The Accounting Onion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

 (Click here for Part 2)

 

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Following my most recent post on financial statement presentation, Eddie Thomas, a frequent commenter of this blog, wrote: "Wouldn't investors be better off pushing for a more robust XBRL so that they can make their own decisions about what is relevant information and what is not? It seems like an effective end run around the politics of the FASB and the IASB."

I agree with Eddie to a point, but I am afraid he may be discounting the "garbage in, garbage out" rule of data processing. The information value of "robust XBRL" heavily depends on the granularity, uniformity and quality of inputs. As to whether GAAP or IFRS has attained a quality level even approaching 'satisfactory' is, as Eddie implies, highly debatable. With respect to granularity and uniformity, it's not even a close call -- hence the financial statement presentation project in the first place.

But, what I am about to suggest can make Eddie's wish to "end run" politically motivated accounting standards come true: balance sheet account reconciliations. In that last post, I suggested that one of three important things that the Boards could do would be to provide reconciliations of the beginning and ending balances of all balance sheet accounts. The other two were to mandate a direct-method statement of cash flows and to maintain a strict separation between financial and operating items. Upon further reflection, the reconciliations would be the single most important thing the Boards could do. It would also be the simplest and most logical way to do raise the level of financial reporting on all dimensions. Here are just three examples.

Example #1: PP&E

A reconciliation of PP&E can provide a separation of depreciation charges by function, and highlight the effect of discrete events hitting the income statement that are widely regarded to be of interest to investors: e.g., business combinations, restructurings, discontinued operations and impairments.

Perhaps some of this information can be teased out by the FASB/IASB proposal, but certainly not all of it. But, the FASB/IASB proposal would subject much too much to management's whim; and without detailed mandates it would be difficult to develop consistent XBRL tags.

The last two items in the reconciliation example clearly go beyond the FASB/IASB proposal: the effect of capitalized interest, and changes in the balance due to "translation" of accounts on the books of foreign subsidiaries at current exchange rates. The transparency of capitalized interest is essential to investors whose first analytical objective is the isolation of the effect of financial decisions on "operating" profits. The effect of foreign currency translation allows the investor to unwind the purely random effect on comprehensive income from multiplying a historic cost by a current foreign currency exchange rate.

Example #2: Inventories

The inventory example has a couple of extra twists. First, methinks it is not well-known that U.S. GAAP permits the capitalization of interest costs in inventory (IFRS does not). Also, "fair value hedge accounting" under both FAS 133 and IAS 39 permit the historic cost of certain inventories to be adjusted by gains and losses due to certain "hedged risks." The result of fair value hedge accounting on the carrying amount of inventories (and other assets/liabilities) is a process that I heard Tom Linsmeier refer to (prior to his being appointed to the FASB, of course) as "mutt" accounting – i.e., neither historic cost nor fair value. If comparability is truly the key reason for U.S. adoption of IFRS, then the Boards should be seeking to enhance comparability generally, and not merely through IFRS adoption. This should mean that investors are entitled to data for unwinding the effect of hedge accounting, a free choice creating lack of comparability, whenever it is applied.

The IASB/FASB proposal calls for disclosure of expenses by "nature" if management deems it to be significant information. Instead, I would require, where applicable, a statement of cost of products manufactured (i.e., a reconciliation of production costs and changes in inventory balances to cost of sales). The components of cost of sales could be highly informative, and, like reconciliations of balance sheet accounts, they are already being prepared for internal control purposes. Besides, undergraduate accounting students learn how to prepare a statement of costs of goods manufactured in their second semester!

Example #3: Trade Receivables

I include this example in part to illustrate that some legitimate foreign exchange losses are hidden in other comprehensive income (i.e., the translation adjustment). These gains and losses, which are derived from assets and liabilities held on the books of foreign subsidiaries (whose functional currency is not the dollar), are no different in their economic substance from other foreign-currency-denominated accounts receivables on a domestic subsidiary's books. Yet, by a 4 – 3 vote, the FASB decided that they should be presented differently.

Reconciliations are a No-Brainer: That's why Investors Can't Have Them

Imagine having those reconciliations along with programs that can read XBRL data! Service providers would be competing with each other to create the very best 'out of the box' analytics, and just as Eddie predicts, users won't even bother glancing at the financial statements as presented by management and the sleep-inducing narrative disclosures written to obfuscate rather than enlighten. The oil and gas industry could stuff their cherished interest capitalization where the sun don't shine, and multinationals could do the same with their foreign exchange translation gyrations.

But, the reasons why we don't currently have reconciliations are the reasons we won't get them. Managers must continue to make value-destroying choices for the sake of the accounting results that, with reconciliations, could be easily unraveled and even prevent fraud. Even though S-OX essentially requires that these reconciliations must exist somwhere in the bowels of each issuers' accounting system, auditors could not abide the prospect of providing each and every investor with the opportunity to perform its own 'analytical review' from which its own could be second-guessed. 

So, there you have it: the result of a couple of days of talking to myself, as opposed to millions of dollars spent by the FASB and IASB to solemnly deliberate for seven years such weighty issues such as whether the direct method for the statement of cash flows should be required, and a bunch of ad hoc ideas like separate identification of recurring and non-recurring revaluations.

If there is hope for improved financial statment presentation, it may be with new leadership of the SEC.  Historically, disaggregation has been under the purview of the FASB or the SEC. For example, SEC Regulation S-X is the main repository of presentation guidance for public companies. About a dozen years ago, the SEC, as a favor to issuers, eliminated supplemental schedules set forth in Reg. S-X that required details on the movements in long-lived assets. But about eight years ago, it also proposed to augment disclosures of the movements in so-called "valuation and qualifying accounts." The proposal was never acted upon, with the advent of S-OX serving as the official excuse. But, intense lobbying against the proposal by the usual suspects is the only plausible scenario.

I am not necessarily saying that the SEC should be taking over this project, but presentation has long been the purview of the SEC, and the FASB is falling way short. The purpose of S-OX in providing an independent funding source for the FASB is to free the FASB from undue influence, so as to carry out its mission in an unbiased and timely fashion. How could something as straightforward as financial statement presentation take seven years (and counting), if it were not for the meddling of special interests? Intentionally, or not, the FASB has neutered itself, and harmed the interests of U.S. investors by agreeing to join forces on the project with the IASB – which is not independently funded, and more than ever appears to be under the thumb of the European Union.

Financial Statement Presentation: The Sequel

Two readers, including Robert Bloomfield, Cornell accounting professor (my alma mater!) and Director of the Financial Accounting Standards Research Initiative (FASRI) of the FASB, were kind enough to point out an error in my previous post. Here is the gist of what Prof. Bloomfield had to say (his full comment is here):

"… you link readers to the 7-page summary document, but there is a lot more than that. …The discussion paper is quite long and detailed, including elaborate examples of a manufacturing and a banking company.

Also, one very interesting aspect of the proposal is a reconciliation footnote that would reconcile, line by line, the cash flow statement to the income statement. The differences are broken into various categories including accruals, fair value remeasurements, other remeasurements, etc.

So if you are opposed to capitalized interest, you are likely to be able to undo a fair bit of that through the footnotes."

Indeed, I mistook the summary of the DP, which was separately posted on a different page on www.fasb.org, for the entire document. My bad. I guess the page numbering in the summary should have tipped me off that there was more to come. But as a feeble defense, the FASB could have made the project page more user-friendly by posting a link to the complete DP right on the project page itself.

Much more important, is that I am happy to have discovered that the Boards may be proposing some significant changes that can result in incremental information for financial statement users. But, in all of the extra data, what may be some of the most sensitive items are still artfully concealed. Notwithstanding Prof. Bloomfield's statement that I should be able to discover more about interest capitalization, "more" is not enough when "all" is easily achievable and principles-based.

Along the same lines, there is nary a scintilla of disaggregated information regarding the effects of foreign currency translation on earnings, assets and liabilities. As I have pointed out in previous posts, FAS 52 creates some pretty crazy effects: translating the fixed assets on the books of foreign subsidiaries at current exchange rates is nothing more than random number generation; gains and losses on foreign-currency-denominated monetary items held by foreign subsidiaries are not presented in a manner consistent with identical exposures that happen to be on the books of domestic subsidiaries.

Making Financial Statement Presentation Simpler – and Much Better

Even though the Boards hide behind a self-imposed constraint to excuse themselves from consideirng recognition and measurement issues, they can still make the effects of some of their most ridiculous rules much more transparent than they are currently proposing. Here's three frustratingly simple things, which if implemented would far exceed the benefits of their current proposal:

1. Along the lines of the logic I presented by the name Largest Possible Entity, maintain a strict and principled separation between financial and non-financial elements in the balance sheet and income statement. Call me cynical, but I simply can no longer accept that giving management any discretion whatsoever over financial statement presentation will result in higher quality or especially more comparable information (the putative goal of IFRS and U.S. GAAP convergence). Every student of finance is apprised at some point that Modigliani and Miller received their Nobel Prizes in large part for seeding the conversation that financial decisions are fundamentally different than whatever one cares to call the rest of the things that management does. The LPE concept is merely an accounting child of their enduring insights.
   
2. Mandate the direct method for the statement of cash flows. The format for the statement of cash flows proposed in the DP is pretty cool, and so is the reconciliation of cash flows to comprehensive income. I also like the new definition of operating cash flows that would comprehend expenditures on assets. But, all of that is icing on the cake compared to simply eliminating the indirect method alternative that was provided at the eleventh hour by the FASB in SFAS 95. Waiting for this simple change seven years after Enron has conditioned me to not ask for too much in this regard.
   
3. Require a reconciliation of the beginning and ending balances of each account on the balance sheet (I still can't bring myself to 'statement of financial position' for an accounting that suspends rules of arithmetic I learned in first grade). If reconciliations are done properly, users can unwind all sorts of silly things – of which the aforementioned interest capitalization, random number generation through foreign currency 'translation' and inconsistent treatment of foreign exchange gains/losses are but three examples.

   The proposed reconciliation information is much too vague, and again is subject to obfuscation by management. Get ready for the naysayers to dismiss this suggestion as impracticable. But, if Worldcom's auditors had actually reconciled the beginning and ending PP&E balances, they would have been heroes instead of goats – and Cynthia Cooper, the Worldcom employee who blew the whistle on Bernie Ebbers et. al. would be memoirless. Especially in these days post S-OX 404, shouldn't each and every consolidated balance sheet account be reconciled? If not, what's the point of "internal controls over financial reporting"?

   In my next post, I'll provide a couple examples of the simple form of reconciliation I have in mind.

Some Additional Tidbits

First, the first paragraph of the DP states that Phase A of the project addressed "statements that constitute a complete set of financial statements… and … Phase B would address more fundamental issues relating to presentation and display of information … including … reconsidering the use of a direct or an indirect method of presenting operating cash flows." [para. 1.1, italics supplied]

Fundamental? More like "highly controversial"! Maybe I'm missing the boat here, but Phase A is the "fundamental" issue, and Phase B is detail—albeit important detail. The DP process could be much more constructive if the Boards would simply set forth the reasons why investors would benefit from a direct method cash flow statement; and more important, why issuers stubbornly resist the wishes of investors. The absence of a willingness to openly acknowledge the actual controversies does not bode well for a satisfactory outcome.

Second, the third paragraph of the DP states that FARSI, Prof. Bloomfield's group, "…will study investor use of financial statements prepared using the proposed presentation model by conducting a series of controlled tests." [para 1.3] To test what? What parts of the DP are even amenable to controlled experiments?

Notwithstanding the unnecessary vagaries, I have to say that I'm not sure that any testing will provide actionable results. Controlled experiments in accounting overwhelmingly tend to address very narrow research questions whose results are difficult, if not impossible, to validly generalize. My fear is that results that merely weakly support the preliminary views expressed in the DP will be over-generalized by vocal proponents of an anti-investor agenda.

But, setting that cavil aside, my greater concern is that investors will provide some "statistically significant" indication that the new presentation format represents an "improvement" over the mishmash of statement and disclosures currently being fed to them – a pretty low hurdle given the current sad state of financial reporting. That "empirical evidence" will be seen as supporting the proposed changes, tepid as they are, and thereby rendering really needed changes to the bottom of the priority pile for another twenty years. If you need evidence, see FAS 115 and that ugly "other than temporary impairment" standard that currently plagues us in the midst of our economic crisis; or SFAS 95, allowing the indirect method. GAAP is littered with disastrous standards that were passed by narrow margins with at least some board members expressing disappointment, but justifying their "yea" votes as compromises in the name of some modicum of progress. Will the Boards be playing the same sorry tune one more time?

Third, the absence of any discussion of XBRL in the DP indicates that both Boards might prefer that XBRL's significant implications for disaggregation of financial information – the more the better – be swept under the rug for a while. Soon may come the day, perhaps even before a final standard becomes effective, that the value of static presentations will fade to dust compared to simple software programs that generate financial statements in accordance with each user's very own preferences. Thus, the real reporting issue of the near future is not presentation, but rather disaggregation.

Having said all that, I'll conclude by stating that I fundamentally object to a management approach. I also have little confidence that the detailed disclosures regarding cash flows, much less the direct method, will be accepted by the IASB. Financial statement presentation was not designated as a convergence topic in the fabled Norwich Agreement, and I believe that the FASB erred in agreeing to conduct the project jointly with them. I believe they chose to form a cartel on this one, because not to have done so would have once again spotlighted the IASB's record of reluctance to push back against their funding sources.

Evidently, the FASB feels that it is a far better outcome to end up with a watered-down presentation standard that won't be revisited for another twenty years than it is to jeopardize IFRS adoption in the U.S.

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

This past October, the FASB and IASB issued a joint discussion paper with their preliminary views on financial statement presentation:

"[The IASB and FASB initiated the joint project on financial statement presentation to address users' concerns that existing requirements permit too many alternative types of presentation and that information in financial statements is highly aggregated and inconsistently presented…" [¶ S1]

Both boards commenced work on separate projects in 2001, and seven years later have barely anything to show for it except for this five-page document, which amounts to little more than a proposal to re-arrange the living room furniture. For the sake of completeness, I should also point out that the IASB did also make a few minor alterations to IAS 1 that mainly catch up IFRS to GAAP in respect to reporting dirty surplus – whoops, I meant "other comprehensive income."

To give you some sense of the nature of these deliberations, such as they have been, I can draw on a personal experience. After the Enron debacle, the lack of transparency afforded by the indirect method of presentation for the statement of cash flows rightly became a focus of critics. In Enron's case, it would have been kinda sorta nice to be aware of how little cash Enron was getting from its customers. Six months following Enron's implosion, I attended the annual reunion of alumni from the SEC's Office of the Chief Accountant. At a presentation to our group, the erstwhile Chief Accountant assured us that the direct method of presentation of cash flows would soon become required. Supposedly, there was a clear consensus that this was the right thing to do.

That was more than six years ago, and nothing whatsoever has changed, other than that we're knee deep in another financial debacle. The preliminary views document disingenuously continues to spout the party line in support of the direct method, and even for further disaggregation of cash flow information. If this were solely an FASB decision, and if President-Elect Obama appoints a non-partisan SEC Chair (I'm rooting for Charles Niemeier), then I might have some reason to hope. But, there's no way this sort of change will find its way into IFRS. EFRAG (European Financial Reporting Advisory Group), and perhaps China, will contrive some sort of excuse that it would harm the ability of companies in their part of the world to compete; and the proposal will fade to black yet one more time.

Another proposal that would have some merit if it weren't watered down with weasel words is, "An entity should further disaggregate its income and expense items by their nature within those functions to the extent that this disaggregation will help users in predicting the entity's future cash flows." [¶ S11, italics supplied] For example, cost of sales would be disaggregated into materials, labor and other components. But, who would decide what "will help users"? Answer: management, of course, because that is the consistent theme of IFRS – trust management to do what is right. If this were an FASB-only project, I'd bet that the document would include examples and illustrations of the principle functional categories to be disaggregated, together with the principle components of the disaggregation.

Separating Financing from Everything Else

No presentation format can be satisfactory unless it assists readers in assessing the performance of a company, independent of any decisions regarding financing that management made. That's why I am so strenuously opposed to the capitalization of interest costs in any way shape or form: assets values should be reported independent of how they are financed, and financial items affecting profitability should be separated from all other revenues and expenses.

Thus, the cockles of my heart warmed as I read these noble words:

"The proposed presentation model requires an entity to present information about the way it creates value (its business activities) separately from information about the way it funds or finances those business activities (its financing activities)." [¶ S4]

But, then, reality intruded upon my reverie as I read the following:

"The classification decision would reside with management…. The Boards support a management approach to classification rather than a prescriptive approach because they believe it will result in financial statements that reflect how management views and manages the entity and its resources." [¶ S6, italics supplied]

In other words, what constituted financing or "business activities" would be subject to the discretion of management. That's not quality financial reporting, it's farcical financial reporting. But perhaps the boards saw no other way to protect interest capitalization, that sop to the oil and gas industry. Also, don't count on management to disaggregate the interest component of cost of sales, or the cost of anything else.

The main point of this post is to demonstrate that the choice between a "prescriptive approach" and a "management approach" is a false choice. A third alternative, as always, is a principles-based approach.

The Principle of the Largest Possible Entity

The late Tom Burns, one of my mentors, once remarked that the most fundamental problem of financial reporting was choosing the entity of account: in other words, the boundaries that marked the affairs of the entity, and the affairs of others. I didn't fully appreciate that statement until too many years later. I was trying to think of a way to explain to my students in a managerial accounting course how the topics for such a course were selected. I eventually decided that managerial accounting explored decision making scenarios in which managers would decide which "real", or "productive" resources a business should acquire, and how best to put them to use. Questions of financing the resource acquisitions would be explored elsewhere in the curriculum.

That was fine and good, but I needed to have a way to explain what was "real" versus merely "financial." This is when, and I can't explain why, I came back to Tom Burns' observation. I asked myself, what would financial statements look like for the largest possible entity (LPE) – as if the universe were one big happy family? In other words, what if all the entities that existed, personal, corporate, government, etc. were consolidated/combined? This is my depiction (units of measure are arbitrary and only for purposes of illustration):

The Largest Possible Entity
Consolidated/Combined Balance Sheet
December 31, 20x1
Inventories	$   100
Plant and equipment	200
Natural resources	300
Knowledge	400
Total assets	$1,000
Equity	$1,000
Consolidated/Combined Income Statement
Year ended December 31, 20x1
Production revenue	$ 500
Utilization of resources in production	400
Net income	$100

 

The most important lesson from the balance sheet is that all of the assets that remain upon elimination of reciprocal accounts are the "real" assets. Therefore, financial assets and liabilities are distinguished by their absence on the balance sheet of the LPE. For example:

• There is no cash on the LPE's balance sheet. The entity already owns and controls all of the goods and services in the economy, so cash is of no use, except perhaps for the paper it is printed on.
• There are no receivables, derivatives of any kind, or liabilities. They all offset, or eliminate, as "intercompany" transactions.
• There are no investments in other entities, because the LPE can't recognize an investment in itself as an asset.

The only categories of revenue and expense that can appear on the LPE's income statement are revenues from the production of real goods and services and expenses from the use of the assets as inputs to the production of those goods and services. Like all receivables and payables, financial revenues and expense are reciprocal items that cancel out.

From the above, I derive the following simple principles that can be the fundamental basis for a financial statement presentation standard:

• Only those assets that are not eliminated in the consolidation/combination process to arrive at the balance sheet for the "largest possible entity" (LPE) are "real," or call them "operating" if you want. All other assets and liabilities are to be reported as financial in their own separate categories.
• Operating expenses are the utilization of real assets in the production or real goods and services. All other expenses are financial.
• Operating revenues are either (1) the measure of the assets (real or financial) that an entity becomes entitled to for having transferred real resources or for having provided real services; or (2) the measure of the reduction in liabilities that an entity is entitled to from having transferred real resources or provided real services. All other revenues are financial.

Thus, the fundamental distinction to be made in financial presentation is between those items on financial statements that are, or are derived from, real versus financial assets and liabilities. If the boards want to give management the discretion to decide what is "operating" and what is "non-operating", that would be fine with me, just so long as financial items are not conflated with real items in any financial statement. Especially after this latest financial debacle, the potential usefulness of this fundamental distinction should be more apparent than ever.

The day may yet come when we will be freed from the eccentricities of financial statement presentation foisted upon investors by managers who have no interest in giving shareholders more information about their actual performance. Sad to say, after seven years of waiting for a five-page, joint preliminary views document, that day will be no closer if the next generation of SEC leadership doesn't give the accounting standard setters a swift kick in the pants.

On that note, I even sent the gist of my LPE principle to a senior staff member of the IASB a number of years ago, not long after the IASB announced the commencement of its financial statement presentation project. His initial reaction was positive, but after I offered to help develop the idea further, I received no further response. I now invite you, kind reader, to be the judge.

FSP APB 14-a: How Long Should it Take to Close a Loophole the Size of Arthur Andersen?

APB 14 was promulgated in 1969 when we were still pretty much in the dark ages with respect to the valuation of derivative financial instruments.  The Opinion addressed two issues, one of them being the accounting for convertible debt. Since the debt features were inseparable from the option to obtain shares (i.e., you gave up the right to the debt payments if you exercised the option to receive shares), separate accounting for the debt and equity features could not simultaneously value both components of this particular hybrid financial instrument. 

Thus, the APB found it in their hearts to allow that convertible debt would be accounted for as if it were straight debt--so long as the debt features were not set at nominal levels.  The rule was chicken salad for companies, for to account separately for the debt and equity components of convertible debt would have meant reporting interest expense at higher rates. 

Apparently, though, the earnings game knows no bounds, as CFOs soon began to tinker with the features of their convertible debt with the objective of circumventing the recognition of potential EPS dilution that could result from additional share issuance.  Eventually, the EITF 'jumped on their bandwagon in EITF 90-19 by conveniently making a bogus connection between cash-settled and equity-settled convertible debt.  But, as I just explained, the APB's justification for single instrument accounting was that if you exercise the option, you lose the cash; but, in a cash-settled option you don't have to give up cash to get the value of the shares. Notwithstanding that annoying detail, the EITF allowed that cash-settled equity conversion options, and variations thereof, could also be accounted for as a single debt instrument, and to sweeten the deal, would also be given more favorable EPS treatment than equity-settled convertible debt.   

"Questions Were Raised" ... "Mistakes Were Made"

Now, 17 years later, here is what the FASB has to say about EITF 90-19:

"Because of the proliferation of such instruments in the marketplace over the past several years, questions were raised [how beautiful the passive voice!] as to whether the accounting guidance in Issue 90-19 appropriately reflected the economics of those instruments." (Proposed FSP APB 14-a, para. B2)

Are we to believe that the EITF, FASB and SEC were unaware of these "questions" 17 years ago? The EITF was tasked earlier this year to finally take their chicken salad off the menu, but evidently they couldn't bring themselves to be the ones to deprive their constituency (basically, the clients of the large audit firms) of something that tasted so good, and could be swallowed practically without chewing.  So, the FASB gave its staff the dirty work, and the result is proposed FSP APB 14-a (in other words, it's not yet a done deal).   

The Even Bigger Issue that Keeps Me Blogging

Ed Teach of CFO.com has written a fine article explaining that separate accounting for the debt and equity features will be required, with the result being that reported interest expense will increase and EPS will decrease by adding shares to the denominator of the diluted EPS calculation.  Ed closes the article by quoting a bigwig investment banker lamenting that the new FSP would effectively put an end to cash-settled convertible debt. 

That last part really gets me. A popular tactic of 'financial management' owed its existence to a bad accounting rule.  Where have I heard this before? What portion of the productivity of enterprising managers has been wasted in self-interested quests to devise financial arrangements whose sole or main benefit is the exploitation of accounting rules that have been tailor-made for exploitation? 

In too many cases, the FASB and SEC should be held to account for the vast destruction of capital that has occurred by allowing abuses like this one to go on for far too long.  In addition to cash-settled securities, examples that easily come to mind are defined benefit pension plans, executive stock options, so-called 'special purpose entities,' ill-conceived mergers and acquisitions, ad nauseum.

Sadly, I don't anticipate that I will be running out of topics to blog about anytime soon.

IAS 23 and FAS 34: Political Interests Trump Accounting for Interest

In Finance 101 it is taught that the decision to acquire assets involves two steps.  First, you figure out which assets you want to acquire (capital budgeting), and second, you figure out how to pay for them (capital structure).  If accounting should represent this process in a faithful manner, interest must be seen as a financing cost, separate from the cost of acquiring the asset.  If you need further convincing, think about this example:

• Two debt-free oil companies undertake to build refineries, with construction costs of $1,000.
• One company pays for its refinery by issuing stock and the other by issuing debt.  Accrued interest on the debt to the date of refinery completion is $100.
• Common sense dictates both assets would be measured at $1,000.
• FAS 34 defies common sense: one company reports assets of $1,000, and the other $1,100.

As you can already tell, I have no problem finding things to criticize about GAAP, but no pronouncement offends me more than FAS 34.  To require interest capitalization is not merely senseless, it was nefariously designed to smooth the earnings of the largest industrial companies and to defeat the efforts of analysts to measure operating expenses separate from financing costs.

Now comes the IASB, newly reconstituted just a few years ago (albeit still dependent on funds from corporate interests), and purportedly to increase the quality of financial reporting by faithful adherence to its conceptual framework.  Mary Barth, an IASB member from the U.S., and her Canadian colleague informed the members of a seminar I attended that they were asked to affirm their faithful adherence to the conceptual framework upon joining the well-compensated board.  It warmed the cockles of my heart to learn that international accounting standards were principles-based and could no longer be corrupted.

Under IAS 23,  prior to the reconstituted IASB getting its hands on it, two accounting treatments were permitted: (1) the benchmark treatment was to apply common sense--non-capitalization of interest costs; (2) the allowable alternative permitted senseless capitalization.  Yet, a few months ago, the IASB amended IAS 23 to be 100% senseless by requiring capitalization of interest.  There can be no reasonable basis for their position, and I report herein what was written as their basis for revising IAS 23 for your amusement:

1. Eliminating a difference between IFRS and GAAP is real progress (i.e., two wrongs can make a right).
2. Allowing only one method will enhance comparability (not true--see above example).
3. It will improve financial reporting (for reasons unstated).

and the best was saved for last:

"The Board further noted that both IAS 23 and SFAS 34 Capitalization of Interest Cost were developed some years ago. [FAS 34 is 20 years older than IAS 23.  IAS 23 is only 9 years old.] Consequently, neither set of specific provisions may be regarded as being of a clearly higher quality than the other. [Huh??] 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." [comments added by yours truly}

In short, the most baseless basis for conclusions I have ever read.  If the new IASB were a virgin, it is now despoiled.