first asset to be written down is generally goodwill (subject to earnings management options that are currently not in U.S. GAAP).

* * * * *

Financial accounting costs too much because it is too darn complex. I am sympathetic towards efforts to reduce the costs of financial reporting, but in most cases, improvements are only slightly incremental and they come with too much baggage. The latest proposal for modifying "goodwill impairment" accounting is a case in point.

 

Is GM's Equity For Real?

GM's recent filing of its registration statement with the SEC represents the collision of two topics I have written about. First, the fortuitous arrival of $30.2 billion of "goodwill" on GM's balance sheet so soon after the company crammed a bankruptcy organization down the throats of irate creditors and shareholders fits nicely into my collection of goodwill accounting curios. Second, GM's description of how that "goodwill" came to be will allow us to further consider the implications of my concern that the SEC's review of GM's IPO registration could be inadequate.

I became of aware of the goodwill issue from reading Jonathan Weil's article in Bloomberg last week. Out of all of the bad things that happened to GM, at least it became eligible for "fresh-start" accounting (see the Accounting Standards Codification starting at ASC 852-10-45-17). What it meant for GM is that measurement of all recognized assets and liabilities began anew on July 10, 2009, plus a fresh delivery of goodwill from being able to pretend that the reorganized shareholder group purchased the reorganized, "New GM," (which, of course, it didn't), and accounted for it by the rules for a business combination.

As set forth in the fresh-start accounting rules, the imaginary terms of the imaginary acquisition is that shareholders bought New GM for its "reorganization value" and assumed all of New GM's liabilities (of course, the shareholders of New GM don't actually pay anything). Any positive difference between the booked assets and liabilities is recognized as "goodwill"; and an asset shortfall would result in negative shareholders' equity.

Jon makes many interesting observations in his article, and I highly recommend that you read it, but the one point that I am going focus on is that GM's shareholders' equity at December 31, 2009 would have been a negative $6.2 billion if it were not able to book a whole bunch of goodwill. Even though everyone knows that goodwill is merely, as GM itself puts it, "a residual," it can be a pretty important residual. To say that few companies would be able to pull off a successful IPO with a negative number for shareholders' equity on its balance sheet would be an understatement. To say the same after applying fresh-start accounting would be a statement of fact.

Negative shareholders' equity is an accounting anomaly. If a balance sheet purports to portray financial position of the shareholders, then – just like a negative share price – negative shareholders' equity makes no sense. The only possible explanation is that assets and liabilities themselves are out of whack. Who wants to invest in a company, especially after fresh-start accounting is applied, whose assets and liabilities are so obviously out of whack?

Let's Play SEC

So, a couple of posts ago, I asked whether the SEC was capable of functioning as an effective gatekeeper of a GM IPO. GM's application of fresh-start accounting, especially the 'goodwill' part, could well be the acid test.

This could make pretty dry reading, but I'm going to play the role of an SEC staffer who is actually drafting comments to GM.  To avoid dry becoming turgid, I'm dispensing with a lot of the formalties to be found in a genuine comment letter, and virtually all of the standard form.  Anyway, here goes nothing.

Comment #1 – Overstatement of reorganization value

On page 125 of your registration statement, you state that reorganization value is the sum of four components: (1) a discounted forecast of expected future cash flows; (2) "the fair value of operating liabilities"; (3) the fair value of non-consolidated investments, and (4) excess cash balances as of July 10, 2009. The following comment pertains to the fair value of operating liabilities (the second component), which you indicate on page 127 was $80,832 million.

We do not believe that you have determined reorganization value in accordance with GAAP. ASC 852-10-05-10 states as follows regarding the determination of reorganization value:

"…Reorganization value generally approximates fair value of the entity before considering liabilities…." [italics supplied]

PLEASE RESTATE to exclude the "fair value of operating liabilities" from the determination of reorganization value [and perhaps wipe out all of the goodwill in the process!].

Comment #2 – Definition of "operating liabilities"

The definition of "operating liabilities" is provided on page 127:

"Operating liabilities are our total liabilities excluding the liabilities listed in the reconciliation above …"

Nothwithstanding any effect of Comment #1 on your registration statement, the forgoing definition is deficient; it does not actually describe "operating liabilities," except in terms of an apparently arbitrary calculation. Should it become necessary to provide a substantive definition of "operating liabilities" after you have taken into consideration our Comment #1, you should provide a definition that is independent of total liabilities and its non-operating liability components. If necessary, restate the amount of "operating liabilities" to conform to the revised definition.

Comment #3 – Excess cash included in reorganization value

On page 126, you state that the excess cash component of the reorganization value was $33.8 billion, and that $21.2 of cash and marketable securities were restricted as to their use.

We note that if there were no excess cash balances, then reorganization value would be reduced such that goodwill recognized by fresh start accounting would be completely wiped out. In consideration of its materiality, PLEASE AMEND your registration statement to provide additional details as to how excess cash was determined. Provide an explanation of the cash flow forecasting model used, its key assumptions, how those assumptions adequately reflect the exceptionally high risks that New GM faces, and provide a sensitivity analysis on those assumptions in a tabular format. Also, provide a description of the negotiations with creditors that granted you the ability to retain excess cash; specifically, how it came to be that creditors did not successfully claim these amounts (if they were truly excess) for themselves. 

In summary, we are skeptical that, with the possible exception of your restricted cash, that New GM should consider itself to be in possession of excess cash balances.

Comment #4 – Effect of Taxes and Pensions on Goodwill

On page 136, you stated the following:

When applying fresh-start reporting, certain accounts, primarily employee benefit and income tax related, were recorded at amounts determined under specific U.S. GAAP rather than fair value, and the difference between the U.S. GAAP and fair value amounts gives rise to goodwill, which is a residual. … If all identifiable assets and liabilities had been recorded at fair value upon application of fresh-start reporting, no goodwill would have resulted." [italics supplied]

The last sentence, above, is incorrect because goodwill is also a function of reorganization value. Therefore, PLEASE AMEND your registration statement to correctly state the calculation of goodwill, and as follows:  

• Provide, preferably in tabular format, the following: the balance sheet categories for which fair value and recorded amounts differed as of July 10, 2009; their recorded amounts and respective estimated fair values; and the difference.
• In separate tables, disaggregate the forgoing differences by the variables that significantly contributed to the differences. State any assumptions that were required for the preparation of this table.

[Note: the deferred tax asset valuation allowance determination is a fertile source of earnings management. At the date of the fresh-start accounting, a "conservatively high" valuation allowance increases goodwill; and in subsequent periods, reductions in the allowance also reduce reported income tax expense. Therefore, it would behoove the SEC reviewer to examine the determination of the initial deferred tax valuation allowance very closely.]

What Will the Real Comment Letter Contain?

In summary, I reviewed only about ten pages of GM's registration statement, and generated the above comments. Among other things, I found three reasons why New GM probably doesn't have any goodwill, and as a consequence, negative shareholders' equity:

1. Overstated reorganization value due to inclusion of operating liabilities;
2. Overstated reorganization value due to overstated excess cash and marketable securities;
3. Potential overstatement of the deferred tax asset valuation allowance, with the added consequence of creating an earnings bank which can be drawn down by reducing the valuation  allowance.

Eventually, the SEC's comment letter on GM's registration statement will have to be made public. Here's hoping the Commission's staff is doing its job—even if it means that GM's IPO doesn't go forward.

A Simple Solution To Standard Setters' "Control" Issues

In the good old days, you recognized the assets you owned. For the reasons why things eventually became a lot more complicated than that, there is plenty of blame to go around. Blame the banks and their minions of financial engineers for arcane securitization transactions that transferred legal ownership of those assets, but not much else, to work the accounting wonders that have now become closely associated with the most recent financial crisis. Blame Enron for trying the same scheme with power plants and such.  Blame lots of companies like Enron that were able to keep a lower profile. 

From the perspective of the rampant abuses that occurred, I suppose you can't find too much fault with the FASB and IASB for taking another tack for asset recognition/derecognition. But, the fact remains that "control" (notwithstanding the difficulty the boards have had in pinning down an abuse-proof definition) as a recognition criteria has problems of its own. Take, for example, lease accounting, one of the more high profile issues of the day. As in my previous post, I'm going to use some recent remarks on the topic attributed to Jim Leisenring by Simon Brown as a jump off point. Before we get to that, however, I am once more compelled to provide a few caveats.

First, I incorporate by reference the caveats as to Simon Brown's reporting of Jim Leisenring's remarks concerning "high quality accounting standards" (HQAS) . Second, I'm really glad I issued that caveat when I did. Soon after I sent that post hurtling into cyberspace, I received a credible email claiming that Brown's reports on Leisenring's remarks as regards to HQAS were inaccurate and misleading. My source claimed that Leisenring had not even referred to any discussions of the characteristics of high quality accounting standards amongst the IASB members.

Although I regret any inaccuracies that may have found their way into my commentary, I only used the information from Brown to establish the existence of an active discussion among IASB members as to what "high quality accounting standards" meant.  I do not believe that any mischaracterizations of Leisenring's remarks, although highly regrettable, should call for alterations to my own personal comments.

As to the current post, I shall with newfound trepidation once again rely on Brown's reporting of comments made by Leisenring – this time, however, concerning lease accounting. I have inquired from my sources as to whether Brown's reporting on this topic was substantially inaccurate; and so far, I have received neither a confirmation nor a denial. As is always my policy, if I should subsequently discover any inaccuracies, I will make disclosures to that effect.

What Brown Said Leisenring Said About Lease Accounting

[Leisenring said,] The boards "have no idea what they're doing collectively, including me," …. [he] said the boards have been arguing about the issue for two months. Some members have argued that lessors should derecognize the portion of the asset they gave up by right of use, which he called "extraordinary accounting." He said the [sic, their?] derecognition model would suggest that every time a hotel rents a room, for example, it should account for the loss of the part of its building that it gave up, then reverse it the next day when a guest checks out.

I Can Fix That Problem!

The hotel example is clearly what one gets by taking a "control" criteria for recognition/derecognition to its logical extreme.  I can think of no other way to fix the problem than to restore "ownership" to its rightful place as the principal criteria for asset recognition; to wit, only legal entitlement to an economic resource may trigger recognition of an (as opposed to "the") asset.

By "legal entitlement," I am referring to one of the types of circumstances: (1) ownership of an asset; (2) a right (conditional or unconditional) to receive an asset; or (3) a right (conditional or unconditional) to use an asset. But unlike any other "traditional" accounting models, I would also need to define a liability symmetrically as an obligation to a holder of (2) and (3), above.

This revised asset/liability criteria makes lease accounting very straightforward, although I want to take this opportunity to remind you that I am severely critical of the measurement aspects of its proposals as well -- they are truly terrible.  Anyway, as regards to recognition only, the lessee (i.e., hotel guest) should recognize an asset for its right to use the property being leased (i.e., hotel room); and an obligation to pay the lessor (i.e., hotel owner) in exchange. The lessor, for its part, recognizes an asset for the right to receive payments from the lessee and an obligation to provide access to the hotel room. Thus, the accounting for the hotel property itself is unaffected by the lease arrangement as no change in ownership occurred.

Does My Fix to the Leasing Problem Create Other Problems?

You may already be thinking of potential shortcomings to my "legal entitlement" approach. So far, I have thought of two – but I can easily live with them.  In fact, I vastly prefer them to the results that come out of the control approach.

First, legal entitlement could put all executory contracts on the balance sheet, not just leases, the pioneer of on-balance-sheet recognition of an executory contract.  That's because it was rightly seen by many as an essential exception to close one of the most popular off-balance sheet loopholes. Years later, a forward contract meeting the restrictive definition of a "derivative" became another form of executory contract that was put on the balance sheet (SFAS 133).

So, I suppose, that standard setters can continue to pick and choose which executory contracts to scope in or out of its rules no matter whether "control" or "legal entitlement" is the asset recognition criterion.  As for my own preferences, except for limited practicability and materiality considerations, the ancient prohibition against recognition of executory contracts has become obsolete.

Second, the "legal entitlement" criterion for liability recognition as I have stated it would not result in recognizing "contingent liabilities" such as pending lawsuits (unless, of course, the case had been adjudicated). It would also not comprehend constructive liabilities. With respect to contingent liabilities, all sorts of regulators have been trying for ages to come up with consistent accounting for contingent liabilities and the results, to be kind, have been inconsistent if not just plain ineffectual. With respect to constructive liabilities, they are merely tools for earnings management.

I'm most happy to get both contingent and constructive liabilities off the balance sheet, although disclosures of contingent and constructive liabilities have their place, and arguably should be strengthened. There is nothing wrong with expansive narrative and quantitative disclosures in notes or in MD&A.

I should also note that my criterion would comprehend contractual warranty obligations and any other similar obligation to stand ready to perform in the future.

Control as a Presentation Criteria

Finally, I should point out that the notion of "control" can still be useful, even though it has done little more than to bollix things up. For another recent example, see the infamous Repo 105 mess.) Its role would be limited to determining the presentation of financial assets. If legal entitlements over financial asset(s) convey the power to control another entity, then consolidated presentation would be appropriate. Other circumstances could also indicate that consolidated presentation is appropriate, too, such as whether an entity is a "primary beneficiary." If the investment(s) confer "joint control," then proportionate consolidation would be appropriate; but, that's certainly fodder for another blog post.

ASU 2010-19: When a Dollar of Cash Is More Than a Dollar on the Balance Sheet

If you think you can find a larger wart on the backside of US GAAP than the one I am about to describe, then give it your best shot.

Here it is in a nutshell: a careful and cynical application of the foreign currency accounting rules (either US GAAP or IFRS) could result in a $10 million bank account balance being reported on the balance sheet at $25 million. That's right: balance sheet cash isn't the cash balance. I double dare you to top that one!

As you may have guessed, the rules I am referring to are part of FAS 52, Foreign Currency Translation (now Topic 830 of the Codification), which was finalized by a 4-3 vote. They have sat there unremarked upon for thirty years, until relatively recently as negative economic developments in Venezuela have elevated them from a few ounces of cream cheese on a bagel to six tons of chopped liver on a Ritz cracker.

So, into the muck gingerly wades the SEC with new guidance in the form of a staff announcement at a recent meeting of the Emerging Issues Task Force. The FASB has codified that guidance with the issuance of ASU 2010-19. As you'll see, the SEC's message to investors is ambivalent, to say the least, on an issue that is as black and white as it gets.

Setting the Stage for the Big Whopper

You may wish to refer to a related post, which I wrote almost 3 years ago, and in which I described how consolidated financial statements could actually report foreign exchange gains and losses on U.S. dollars. Here's an example from that post, albeit slightly tweaked, to set the stage for the whopper to come.

Alpha Co. is based in the U.S. and presents its financial statements in U.S. dollars (USD). Beta is Alpha's Venezuelan subsidiary, and its functional currency is the local currency of Venezuela, the Bolivar (VEB). Inflation has been high in Venezuela in recent years. For this reason, Beta holds its cash balances, worth $10 million, in USD-denominated accounts. Also, as a result of the high rate of inflation, the VEB has been steadily devaluing against the USD.

For simplicity, let's assume that the cash balances I mentioned are Beta's only asset. Under normal circumstances, this is the way that consolidation of Beta with Alpha would work:

1. The USD cash balances held by Beta would be "remeasured" into VEBs; the resulting gain (because the VEB is losing value) would be reported on Beta's income statement (in VEBs).
2. Beta's VEB financial statements (including the gain on holding USDs in Venezuela) would be "translated" to dollars for the purpose of consolidating Beta's financial statements with Alpha's.
3. The effects of the "translation" process on equity would be reported in a separate "translation adjustment" category, which would not affect income.

Thus, although total owners' equity does not change from the roundtrip that the USD is taking in the accounting records — USD Þ VEB (on the sub's books) Þ USD (in the consolidated financial statements) — the gain from the outbound leg of the trip would be reported in income, but the loss from the homeward leg would bypass the income statement and only be reported in a separate component of owners' equity, i.e., the so-called "translation adjustment."

Of course, it's a ludicrous outcome buttressed by extremely flimsy logic, but I have already beaten that drum. Here comes the whopper I've been fixin' to tell you about.

The Dual Exchange Rate Problem

Even if you absolutely detest the effect of FAS 52's remeasurement/translate procedures on reported earnings, there is the small consolation that cash (and other monetary items) are correctly stated—even after their round trip. However, this is not always the case for two reasons: (1) currency exchange controls by the country in which a foreign subsidiary is located; and (2) more bad accounting rules.

As to those currency exchange controls, they can result in multiple exchange rates. Here, for example, is how the SEC staff, in ASU 2010-19, describes the current situation in Venezuela:

"[C]urrent restrictions of foreign currency exchange in Venezuela provide that entities use the official rate of exchange to exchange funds.... As an alternative to the use of the official rate it may also be legal to utilize the parallel rate. It is possible that the parallel rate provides entities with a more liquid exchange and entities can access the parallel rate using a series of transactions via a broker."

When multiple exchange rates exist, US GAAP may permit the use of one of those exchange rates for remeasurement (per ASC 830-20-30-1, the "current rate of exchange") and another for translation (per ASC 830-30-45-6, the "dividends remittance rate"). Thus spake the SEC staff on these provisions as they apply to Venezuelan operations:

"[T]he staff has recently become aware that... certain entities may have used the parallel rate to remeasure certain US dollar denominated balances that the Venezuelan subsidiary held and then subsequently translated the Venezuelan subsidiary's assets, liabilities, and operations using the official rate. The effect of this accounting treatment resulted in reported balances in an entity's financial statements that differed from their underlying US dollar denominated values."

 [For example,] assume that at a period end … a U.S. entity's Venezuelan subsidiary held $10 million of cash denominated in U.S. dollars. Further assume that at the end of the period, the parallel rate was 5 Bolivars to every 1 U.S. dollar and the official rate was 2 Bolivars to every 1 U.S. dollar. Upon the remeasurement of the U.S. denominated cash to Bolivars and the subsequent translation of the Venezuelan subsidiary's financial statements, an entity would have reported cash of $25 million for financial reporting purposes. [Italics supplied]

 

Finally, after 30 years of sitting on its hands, the SEC has acknowledged the insanity of using one rate for remeasurement and another for translation: among other crazy things, $10 million in cash is transformed to $25 million on the balance sheet—with a hefty income statement gain in the process (due to the declining VEB).

Unfortunately, though, the SEC's solution is to soft pedal. If you're in Venezuela, but nowhere else, kindly provide some additional disclosures. Everybody else: you can keep doing that thing you do with multiple exchange rates. To all you investors out there, take comfort in knowng that the EITF, staffed with your good friends from the Big Four, has this 30-year-old emerging issue on its agenda; they'll know how to make things right—eventually.

I expect the SEC would respond that their longstanding policy is to stay away from overriding FASB rules until the Board has had its chance to fix a problem—no matter how insane and damaging those rules may be. My response is: that's not even close to good enough.  The feeling I'm left with is that the SEC, in ASU 2010-19, is conducting the orchestra with a wet noodle instead of a baton.

To help see why I think that the SEC's response is inadequate, let's try look at the problem from an auditor's perspective; or stated another way, how an investor should have expected an auditor to have resolved these kinds of problems as they arose. Let's imagine that an issuer shows the auditor the GAAP rules that lead to an actual $10 million in cash being reported as a fictitious $25 million; and the auditor perforce concludes that the issuer adhered to the letter of those rules. The auditor knows that the client's balance sheet is materially misleading: is there nothing more to be done?

For the answer to that question, I refer to Interpretation 203-1 of the AICPA's Code of Professional Conduct, Departures from Established Accounting Principles, which states as follows:

"[I]n the establishment of accounting principles it is difficult to anticipate all of the circumstances to which such principles might be applied. This rule therefore recognizes that upon occasion there may be unusual circumstances where the literal application of pronouncements on accounting principles would have the effect of rendering financial statements misleading. In such cases, the proper accounting treatment is that which will render the financial statements not misleading." [italics supplied]

 

If Interpretation 203-1 is anything more than hot air, then surely it must be invoked by an auditor faced with the now-codified Venezuela fact pattern. Never happened and never will, you say? Conclusion: Interpretation 203-1 is hot air.

Surely, when looking to the FASB for accounting standards, the SEC must hold itself and the Board to a standard that meets or exceeds the minimum (albeit nominal) ethical responsibilities of CPAs. In applying those standards to ASU 2010-19, I can only conclude that once again, little more than hot air has been produced.  If a GAAP rule fails to report dollars sitting in a bank account on the balance sheet according to their bank balances, that rule must be so arbitrary that it cannot be anything but misleading.  I cringe at the fact that such a rule is referred to by people who should know better as "accounting."   

 Chief Accountant Kroeker, I challenge you to find me an uglier wart in GAAP than this one. If you won't act decisively, and with the integrity expected of all CPAs, to repair dysfunctional rules that materially misstate cash no less, then kindly explain to investors what exactly it is that you are doing.

Goodwill Impairment: I Love a Charade

I have written about initial recognition of goodwill on numerous occasions. I suppose it might be less bothersome if goodwill had the good grace to sit and stay like a good dog on the balance sheet at its opening 'value'; but alas, such is not the case. Not even close.

Goodwill impairment tests chew up good money, and as I am about to describe, they screw up the accounting for just about everything else. Even in the best of circumstances (by which I mean that goodwill could actually be something more than a garbage can for overpayments, mis-measurements and measurement exceptions) the goodwill impairment test is a ludicrous charade.

To Illustrate

Let's start with a simple set of made-up facts, albeit loosely based on a real situation as described to me. The teller of the tale attended a business combinations workshop that I had recently led:

Acquiror Company purchased 100% of the outstanding shares of Target, a consulting company for $1,000. None of Target's liabilities were assumed; the only asset eligible for recognition other than goodwill was a customer-related intangible, with a fair value of $400 million and an expected economic life of 8 years. Therefore, goodwill was initially "measured" (the FASB's misleading term, not mine) at $600 million (=$1,000-$400). Why such a high amount for goodwill? Acquiror viewed Target's assembled workforce to be its most valuable asset, which may not be recognized separately under GAAP (or IFRS).

One-year later, negative events associated with the recession significantly diminished Target's prospects. Principally, the value of the previously recognized customer related intangibles declined significantly; however, their remaining expected economic life still has seven years to run. (The remaining expected economic life of the asset is not particularly relevant to my analysis to follow, but there it is, anyway.)

U.S. GAAP requires that the customer-related intangible be tested for impairment before the goodwill is tested. To make a long story mercifully short, one first assigns the current carrying amount to the smallest cash-generating unit (CGU) for which cash flows can be reasonably attributed. Acquiror determines the CGU to be Target itself, and then determines the expected undiscounted cash flows to be just slightly greater than $350 million (which is the carrying amount of the CGU. Thus, no impairment of the customer-related intangible is recognized, even though its value is surely far below the carrying amount.

Now, it's on to the goodwill; and for the FAS 142 cognoscenti among you, we shall stipulate that Target constitutes a "reporting unit." Cutting to the chase again, GAAP requires that the current fair value of Target be compared to its carrying amount. Let's say that the fair value of Target is determined to be $300 million. Since that's less than Target's carrying amount of $950 million (=$350 + $600), Acquiror must launch itself through the gauntlet of the goodwill impairment test, known as "Step 2."

Step 2 requires Acquiror to pretend that it purchased Target today for its fair value, and to figure out what goodwill would be recorded at today, should that impossible fantasy somehow be the reality. So, let's see: assuming a purchase price of $300 million and a fair value for the customer related intangible of $200 million, the "implied fair value of goodwill" (another fabricated and misleading term to add to one's collection) comes to $100 million.

Thus, a "goodwill impairment" of $500 million (=$600 - $100) must be recorded, even though everyone and their brothers and sisters all know that it is the customer-related intangible that is deep underwater. Acquiror's management knows that the customer-related intangible is worth $200 million less than the amount reported on the consolidated financial statements, but investors don't know that. All they see is a writedown to goodwill; which everyone and their brothers and sisters dismiss as merely the result of an arbitrary recalculation of an arbitrary calculation.

So now you know why issuers don't complain too much about goodwill impairment accounting, even though the charade by which it is calculated can be a gigantic pain in the tuchas. It's just one more line of defense for hiding information about real impairments on any kind of long-lived asset other than goodwill that you can imagine. Nothing actually re-measured, only goodwill actually lost.

Is IFRS Any Better?

No. It's worse and with no prospects of improvement anywhere close to being on the horizon. Unless management elects to separately estimate the "recoverable amount" (higher of net fair value and "value in use"), then all of the goodwill and customer-related intangibles carrying amounts are thrown into the CGU bucket. If the CGU's fair value is less than its total carrying amount, then you will always write down goodwill before you touch any of the other long-lived assets.

Although in this case the GAAP and IFRS answer would be identical, the difference is that under GAAP there is at least some chance that non-goodwill assets would be stated at a more realistic value for them. Moreover, the SEC has demonstrated its awareness of the anomaly and willingness to hold a registrant's feet to the fire. For example, here is one case of an SEC comment letter to a company expressing its incredulity that goodwill was written down while miraculously preserving the carrying amounts of its non-goodwill assets:

Taking into consideration the circumstances that caused you to recognize an impairment charge on the Birmingham market goodwill, tell us whether you first tested your long-lived assets … If you did test your long-lived assets for impairment, explain to us in why an impairment charge was not recognized. If you have not tested your long-lived assets for impairment explain to us why not. Please also tell us how you group your long-lived assets for purposes of testing your long-lived assets for impairment …. [Letter from the SEC to Cox Radio, Inc., dated July 17, 2006]

Don't Worry, Be Happy

Small wonder that goodwill and long-lived asset impairment is not on the rush-rush 2011 convergence agenda, or even anytime thereafter. The financial crisis has clearly demonstrated, asset impairment accounting is a sacred cow that may only be approached in circumstances involving extreme unction. Not very long ago, it was hard enough for the FASB to push through any sort of consistent impairment standard for long-lived assets. Now, with the EU already threatening to jump ship on financial instrument impairment, the only choice the Boards have is to pretend that the shortcomings of impairment standards are not a high priority, not to mention the gaping inconsistencies within and between IFRS and GAAP.

I love a charade.

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

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

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

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

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

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

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

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

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

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

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

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

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

Spinning "Convergence"

"Converge" from Merriam-Webster's Online Dictionary:

1. to tend or move toward one point or another: come together: meet

2. to come together and unite in a common interest or focus

3. to approach a limit as the number of terms increases without limit

Now that it has become abundantly clear that convergence of IFRS and U.S. GAAP is not likely to happen, the proponents of IFRS adoption in the U.S. are trying to downplay its importance, and spinning what convergence is supposed to mean. That stratagem should come as no surprise to those who have observed the numerous instances where immutable plain English words have been misappropriated by accounting standards to serve as terms of art no more artful than Dickens' Artful Dodger.* (For some examples I have posted, see here, here and here.)

I have been meaning to write about the notion of convergence and its implications for some time now, but I was having trouble organizing my thoughts until I read D.J. Gannon's article, The IFRS Convergence Quandary.  Gannon is a Deloitte & Touche partner and as far as I can tell, he is his firm's point person on issues related to the SEC Roadmap.  (As Gannon seems to be singing in unison with the Big Four chorus, I hope that my criticisms are not taken to be a personal attack, but simply as a convenient point of reference.)

"Let's start with what convergence is. Convergence is designed to bring U.S. GAAP and IFRS closer together. The focus is on having similar general principles. Many have misinterpreted convergence as meaning the development of the same or "identical" standards. The reality is that convergence never really contemplated "identical" standards.

In fact, the FASB and IASB have acknowledged that doing so is too difficult to accomplish. This is evident in the boards' recently issued business combinations standards that contain differences in certain requirements. And, based on the boards' current thinking on topics such as consolidations and leasing, differences likely will exist in future converged standards."

I would like to suggest that a reading of very plain language in the Boards' 2008 joint progress reporton the Memorandum of Understanding between the FASB and the IASB indicates a very different view of "convergence":

"Convergence of accounting standards can best be achieved through the development of high quality, common standards over time." [italics supplied]

In other words, both Boards have stated that convergence was intended for GAAP and IFRS to actually meet, and not merely come "closer together." The distinction is crucial, because, by claiming that "convergence" has a meaning that is not in the ordinary-folks dictionary, proponents of IFRS adoption now seem to be trying to find excuses for a lack of progress on convergence—and more important, the increasingly dysfunctional relationships between prime movers at the IASB.  I also can't resist pointing out that the phrase "differences likely will exist in future converged standards" makes no sense without some special meaning for convergence, which neither appears to have been contemplated by the MOU nor accomodated by the dictionary definition of "converge."

As to what the FASB and IASB have "acknowledged" regarding their convergence efforts, the alleged facts are that IASB representatives sat in Norwalk as the FASB determined to finalize their new business combination standards (FAS 141(R) and FAS 160). Those envoys reportedly gave assurances that the areas in which the FASB was sticking its neck out would be adopted by the IASB as well. In essence, the IASB reneged on its assurances; and that's as close to an 'acknowledgement' that I am aware of.

Convergence Has Reached the End of the Road -- Now What?

Actually, D. J. Gannon and I do agree on one thing. We both believe that convergence has probably gone as far as it can go. Our differences concern the question of what to do next. Gannon thinks that the U.S. should be ready for IFRS adoption:

"…[Y]ou only have to look at the recent events surrounding the current financial crisis. What historically have been seemingly harmless differences between U.S. GAAP and IFRS now are the source of much politicization.

Take, for example, the issue of when companies can change the classification of financial assets, which in turn impacts the measurement of these items. Prior to last year, the "technical differences" on classification between U.S. GAAP and IFRS were never considered a significant issue in practice. However, the financial crisis put the IASB under tremendous pressure to conform IFRS to arguably a "lesser-quality" answer under U.S. GAAP. This is only one example of literally hundreds of differences between U.S. GAAP and IFRS that likely will never be addressed by convergence."

Actually, it was the EU (not the "financial crisis") that put the IASB under "tremendous pressure," and just as the FASB responded to the U.S. Congress, the IASB caved. I see nothing compelling about this particular case, but that's not my main point. I find it curious that of the "literally hundreds of differences" that could have been picked, Gannon happened to pick one whose lessons are obscured by anomalous constraints imposed by inefficient banking regulations. Just because Congress and the EU want to shoot the messengers, that doesn't mean the U.S. should appoint a new messenger who will no doubt be harder to shoot the next time Congress wants to engage in that distasteful exercise.  

Also, my wandering mind wants to liken the relationship between the FASB and the IASB, as set out in the 2002 MOU, to a crumbling marriage. Both spouses have made some very poor choices in the past and it's as if one spouse is desperately imploring the other to stay together despite a tumultuous past together. "Everything could be just like it was when we first fell in love if we started a family—just like we were planning when we got engaged!" (sob, sob)

Whoa. I say divorce now rather than take a crazy risk like having kids. And, don't think further counseling is the answer either. As Gannon points out, there are "literally hundreds" of irreconcilable differences. Maybe none of those little tics and peeves matter by themselves, but collectively they're sure to drive the whole family nuts.

In case you don't get it from my cutsey troubled marriage analogy, let me spell it out for you.  Adopting IFRS any time soon will require a giant leap of faith that is not at all warranted by past actions. 

What Exactly is the Problem that IFRS Adoption Will Solve?

I learned from a colleague some years ago that the way to resolve a turf battle is to ask the power grabber to describe precisely what the problem is they are trying to solve, and how their solution solves that problem. 

Gannon's opening statement lays out that problem, insofar as IFRS adoption proponents would have the rest of us see it:  

"One thing most everyone in the financial reporting community can agree on is the need for a single set of high-quality globally accepted accounting standards."

Let's start with the presumption that IFRS is "high-quality." I see that as the biggest reason why the arguments of IFRS adoption proponents are not persuasive to skeptics such as myself. To my way of thinking, the one thing that most everyone in the financial reporting community really should finally admit is that IFRS is deeply flawed, and U.S. GAAP is no better.

In far too many respects that belie any pretense of quality, IFRS merely apes GAAP. The GAAP standards that have wrought the savings and loan crisis, the pension crisis, the thousands of pages of hedge accounting rules, hidden executive compensation costs, and now the worldwide financial crisis are converged all right. They're converged at a point barely above lousy.  In short, we will certainly be no closer to high quality accounting standards by adopting IFRS.

As to the advantages of having a "single set" of standards, it would certainly be desirable for all financial statements to spring from a single set of high-quality accounting standards, but we are worlds away from that utopia.   Indeed, dysfunction is beginning to take over the IASB's most prized relationship, the EU.  Charley McGreevy is grumbling that the IASB may not be able to be satisfy the financial reporting needs of the EU, so it remains a distinct worst-case scenario that the U.S. could adopt IFRS just as the EU is trashing it.

But let's ignore that, and assume that we do end up with a single set of accounting standards, albeit badly in need of improvement.  In that case, I predict that, with the U.S. voice muted, the chances will only increase that broken financial reporting standards will stay broken. I still have high hopes that better financial reporting standards can be obtained, but getting them is much more likely to spring from competition between standard setters than cooperation. In all things capitalistic, competition breeds excellence; and cooperation is the fuel for a race to the bottom.

In summary, failure to converge may be a "quandary" for IFRS adoption proponents.  Should we stop convergence efforts and set the stage for adoption?  "Absolutely," they say.  "Damn the risks and costs... full speed ahead (towards higher consulting fees)!"  But for me, the whole notion of convergence is, and always has been, nothing more than propaganda.

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*"He was a snub-nosed, flat-browed, common-faced boy enough; and as dirty a juvenile as one would wish to see; but he had about him all the airs and manners of a man." (Oliver Twist)

SAB 112: Let the New Earnings Game Begin

In a recent post on business combinations accounting that is related to SAB 112, I criticized the FASB for creating yet another loophole in business combinations accounting that make M&A transactions more attractive than they really should be. To recap, I described how JP Morgan wrote down toxic loans acquired from WaMu so that, going forward, JP Morgan had a built-in stream of future earnings at very high interest rates.

First, a Mea Culpa

I was feeling pretty satisfied with myself until reader Michael interrupted my reverie with several interesting and valid comments. With great reluctance, I began to re-think parts of my screed.

First of all, he found a couple of inaccuracies in my telling, which should be corrected:

"Tom, I think I'm with you on your conclusion (i.e. mark all financial assets to fair value (replacement cost?)) but the area of GAAP causing the inconsistent measurement is not FAS 141(R). FAS 141(R) was first effective for transactions that closed on or after 1/1/09 for calendar year companies. JPMorgan was subject to FAS 141 (no R) for this transaction and disclosed as such. However, you may be aware that even under FAS 141, certain loans were required to be accounted for at fair value, notwithstanding the SAB [Topic 2A-(5)]...those loans that were purchased at a significant discount are subject to the guidance in SOP 03-3, which requires a fair value measurement [at the acquisition date] for such loans. Given the purely awful composition of WaMu's portfolio, it is not surprising that half their loans fell into that guidance. I think most of the focus should be on the criminal allowance put up by WaMu pre-transaction...$2 billion on $240 billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes." [italics and bolding supplied]

That's a really interesting last sentence, especially coming from an auditor, and I'm betting that even the PCAOB will not want to go near that one. As important as that may be, it's a digression from the mea culpa I now proffer to all who read that post: I overlooked the fact that SOP 03-3 would be applicable, because I mistakenly thought the acquisition of WaMu was accounted for under FAS 141(R).

Michael's comment and my mea culpa notwithstanding, the fact remains that henceforth, FAS 141(R) has taken over for SOP 03-3 in the earnings management toolbox when it comes to making sure that a business combination transaction will be accretive to future earnings. (Note: that doesn't mean that SOP 03-3 has become obsolete. Loan acquisitions that are not part of a business combination are also within its scope.)

Michael also responded to my suggestion that the offending provision of FAS 141(R) should be suspended until loans are fair valued.  He pointed out that should that day ever come, the invitation for earnings management of which I spoke doesn't completely go away:

" … [L]et's assume that all financial instruments were remeasured each period at fair value. While there will be timing differences with loans that are measured at fair value at acquisition, net income over the life of the same loans will be the same...if JPMorgan had to continue to remark the loans, they'd still recognize that accretion into earnings if the loans ultimately perform. I understand your generally well founded skepticism, but I think this is one of the less offensive areas of FAS 141R.

Michael is right (again). I could live with an outcome whereby unbiased fair value measurements will provide a stream of accounting earnings to an acquiree. But, I am indeed more than a little skeptical that two versions of fair value will emerge from FAS 141(R)—if they haven't already from other games that executives will play with earnings. The WaMu's will still have strong incentives to overstate market value, and even Michael implies that auditors are not likely to stand in their way. The JP Morgans of the world have incentives to understate the same fair values.

Enter SAB 112

That's where SAB 112 comes into the discussion. Among other ministerial changes, it deleted Topic 2A-(5) of the SAB codification, which I described in the earlier post and became unnecessary after FAS 141(R) instituted the fair value requirement for acquired loans. The crux of this post is this: if the SEC thought that manipulation of loan loss reserves during a business combination merited an anti-abuse rule, then more than ministerial adaptations were called for.  How can the SEC be so naïve as to think that fair value will fix the problem of loan value manipulation? Instead of merely deleting Topic 2A-(5), they should have re-written it to put the brakes on what will surely become a new recipe for chicken salad. It would have been really simple for the SEC to make the following rule:

Irrespective of pre- and post-acquisition bases of measurement, the new carrying amount of every asset recognized may be no less at the date of acquisition than the carrying amount recognized by the acquiree; similarly, the fair value of liabilities assumed may be no greater than amounts recognized by acquirees.

I know that my suggestion may sound unprinicpled and draconian to some (and I would be prepared to allow for some exceptions), but the reality is that no set of business combination accounting rules will be perfectly 'efficient.' For any accounting rule, it is inevitable that some value-creating transactions will be discouraged, and some value-destroying transactions will occur because the accounting result is too sweet to resist. The key for regulators is to strike an appropriate balance based on broadly acceptable objectives for financial reporting.

In regard to business combinations, there have been no such objectives ever before.  It is clear that the rules have been completely out of whack since the inception of GAAP in the 1930s. As for the last few decades, the evidence is crystal clear that our economy has been administered a nearly lethal dose of value-destroying business combinations to juice executive compensation while killing share prices and wreaking havoc among rank and file employees. That's why I believe it is time to trying something more radical: an acquiror should not be able to create a stream of reported earnings by writedowns to assets or increases to liabilities. Therefore, post acquisition writedowns of assets and write-ups of liabilities would be charged against the post-combination earnings of the acquiror.

Let's see if the 'new SEC' is up to the task. We'll know they're doing it right if the EU and IASB have conniptions over it.

FAS 141(R): Turning Toxic Loans into Star Performers*

From a MoneyNews.com story published this Wednesday headlined "Banks Stand to Reap Billions from Purchased Bad Loans," came an account of a jaw-dropping transaction. It was spawned by FAS 141(R), the latest and greatest standard on accounting for business combinations:

"When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule [FAS 141(R)] to record impaired loans at fair value, marking down 118.2 billion of assets by 25 percent.

Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank within an accretable-yield balance that could result in additional income of $29.1 billion."

Business combination accounting has forever been fertile ground for earnings and balance sheet management for one simple reason: the opportunity to tweak the amounts reported for the assets acquired and liabilities assumed, with the ultimate objective of brightening post-acquisition earnings reports. But, as tiresome as that old game might be, the kind of maneuver that JPMorgan's management has engineered is a novel twist on an old loophole that had once been closed pretty tightly by the SEC.

The Closed Loophole that Would Be Re-Opened by the FASB

Once the "pooling of interests" method of business combination accounting of APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)), the most basic surviving principle of business combination accounting became thus: the acquisition of a business should always be reflected on the financial statements of the acquiror by assigning a new carrying amount to each of the acquired company's assets and liabilities. This new carrying amount would be updated, based on current assumptions and estimates regarding the future role of the acquired assets and liabilities in the combined entity. The implementation of this principle had long been known as the "purchase accounting" method for business combinations.

With certain important exceptions, SFAS 141 mandated that new carrying amounts for assets acquired in a business combinations would be based on their fair values. The exception that is germane to the JPMorgan story pertains to loans (i.e., trade receivables, interest-bearing loans and marketable debt securities classified as held-to-maturity). The measurement bases for these items were carried forward from APB 16's version of the purchase accounting method: a gross amount reduced by an appropriate allowance for uncollectible accounts. This exception to loan measurement was important, because it also meant that a 1986 SEC staff position would still be applicable to purchase accounting.

At that time, the SEC saw fit to put a stop to unwarranted increases in the allowance for loan losses as part of the business combination transaction. Increases to loan loss allowances would mathematically transfer future loan losses to goodwill, where they would be deferred indefinitely, with the effect of reporting inflated earnings in future periods as the loans were eventually settled for more than their understated carrying amounts. Staff Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit any adjustments of the acquiree's estimate of loan loss reserves, unless the acquiror's plans for ultimate recovery of the loans were demonstrably different from the plans that had served as the basis for the acquiree's estimates of the loss reserves.

FASB Amnesia?

FAS 141(R) did away with the "purchase method" and established the "acquisition method" of accounting for business combinations. It apparently did so out of a belief that measurements of assets and liabilities that are based on the most current information available are usually, if not always, preferable to valuations based on less-current information. The JPMorgan case glaringly points to a significant flaw in that belief: inconsistent application of fair value could be more harmful than consistent application of a less desirable attribute. As to the case at hand:

• WaMu, as is quite common, accounted for its loans based on a held-to-maturity model. That is, except for recognizing declines in creditworthiness, the loan carrying amount is based on the original contractual terms; interest is accrued by multiplying the net carrying amount by the yield to maturity as of the date the loan was originated/acquired.

• Even though the market value of these loans had declined significantly as they turned toxic, WaMu apparently was not required to record losses to bring the loans down to their fair values.

• JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans to market. Subsequent accounting by JPMorgan will continue the WaMu the held-to-maturity model.

It would be a pretty safe bet that JPMorgan was very 'conservative' in their estimates of fair value for the loans; that's because the lower the fair value, the higher the yield to maturity, and the higher the amount of reported future earnings. Of course, there are some limits to JPMorgan's estimate of fair value: auditor pushback, SEC review, increased risk of goodwill impairment charges, and capital adequacy regulations. But, at least in this case, it is possible to become rich without being greedy.

Where is the SEC!?

Maybe there has been more coverage of this issue, but I haven't seen it; kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that bank executives are being overcompensated, especially on the taxpayers' dime, here is a prime example of where insufficient oversight has spawned a new source of moral hazard.

For starters, the SEC should put a stop to this obvious and blatant abuse, immediately. They should issue another SAB, carving out the offending provision of FAS 141(R) and restoring the long-established and functioning status quo. Every company that benefitted from the ill-conceived accounting rule should be forced to retroactively restate their earnings – especially any financial institution on the government dole.

Perhaps the lack of permanent leadership in the Commission's Office of the Chief Accountant is contributing to a lack of attention to this obvious problem, but it is in no way an excuse. Also, this is a problem created by the FASB. Let's be charitable and call it an unintended consequence, but whatever the cause, the FASB should move to fix it forthwith. I'm suggesting that the SEC should act first, solely because they have the demonstrated capability of being able to move the fastest. That's because a SAB doesn't have to be exposed for comment before it can be issued.

But, lacking any actions by either the FASB or SEC to put the cat back in the bag, auditors (perhaps via the PCAOB), and boards should be put on notice of a new potential scheme to inflate executive compensation in the absence of actual value creation for stakeholders. If a single dime of executive compensation comes out of accreted excess earnings from these business combination games, I hope that private securities lawyers will round up the proxies and the lawsuits, settling for nothing less than "a pound of flesh."

A larger lesson is important to briefly discuss in order to understand how this kind of loophole can occur: in accounting for financial assets, the only workable system is comprehensive mark-to-market, all of the time. The current situation is a consequence (intended or otherwise) of the piecemeal approach pursued by the FASB (and IASB) towards fair value accounting.

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*Note:  I made a technical correction to this post, that you can view here.

High Time to Abandon the Accounting for Contingent Liabilities

What the FASB calls "contingent liabilities" in FAS 5, the IASB terms "provisions" in IAS 37. I prefer the IASB's language, because of its pejorative ring to my American ears: it more clearly connotes the virtually unchecked discretion issuers have abused to obfuscate liabilities and trends in earnings.

In a previous post, I described how the IASB has been working on giving issuers even more discretion to manage their provisions.At the same time, the FASB has been fighting the good fight, but getting its butt kicked in the process. Their latest defeat was the issuance of FSP FAS 141(R)-1, to back off of their requirement to measure at fair value contingent liabilities assumed in a business combination.

Part of the FASB's problem is that they still haven't fully come to grips with measuring the fair value of any liability, much less a contingent liability. It seems reasonable enough to aim for consistent measurement of all assets acquired and liabilities assumed; but, how does one measure the fair value of a matter under litigation? Even if it were legal to pay a third party to assume the consequences of a matter in litigation, a 'moral hazard' is likely an unwanted by-product. Specifically, the transferor's incentives to act in ways that could lessen the ultimate consequences of the obligation could diminish significantly. The bottom line: score one for the issuers who fought the offending provisions in FAS 141(R) and made the FASB retreat.

But, as the FASB has retreated in one area, it is retrenching in another with the issuance of Proposed FSP No. FAS 157-f, Measuring Liabilities under FASB Statement No. 157. The FSP, among other things, addresses fair value measurement of a liability when contractual restrictions may prevent it from being transferred. The proposed FSP provides that if a quoted price in an active market for the identical liability is available, that price must be used to measure fair value. In all other circumstances, fair value would be measured by selecting the one approach, of four allowable approaches, that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The four allowable approaches are as follows:

• The quoted price of the identical liability when traded as an asset in an active market;

• The quoted price of the identical liability, or the identical liability when traded as an asset in markets that are not active;

• The quoted price for similar liabilities, or similar liabilities when traded as assets in markets that are active;

• Another valuation technique that is consistent with the principles of SFAS 157.

 

So, as best as I can tell, the issue of measuring contingent liabilities is still not resolved. Since FAS 157 defines the fair value of a liability as the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date (para. 5), it seems that the FSP is providing no help for contingent liabilities. The first three approaches permitted by the proposed FSP are clearly inapplicable, and there is nothing new in the fourth approach that would permit the evaluation of a contingent liability from the perspective of the asset holder.

 

A Solution: Assume There is No Problem

As I mentioned earlier, both the FASB and the IASB have been working on the contingent liability problem in their own separate ways. The FASB has been getting lambasted for their proposals to enhance disclosures and fair value measurement, while the IASB is going on its merry way to see how they can make a new and improved version of chicken salad for issuers. They have been mulling over an approach that would recognize all 'present obligations' (whatever that means), regardless of likelihood of payment, if they can be measured 'reliably' (whatever that means).  Since likelihood of payment is being taken out of the equation, whatever 'present obligation' means is the crux of the matter. And, as it turns out, a hypothetical case scenario that the IASB discussed during its deliberations is a convenient vehicle for me to express how I think contingent liabilities ought to be handled.

Here's the case:

A vendor sells hamburgers in a jurisdiction where the law stipulates that the vendor must pay compensation of C100,000 to each customer who receives a contaminated hamburger. Past experience indicates that one in every one million hamburgers is contaminated. On the last day of the reporting period, the vendor sold one hamburger.

And, here are some questions, along with my responses:

Question #1: Does the vendor have a present obligation at the balance sheet date?

My response: No.

Businesses have many responsibilities under various laws: reasonably ensuring that no physical harm will come to their customers as a result of their actions, truth in advertising, not polluting, and so on and so forth. Although investors would care to know about these exposures and their potential affect on future cash flows it is simply not practical to convey this information through recognition of contingent liabilities on the balance sheet.  It has been vividly demonstrated over the past 35 years that FAS 5 has been in existence that it is a pipe dream to think that reliable estimates can be expected from issuers when doing so conflicts with the interests of executives. (Note as well, that the ability to precisely state an amount for the contingency does not affect my response to this question.)

Question #2: Does the answer change if the probability of contamination is more likely than not instead of one in a million?

My response: No.

This gets at the key issue as to whether the probability of an outcome should determine whether a contingent liability is recognized. I agree with the IASB in so far that the probability of an outcome should not affect recognition. Whatever their reasoning, however, mine is that FAS 5 and IAS 37, which depend on probability estimates, have failed. Moreover, from my point of view, which is different from theirs, it is undesirable to let preparers continue to abuse the opportunities to exercise "judgment" in FAS 5 to manage earnings. The only solution is to restrict liability recognition to legally certain obligations.

Question #3: Should the answer change if the customer who purchased the hamburger claimed it was contaminated?

My response: No, unless it is established with virtual certainty that the vendor has a legal obligation.

I admit that judgment would be required to determine whether a legal obligation exists, but it is significantly less consequential than estimating probabilities and expected outcomes of contingent liabilities.

Question #4: Reverting to the original scenario, should the answer change if the vendor warranted the safety of their hamburgers, and stood ready to pay C100,000 to anyone with a valid claim?

My response: Yes.

The vendor clearly has a present obligation to stand ready to compensate customers who have been served contaminated hamburgers. That obligation is strongly analogous to an insurer's obligation, and should be accounted for the same way. Amazingly, neither GAAP nor IFRS currently require recognition of liabilities arising from a product warranty unless the warranty is separately priced.

Question #5: Reverting to the original scenario, should the answer change if there was a "constructive obligation" to compensate customers who were served with contaminated hamburgers?

My response: No.

Basically, a constructive obligation is defined in both GAAP and IFRS as a non-legal obligation inferred from business conditions indicating that if a payment would not be made, then the impairment of future business prospects would be greater than the payment saved. While there is some justification to be made on economic grounds, the practical problems of inviting preparers to exercise "judgment" once again trump.

In summary, after years of thinking about ways to improve the accounting for contingent liabilities, I am now throwing in the towel on what I have come to see as a futile exercise. By limiting liability recognition to present legal obligations, standard setters can kill two birds with one stone: first, financial statements will become more reliable and auditable; second, some of the difficult issues in measuring the fair value of liabilities that have not yet been satisfactorily addressed would become moot.

Compromising Accounting Principles: A History Lesson (and a Mea Culpa)

(I apologize to anyone who has read an earlier version of this post. Due to a problem with my blogging software, it was not sent out to subscribers. Therefore, I am re-posting it.)

First, the Mea Culpa

Over the year that I have been writing my blog, I have been fortunate to receive kind words every now and then from readers.  Writing alone, being provocative at times, and hitting the "publish" button perhaps too soon to meet a self-imposed deadline often combine to give me an uneasy feeling that I could be sitting way out on a high limb.  It was inevitable that at times I have been accused of being wrong, but never unfair -- until now.

I recently received from two readers similarly critical missives concerning some not-so-nice things I wrote about Jim Leisenring, former FASB and current IASB member. One of the commenters, identifying himself as "Guest," wrote:

"That's a pretty unfair attack on Leisenring with no appropriate context regarding the background of FAS 133. The alternative to FAS 133 was virtually no recognition of derivatives in financial statements. Is it perfect? No. Were compromises made? Absolutely. But it was better than what was there before. And it certainly doesn't indicate a pattern of Jim "capitulating to the majority." If you've ever met Jim [actually, I have], then you know he's not real concerned with what the majority thinks." (comment in brackets is mine)

After thinking about these comments for a few days and discussing it with my genious wife, I have decided that I owe an apology. When I gratuitously remarked that I was not surprised by Jim Leisenring's decision to "capitulate" on IFRS 3(R) because of his past participation in FAS 133, I crossed a line.

The Point I Was Really Trying to Make

Now that I hope I have cleared that up to the satisfaction of all, I want to address the related issue raised by Guest, which should have been the real point of my criticism.  I do not believe that compromising one's principles in crafting accounting standards in the name of incremental progress can be expected to produce a net benefit for investors.

Merely being "better than it was before" (to quote Guest) may still be far from good enough, and there is plenty of U.S. GAAP history to back that up. The table below is a partial list of standards where compromises clearly must have occurred, and serious consequences ensued:

Statement	What Gained	What Lost and Consequences
FAS 87 - pensions	Balance sheet recognition of some pension liabilities.	Timely recognition of gains and losses in pension plans. Plans were mismanaged because of FAS 87.  The toll in shareholder value destruction and lost pension benefits has been enormous.
FAS 13 - leases	On-balance sheet treatment of some leases	Most leases can still be classified as "operating." Managements have misspent vast sums over the past 30 years on financial advisers and auditors because FAS 13 invites unnecessarily complex and inefficient lease contracts.
FAS 133 - derivatives and hedge accounting	Fair valuation of derivatives	Complex and unprincipled hedge accounting rules distort values of other assets and liabilities, or permit deferral of gains and losses from holding derivatives. Managements engage in costly and inefficient accounting hedges that may not result in appropriate hedges of economic risks. The value destruction caused by Fannie Mae's misapplication of FAS 133 may be enough by itself to regard FAS 133 as having failed.
FAS 115 - marketable securities	Current values for some investments whose market value is readily determinable	Securities classified as available-for-sale or held-to maturity categories are mismanaged because ofFAS 115. The held-to-maturity category unreasonably deprives investors of current value information.
FAS 123 - stock options	Grant date present value of options granted to employees	Because of FAS 123's option for footnote disclosure without income statement recognition, excess stock options were granted to employees.
FAS 114 - loan impairment	Consistent measurement of impaired loans	Measurements are still based on historic interest rates, and the criteria for timing of loan loss recognition provide inappropriate discretion to manage earnings. As a result, investors have been deprived of accurate and timely information; management makes inefficient decisions on delinquent loans out of a desire to manage reported earnings.
FAS 141, 142 - business combinations	Elimination of pooling of interests and amortization of goodwill	Costly goodwill impairment test on a number that provides minimal information to investors. As a result, excess financial statement preparation, auditing and consulting costs are incurred.
FAS 95 - statement of cash flows	Converting inconsistent funds flow statements to more consistent cash flow statements.	The direct method of presentation is rarely used, depriving investors of information regarding actual operating receipts and disbursements.  Subsequent attempts to revise this glaring flaw in FAS 95 have failed.

What would have happened in each of these cases if those who those who gave up the fight in the name of incremental progress refused to yield the high ground?  For example, how would derivatives and non-derivative marketable securities be accounted for today if compromises had not been made ten and fifteen years ago? Fair value is still the only plausible answer. The lost momentum of compromise with closure reigns forever and a day.  In the case of FAS 133, it's been 10 years and counting.  As for lease accounting, it's been 30 years and even getting a second wind no less; the FASB has recently announced that it is limiting the scope of the project to revise lease accounting rules, which has already dragged on for far too long.  I may be able to add to my list of compromises with negative examples, and I cannot think of a single compromise that ended up as a standard making those who compromised eventually look like heroes instead of patsies.

My point is that the absence of patience and fortitude can leave its stain on accounting standards for generations.  The IASB's process leading to IFRS 3(R) tells me that the lessons of history demonstrating the futility of compromise go unheeded by the putative heirs to U.S. GAAP.

I have read from numerous sources that adoption of IFRS in the U.S. is regarded to be "inevitable." I don't know about that, but I am convinced that uneconomic mergers doing immeasurable harm to both shareholders and work forces will occur because of IFRS3(R)'s loosey-goosey business combination standards. Even more important, if the non-U.S. members of the IASB come to understand that we in the U.S. are effectively committed to allowing sausage-factory-style accounting standard setting in our capital markets, we will be doomed to a steady diet of sausage.

That's why Jim Leisenring should not have voted for IFRS 3(R). 

The Revisions to IFRS 3: Bad Enough to Abandon Faith in IFRS?

In my previous post, I described how an SEC honcho, while speaking to the choir at an event sponsored by FEI, espoused his version of faith-based accounting; though he could not provide a single, solid reason to explain why the U.S. should adopt IFRS, he has seen the light and has become a true believer.   In contrast, reason-based accounting permits recitation of a vast litany of blasphemies against IFRS to make one a serious, if not committed, agnostic.  Today, I write of one of these latest abominations: the latest revision to IFRS 3 on the accounting for business combinations.

Goodwill and NCI:  IASB Fakes Right and Goes Left

Perhaps the most significant development in the accounting for business combinations is that FAS 141(R) now requires the same basis of measurement for assets acquired and liabilities assumed, regardless of the percentage of a company acquired (so long as control is achieved).  Therefore, if control is attained without purchasing 100% of the existing equity interests in the acquiree, non-controlling interests (NCI) must be measured at full fair value. 

As you may be aware from reading my post "What Good Comes from Goodwill Accounting?", I am not a big fan of recognizing 'goodwill' under any circumstance, so I will grant that the justification for the FASB's approach is not airtight.  Nevertheless, it was common knowledge that the FASB was given to understand that, by sticking its neck out to make these controversial changes to FAS 141(R), the IASB would follow suit. 

Instead, the IASB renegged on its promise in the worst way imaginable: they voted to allow entities a free choicebetween the partial and full fair value alternatives to goodwill and NCI measurement.  What's more, issuers can make their choice on a transaction-by-transaction basis -- kind of like going to church one week and synagouge the next.  Not even the most devoted acolyte can spin this any other way except as a significant step backwards from establishing the IASB as a credible agent of quality financial reporting and investor protection. 

And, it's not just me who is outraged.  Read the strongly-worded dissents* of Mary Barth and John Smith, two of the three Americans on the IASB.  As to the third American, Jim Leisenring, I guess I shouldn't be surprised that he capitulated to the majority.  Leisenring was the most prominent voice in support of FAS 133 (on hedge accounting) when he was on the FASB; a standard whose middle name is inconsistency.  Be that as it may, one can only imagine where the IASB will take the interests of U.S. investors when our membership, and hence our influence, on IFRS inevitably wanes. 

Mind These GAAPs, Too 

If the unprincipled and unconstrained choice of accounting treatments for goodwill and NCI aren't enough for you to abandon any faith in a high-quality convergence, consider two more of the numerous departures from U.S. GAAP; these may be even worse.

First, the devilish game of managing the timing of contingent liabilities still thrives in IFRS.  FAS 141(R) now requires that any non-contractual, contingent liability assumed in a business combination must be recognized at fair value, if the probability of occurrence is more likely than not.  IFRS allows any contingent liability to be recognized, regardless of likelihood, if it can be reliably measured. 

As I discussed in a previous post on IASB machinations of contingent liability accounting, the ubiquitous criterion of "reliable measurement" is one of those areas of "judgement" in IFRS that help management make their numbers with little chance of being challenged by auditors.  Here is how this game will be played in a business combination under IFRS 3(R):  if management thinks that goodwill won't be impaired any time soon, they will recognize contingent liabilities to the max.  The effect is to create an earnings bank of liability writedowns when unlikely events become, as anticipated, resolved without the incurrence of an actual liability.  And speaking of inconsistency, IFRS 3(R) provides that all intangible assets are to be recognized, even if their fair values cannot be measured reliably.  Where is the "principle" for that one? 

Second, FAS 141(R) requires extensive disclosures that are designed to aid analysts in determining the past and future effect of a business combination on earnings and financial position.  For example, FAS 141(R) requires the following disclosures:

• The amount of revenue and earnings of the acquiree since the date of acquisition. 
• Revenue and earnings of the combined entity for the current period as though the acquisition had been consummated as of the beginning of the period
• Revenue and earnings of the combined entity for the previous period, as if the acquisition had been consummated as of the beginning of the previous period. 

Inexplicably, IFRS does not require the third item, above.  Therefore, inferences as to earnings trends of the combined entity from historical financial statements are defeated.

The recent activities of the IASB, the high priests of IFRS, confirm that they are most definitely not the august body to which the future of U.S. financial accounting standards should be entrusted.  To those who persist in practicing faith-based accounting, put IFRS's accounting for business combinations in your pipe and smoke it.

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*Unlike statements of the FASB, IFRS publications are not freely available.  Just thought you might want to know why I didn't provide a link.