The Accounting Onion

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

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

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

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

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

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

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

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

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

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

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

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

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

Bringing Back the Dead

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

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

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

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

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

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

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

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

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

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

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

 

Why Nothing Sticks to Auditors when Loans Go Bad

I read numerous news sources this week echoing the SEC's announcement that it finally has a case it thinks it can win against auditors stemming from the 2008 financial crisis. One journalist, Jon Weil of Bloomberg, takes it a step further to ask, 'What took so long'?

"It has been frustrating to look at the SEC's own highlights of the lawsuits it has filed in connection with the financial crisis -- and to see that none of them had been against an auditor. Now the SEC will have one case to cite, albeit against a couple of small fries. It also should be stressed that the agency hasn't proved any of its allegations against these two accountants. Surely the SEC can find some bigger targets out there in the auditing world if it wants to. [emphasis added]

Actually, Jon, it can't.  The paucity of enforcement actions against auditors surely has not been for lack of trying. But, just as surely, auditors have not been doing much lately to protect investors and to promote economic stability. The topic of audit reform in response to the financial crisis has been everywhere in both the U.S. and Europe (except perhaps where it counts the most – at the SEC).

The SEC announcement comes coincidentally right on the heels of the FASB's proposal to make changes to loan accounting. Which adds another question to Jon's: would better loan accounting standards beget higher quality audits? But more on that later. First, let's discuss why auditors have been to financial reporting as Teflon is to frying pans – nothing sticks.

 

The Problem of Auditing what Managers See through Rose-colored Lenses

I've explained this before, but it bears repeating. Several financial elements are capable of being determined objectively (e.g., cash and contractual amounts for receivables and payables). Auditors are trained to verify these financial statement inputs by counting, reading, confirming, etc., and they generally do an outstanding job at this kind of work – for which any CPA is eminently qualified.

However, dozens of financial statement elements depend on management's subjective estimates of unknowable future events and myriad scenarios based on complex contracts that are often engineered solely to confound. The problem of audit reliability is almost entirely due to requirements for the auditor to state that management's judgments (in which they often have a direct interest) and mere representations of intent "appear reasonable." The impossibility of auditing the ineffable cuts to the heart of any bubble-induced banking crisis – past, present or future.

As Jon Weil observes, even if the SEC prevails in its modest quest to hold at least a couple of auditors accountable, the message value will be minimal. Moreover, for the reasons I've just stated, there is reason to fear that the SEC won't get its case past an administrative law judge (ALJ).

The SEC's case reads well. The auditors allegedly should have seen that internal controls were inadequate, they had reason to know that management's estimates were biased, and they ignored important information concernin the value of loan collateral. But, there are at least two sides to every story; and the SEC may have to meet a very high standard for its side to prevail.

If the auditors don't settle, then (follow me on this one) the SEC will have to convince the ALJ that the auditors acted "unreasonably" by not concluding that the numbers fed to them by management were themselves "unreasonable." Basically, the SEC has two shots, and I have feeling that neither one is a slam dunk. Under Section 4C of the Exchange Act, the SEC can show either one of the following: at least one instance of "highly unreasonable" conduct; or "repeated" instances of merely "unreasonable" conduct that together indicate "lack of competence."

I don't want to get into a lot of details here, but these particular standards are less than 20 years old; and they have not been tested in court very often. What is important to know (and the irony to appreciate) is that in an audit engagement or in a court of law, determining what is reasonable in the context of financial reporting is a quixotic venture. It may not matter that in this case, according to Jon Weil, the bank regulator – and not the auditor – caught the accounting errors; and the auditor resigned only weeks before the bank failed in 2010. As a matter of law, none of that may speak to the question put before an ALJ.

My guess is that the auditor is willing to put the SEC to its proof because they estimate that there is a good chance of prevailing. If they do, it will be helpful in defending against all sorts of civil litigation, where the real money is involved. (By the way, Section 4C which was added by Sarbanes-Oxley in 2002, does not permit the SEC to seek monetary damages from accountants. Maybe it should?)

 

The Only Way Forward

If I am right about the reasons why auditors have avoided SEC sanctions for their shoddy bank audits, then one must also conclude that the FASB's and IASB's proposals will accomplish nothing. Readers of financial statements will continue to be at the mercy of management wearing rose-colored lenses in bad times and creating rainy-day reserves in good times; and auditors will look on with impunity.

The facts are that holding management ultimately accountable for the accuracy of financial statements doesn't work anymore (if it ever did). Different auditing standards won't make the audit more reliable as a deterrent to financial manipulation, so long as management has the license to do the estimating – and to hire and fire the auditors.

Fundamental change is required, and that can't happen by simply leaving the IASB and FASB to their own devices. Beginning with the premise that investors want information from reliable sources that are independent of management, the only way forward is for reporting of loans to be based on fair values, which are produced by independent valuation experts. If that can be made to happen, then auditor involvement can be limited to things that every CPA already knows how to do:

• Verify the inputs to fair value measure that can be objectively measured;
• Attest to the adherence of professional standards by the independent valuation experts;
• Verify that the independent valuation experts performed the procedures they were supposed to perform.

Auditors might make less money on audits, but there are benefits.  There are arguments to be made that some services that are now prohibited, should not be seen as threats to auditor independence. They won't be spending their profits defending against civil litigation and the SEC. 

They'll sleep better.

FASB Pretends It Never Voted to Mark Loans to Market

I will have a lot to say about the FASB's recent publication of its proposed revisions to the accounting for loans over the next few months. In particular, I'm going to vivisect the horrendous "basis for conclusions" section of Proposed Accounting Standards Update 2012-260. To give you a preview of the issues I'll be covering, however, nothing in the proposed ASU's basis for conclusions even acknowledges that the FASB once considered measuring all loans and most other financial instruments at fair value.

At least it proves my point that "due process" at the FASB is a myth.

Bless the Journalists, for They Know Not (Enough) of Accounting

For now, though, I want to get something else off my chest.  As I began to gather my sources, and even before I reviewed the proposed ASU itself, I read the article that reported its issuance in the New York Times.

Let's begin with the good part. The author of the article, respected long-time columnist Floyd Norris, wrote:

"The international regulators [IASB] privately argued [to the FASB] that the pricing of loans reflected the degree of loss expected, therefore there was no need for an initial write-down." [emphasis added]

Kudos to Mr. Norris for pointing out that the IASB was initially on the right track – until it got sidetracked. The FASB even concedes that point – albeit very briefly in the proposed ASU before a clumsy finesse around this economic reality in paragraph BC21. (More on that in a later post.) The IASB's view also corresponds to the reasoning that I set out in a post this past August – see the section "A Mistaken Rationale for the Expected Loss Model."

The bad part of the article is that, instead of just sticking to the facts, Mr. Norris somehow somehow has seen fit to bestow upon us his own two cents worth of accounting logic:

"As a practical matter, it seems likely that any bank making a loan would almost immediately have to write down the value of the loan, even though nothing indicated that particular loan was likely to go bad, simply because experience would indicate that some percentage of similar loans do wind up defaulting." [emphasis added]

I'm not a journalist, but it seems to me that if Mr. Norris felt that his reporting would not be complete without a justification for the proposed "expected loss" approach to measuring loan losses, he should have found an independent expert to do the deed. For surely he knows plenty of them. Or, he could have actually referred to language in the proposed ASU itself. (Did he read it?)

One would hope that any expert without a dog in the hunt would have reminded Mr. Norris that the FASB had decades before explicitly rejected the kind of rationalization that he has made (SFAS No. 5), when it was clearly more concerned with establishing accounting standards that were consistently based on sound principles.

As to any "practical matter," I would suggest that the most salient might be the Board bucking the wishes of the American Bankers Association. Indeed, there are many reasons to believe that auditing the expected loss approach will prove to be impractical, if not downright ineffectual.

The expected loss approach in whatever form it may take is purely a political gambit to give the appearance that accounting is reforming itself after the latest financial crisis, while continuing to avoid providing investors the information they deserve – marking loans to market (which the big banks do every day for their own internal purposes). For evidence of who is actually pulling the strings at the FASB, see the ABA's press release that came out almost simultaneously with the proposed ASU. They're like a parent to a child coming home with a 3.7 GPA: 'very good, but not yet good enough.'

"FASB's proposal is a move in the right direction for both bankers and investors as it seeks to simplify many areas of impairment accounting. However, we believe additional work is needed to ensure that the model better reflects how banks manage credit risk."

It's okay to set up a Day 1 allowance for loan losses, but it shouldn't be too much, and don't ever second-guess management's estimates!

I believe (based on reading his columns and reporting over the years) that Mr. Norris made a good faith effort to be "balanced." However, in doing so he made a grievous error that resulted in misleading his readers to believe that policy makers are undertaking a good faith effort to fix a weakness in accounting standards. The real story is that the deliberations of the FASB amount to little more than constructing lame excuses for avoiding marking loans to market at the behest of the ABA. The "expected loss" approach is a red herring; it's nothing more or less than a long-ago discredited relic of German accounting.

The Opinion of a Real Expert

Subtract the gratuitous sarcasm from the forgoing critique, and you will pretty much have the gist of an email that I wrote to Mr. Norris soon after publication of his report.

I also cc'd that email to a couple of true experts on loan accounting, to solicit their reactions to my concerns. The irony did not occur to me at the time, but one of them, Lynn Turner (former SEC Chief Accountant), has been quoted by Mr. Norris on numerous occasions. Anyway, this is what Lynn wrote (with minor redactions by me) in response:

Tom - I agree with you that fair valuing a loan is the best way to go. The FASB proposed this while Bob Herz was chair, but that notion was dropped after Bob was pushed out at the FASB.[*] ...

I note with interest that Floyd discussed that the proposal would require a write down when the expected cash flows would no longer be equal to those required in the loan agreement.  Quite frankly, that is very much like the current standard.  And of course, during the S&L and banking crisis of the late '80's and early '90's, banks did not take their write downs.  A GAO report at the time issued while Chuck Bowsher was the US Comptroller and head of the GAO did favor going to fair value for loans.

During the most recent financial crisis banks again did not take timely writedowns, despite the accounting standard requiring them to do so when the cash flows from the loan was no longer expected to be equal to the loan agreement.  In addition, SAB 102 and substantially the same guidance from the Banking regulators did require writedowns when economic conditions changed, as they did in '06 and '07.  Yet the banking regulators, well aware of the problems with the subprime portfolios, did not require writedowns.

I was doing work for OFHEO [Office of Federal Housing Enterprise Oversight – later subsumed into FHFA] at the time and it was clear the subprime loan markets had major problems, including with respect to portfolios at Citi, Freddie and Fannie, and yet the regulators sat on their thumbs and did nothing.

What the banking regulators want quite simply is "cookie jar reserves" that can be used and drawn down when times get bad.  This is typically done in a bank by building up the cookie jar and setting aside a portion of earnings each period, for the rainy day to come in the future, as it always does.  The problem with this approach is it still requires the banking regulator to step in a make sure enough is being set aside, and is solely based on a safety and soundness approach.  Yet I cannot recall a single instance of bad economic times when the federal banking regulators have actually been tough enough with their exams, to make sure the banks were safe and sound, and their allowances for loan losses sufficient.  "Safety and Soundness" is a dream - a figment of imaginations emulating from the swamp lands of Washington DC.

I began my career as a CPA in 1976 auditing banks.  I have audited both big and small banks, including as an audit partner.  Twice I have also dealt with banks and their regulators as a member of the SEC staff.  I have also done projects for OFHEO, the FHLBB, and IMF.  And two things have been constant throughout all the years.  First, Banks hate transparency, hate to report anything other than "smoothed" earnings, which in turn helps them deal with capital requirements. And their banking regulators, including the banking examiners, are pretty much worthless when it comes to ensuring banks comply with basic sound banking business practices, compliance with laws, and the establishment of adequate internal controls.  In fact, many a CEO I have dealt with viewed the bank's balance sheet as "his" money more than the money of depositors or stockholders.

As a result, I have little to no faith in financial statements issued by these institutions.  …  The proposal by the FASB, which is worse than the one proposed by the IASB, but both of which are pretty bad, only convinces me more that financial statements are slowly evolving into a mediocre medium of value. [emphasis added]

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As Mr. Norris's colleague, Paul Krugman, has pointed out on more than a few occasions, balanced reporting is appropriate only when the arguments on both sides of an issue are balanced:

"News reports portray the parties as equally intransigent; pundits fantasize about some kind of ‘centrist’ uprising as if the problem was too much partisanship on both sides. Some of us have long complained about the cult of ‘balance,’ the insistence on portraying both parties as equally wrong and equally at fault on any issue, never mind the facts. I joked long ago that if one party declared that the earth was flat, the headlines would read 'Views Differ on Shape of Planet.'

My point is that rather than trying to defend the indefensible "logic" underlying the "expected loss" approach to loan accounting, the article that I would hope to read would provide the following information:

• Just how politicized the issue of loan accounting has become;
• Why it has become so politicized;
• The enormous stakes involved for economic stability; and
• A fulsome explanation of the choices (Mr. Norris, following the cue of the FASB, didn't even mention the possibility of marking to market in his article).

As a model of this type of reporting, there is the recent and ongoing coverage that NYT has recently devoted to the problem of gun violence in the U.S. It shows why NYT is the greatest English-language newspaper in the world.

But, unlike gun violence, which frustrates everyone on every side of the issue, accounting that can lead to prudent bank regulation and investor protection is straightforward and eminently feasible. If there is a special role in a free society for 'traditional' media, it must be to recognize its responsibility to communicate such facts.

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Happy New Year. My father and his twin brother would have had their 95^th birthdays on New Year's Day. Sometimes I think that this blogging obsession with which I am afflicted is my homage to them.

Like the biblical Jacob and Esau, they were as different as night and day. With no disrespect to my dear mother, and with tongue only slightly in cheek, I'm about 50% Dad, 30% Uncle Leo and 20% a reaction to being ridiculed by other children (whose names I have forgotten).

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*Readers who have accused me of inferring without adequate evidence the actual (opposed to 'official') cause of Herz's departure from the FASB, kindly take note.

"Double Entry": A Tale of Two Books

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

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

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

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

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

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

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

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

Autonomy: Investors are Entitled to Know what HP's Management Knows -- by New Year's Eve

Hewlett Packard Co. claims they were 'misled' (to put it mildly) by accounting 'misstatements' (to put it mildly) into overpaying, on the order of $8 billion, to acquire Autonomy. But, if anybody outside of HP has precise knowledge of those questionable accounting practices, they're not letting on in their public disclosures (e.g. Form 8-K):

"Following the completion of its annual review of its goodwill and purchased intangible assets for impairment, on November 20, 2012, HP announced that it recorded a non-cash charge for the impairment of goodwill and intangible assets within its Software segment of approximately $8.8 billion in the fourth quarter of its 2012 fiscal year. The majority of this impairment charge relates to accounting improprieties and disclosure failures at Autonomy Corporation plc ("Autonomy") that occurred prior to HP's acquisition of Autonomy, misrepresentations made to HP in connection with its acquisition of Autonomy, and the impact of those improprieties, failures and misrepresentations on the expected future financial performance [emphasis supplied] of the Autonomy business over the long-term…. HP does not expect the impairment charge to result in any future cash expenditures."

Which may explain why the reports in the press are all over the place. Roughly ordered from least to most egregious, here are some possibilities gleaned from what I have read thus far:

• Autonomy, as a UK company, allegedly exploited the mutability of International Financial Reporting Standards (earnestly referred to by its promoters as "principles") to recognize revenues earlier than would have been permitted by U.S. GAAP. This allegation is founded on the belief that Autonomy often bundled two products in its contracts with customers: software and data storage services. If Autonomy wanted to be as aggressive as possible in its revenue recognition, it would maximize the allocation of the total consideration to be received under the arrangement to the software element under a contract (which might have been recognized upon delivery) and too little to the storage services (which is recognized over time).
• To add insult to injury, the revenue from the software sales in the forgoing scenario could have been recognized prematurely if they were in the form of licenses, which perhaps should have been accrued over time. Again, I'm not sure that IFRS provides much in the way of practical constraints. The applicable standard (IAS 18, para. 20), provides that licensing revenue would be recognized up-front when the agreement is for a fixed fee and the licensor has no further obligations. But, whether that fits the facts and circumstances of Autonomy's business is not known. Moreover, IFRS does not explicitly state that these are the only fact patterns that would support up-front recognition of license fees.
• Expenses were allegedly shifted out of 'cost of sales' and into marketing to give the impression of investments in the brand, and to inflate current gross margins.
• Software was sold or licensed (I don't know which) through third-party resellers. The most serious allegations could be that either the resellers or Autonomy itself fabricated these transactions.

As an aside, it's also very curious that none of the information HP has put out squares with the views of Autonomy's auditor before the acquisition, Deloitte. They firmly stand by their audit – if you want to call it that, for if judged by U.S. rules (SEC, S-OX, PCAOB) Deloitte was not in a position to be considered independent. The very nature of the non-audit services provided – for example, providing advice on executive compensation schemes – makes it so. Moreover, Deloitte's revenues from those non-audit services were pretty lucrative: it has been reported that for every dollar collected from audit services, Deloitte collected approximately $1.10 from providing non-audit services. If Autonomy's accounting practices were too aggressive, would Deloitte's staff have had the gumption to push back given the stakes?  I'm just asking.

As another aside, I wonder about the accuracy of the last sentence in the disclosure tidbit I provided above:  "HP does not expect the impairment charge to result in any future cash expenditures."  In a narrow sense, this is too obvious to have to mention:  that recording an impairment charge does not affect cash flows in and of itself.  But if HP is actually stating that there will be no future cash outflow effects resulting from the Autonomy affair, then that should raise a big red flag.  What about future legal costs in an attempt to recover damages from Autonomy's former managers and shareholders?  Or, if business is a lot worse than they thought, are restructuring costs imminent?

Getting back to HP's disclosures about the facts and circumstances surrounding the goodwill impairment charge, it may have complied thus far with the letter of the SEC's rules, but there are still far too many unknowns to conclude that HP has been adequately forthcoming. What I do know, however, is that SEC rules will eventually compel HP to tell the public in clear language what all the fuss has been about.

The rules I am referring to are set forth in Item 303 of Regulation S-K, Management's Discussion and Analysis of financial Condition and Results of Operations (MD&A). According to my calculations, HP's next MD&A should be filed no later than the last day of 2012 in its annual report on Form 10-K.

The clearest indication of what that MD&A is supposed to contain with regard to the Autonomy affair is from well-known and oft-repeated SEC's interpretive guidance from 1989. It reminds filers that the purpose of MD&A has always been, from the time it was first proposed, to give investors the opportunity to see the company "through the eyes of management." In this instance, such a statement can only mean that investors are entitled to the following specifics: what management knows as of the date of the filing; how they know it and when they came to know it; how it changes expectations of future profitability and liquidity (quantified to the extent possible), and most important, the actions that management is currently taking, and may likely take, to mitigate the negative developments.

Sarbanes-Oxley only requires that the SEC review (in unspecified detail) HP's disclosures every once in three years. But, following on the heels of an announcement of an $8 billion impairment charge to goodwill and a 12% shock to the share price of such a high profile company, the only accetable staff response to the events at HP would be to review HP's MD&A and related disclosures with a fine-toothed comb as soon as its collective New Year's Eve buzz wears off.

One could reasonably argue that the SEC's interpretive guidance on MD&A is too general to be enforceable; and even if it were, that it takes disclosure regulation a bit too far. But, it seems to me that this is the kind of situation that belies such propositions.  We, the public, are counting on the SEC staff -- under its new chair Elisse Walter -- to hold HP's feet to the fire.

I hope that Ms. Walter's is thinking that this could be her first big test -- and is eager to face the challenge.

Off-Topic (But In-Season): Accountants for Peace and Prosperity

The author of this post is Annie Schedrin of the London-based organization Accounting for International Development (AfID). It seems like they do good work where it is much needed. I am always hopeful that educators will share my posts with their students – but this one especially so.

In many ways good financial management is the foundation upon which effective international development is built. If a school in a Malawian slum hasn't budgeted properly for the academic year it might run out of funds half way through and have to cut short the education of its most impoverished children. It might even have to close permanently. If a health clinic in rural Cambodia isn't able to produce regular, clear and transparent financial reports alongside helping hundreds of individuals, its international donor might have to withdraw vital funding.

This has led to a change in volunteering. It is no longer just those with medical or educational backgrounds who are seen as invaluable when lending their time. Now volunteers with finance skills are in high demand. Qualified accountants have the training and experience to build the confidence of local finance staff and improve the systems in use at grassroots charities across the developing world. Depending on the need, highly effective volunteer roles can last from two weeks to a year, either at a single small charity, at multiple charities, or at the Country Office of a large international NGO.

Founded in 2009, Accounting for International Development (AfID) is a multi-award winning social enterprise ensuring that experienced finance professionals are given the opportunity to volunteer their skills in order to make a genuine difference overseas and gain rewarding hands-on International Development experience at the same time.

Since its inception only three years ago, AfID has partnered with more than 150 charities and NGOs. Over 300 volunteers have been sent to 28 countries across Africa, Asia and South America, taking the total hours of pro-bono financial management to over 50 000. This equates to £5.6 Million of professional financial services rendered to non-profit organisations across the world.

The partner organisation who have receive invaluable support are a blend of international charities and grassroots community based organisations such as street child centres, hospitals, micro-finance organisations, conservation projects, schools and women's empowerment programmes. Volunteers have ranged from 22 to 71 years of age, have included 15 couples (as well as one marriage proposal) and have been from a number of destinations including Switzerland, Australia, Canada, Bermuda and Hong Kong.

A typical placement could be as follows: http://www.afid.org.uk/sites/default/files/Jonathan%20Broadley%20Case%20Study%20Kenya%20National%20Audit%20Office.pdf

For more information on accountancy volunteering opportunities, please see AfID's website www.afid.org.uk or email [email protected].

 

The IASB's Stages of Grief

The Mary Schapiro era at the SEC is coming to an end without, despite herculean efforts, having moved the ball forward on IFRS convergence. The final denouement was the departure of Chief Accountant James Kroeker on the day before the release of his staff's dismal (in more than one sense) final report to wind-up the two-year study of IFRS adoption. It should go without saying that the timing of Mr. Kroeker's departure was carefully timed to minimize the humiliation.

For its part, the IASB must surely understand that the SEC staff's backtracking has posed an existential threat – if not to the IASB's existence, then at least as the standard setter for the U.S. and Europe. After Europe finds that working with an IASB that doesn't control the U.S. does it no good, then it will be all over but the shouting. The next step down will be for every other country with mature standard setting mechanisms to revert to their old ways, and the IASB will find itself where it was about twenty years ago – where only smaller economies will require companies to represent full compliance with IFRS, and everyone else will pick up the rules they like and leave the rest.

While reading the IASB staff report, it occurred to me that the IASB is reacting to the SEC staff report like a patient who receives a diagnosis of terminal cancer from its doctor. First comes Denial, of which there are numerous manifestations in the IASB report; but, the following is particularly revealing:

"The SEC Staff Report notes that even after a decade-long convergence programme, some [?!] differences remain between IFRS and US GAAP. The SEC Staff Report does not imply that either US GAAP or IFRS has the better solution, only that they are different." [italics supplied]

First, let's look at a couple of the topics that the Boards attempted to convergence, but failed. Most prominent, is research and development. After many months of back and forth debate, nary a comma of either U.S. GAAP or IFRS met its demise.

Can one rationally claim that IFRS and U.S. GAAP R&D standards are merely different? If that's actually the case, then how come they aren't converged? So sorry to have to break it to the IASB staff, but they are deluding themselves.  The reality is that the FASB believes that U.S. GAAP is better.

The topic of business combinations deserves a dishonorable mention, because although the Boards count this as converged, substantial differences still remain – mainly because the IASB showed itself to be more beholden to issuers on this one than the FASB. As I described here, the IFRS version gives issuers comparability-defeating free choices and watered-down disclosures in key areas.

Second, let's look at the topics for which the IASB issued new standards outside of the convergence agenda. The revisions to IAS 23 requiring interest capitalization is my favorite example for showing that when the rubber hits the road, the IASB can't be counted on to adhere to its own due process rules. Or, to cover its tracks, the IASB would have to claim that its standard is better than U.S. GAAP; for if that were not the case, then why didn't the IASB simply adopt U.S. GAAP when it had the chance?

Another situation I have written about is IFRIC 15, which harkens back to the old ways that U.S. GAAP used to treat real estate construction projects – but doesn't anymore. Here again, U.S. GAAP setters long ago rejected the IASB's approach, for it gives too much discretion to management that could be used to manipulate earnings.

Third, let's consider the numerous issues for which the chasm is so wide between U.S. GAAP and IFRS that convergence hasn't even been seriously discussed:

Statement of cash flows—The IASB proudly trumpets its sham principles-based emphasis on substance over form. There can be no greater exposure of the falsity of these claims than IAS 7, which permits (but does not require) overdrafts (i.e., loans masquerading as negative cash balances) to be offset against cash accounts with positive balances.

Contingent liabilities—The IASB is proposing that management will decide whether or not a particular contingent liability can be measured reliably. That's an open invitation to earnings management. U.S. GAAP has its own problems regarding contingent liabilities, but I'll still take it over what the IASB has proposed.

Impairment—This may be the area in which U.S. GAAP and IFRS are most different, yet it's not on the convergence agenda. That's an incredible omission.

Inventories – There is a little-known yet significant IFRS requirement to value biological assets at net fair value. It sounds principles-based, but it's just another opportunity to manage earnings. Do you prefer to recognize revenue on your current apple crop in the quarter before or after selling it on the market? IFRS gives you a choice, which you can take by the timing of your harvest.

For all of the above, I would conclude that U.S. GAAP is better – not just different. But, whatever I might think, the fact is that these matters would have been converged if there were not a difference of opinion between standard setting bodies. Logic dictates that there has to be more here than standards being merely different.

Fourth, let's consider current major convergence projects. With respect to the loan impairment project, the Boards disagree on how to implement the so-called "expected loss" approach. That the IASB Staff sees this as merely a difference is delusional.

* * * * *

After Denial comes Anger. Reuters reports that "Han Hoogervorst has expressed frustration at how convergence has slowed and wants to move beyond the seemingly permanent joint meetings with the Americans."

And after Anger comes Bargaining. IFRS Trustee Chair Michel Prada (who probably knows even less about accounting than Hans Hoogervorst) seems ready to make a deal with the devil:

"While acknowledging the challenges, the analysis conducted by the IFRS Foundation staff shows that there are no insurmountable obstacles for adoption of IFRSs by the United States…"

Unfortunately, Depression pervades throughout. We'll know more about the prospects for Acceptance after Ms. Schapiro's imminently expected resignation and President Obama names her successor.

Is Money Market Fund Accounting Fair to Investors?

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

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

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

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

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

* * * * *

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

Question #1:

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

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

Question #2:

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

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

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

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

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

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

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

Question #2a:

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

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

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

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

Question #3:

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

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

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

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

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

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

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

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

Bigger than Loan Impairment – Adjusting Bank Profits for Inflation

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

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

The Effect of Inflation on Accounting in a Nutshell

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

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

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

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

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

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

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

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

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

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

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

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

The $64-K Question

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

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

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

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

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

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

A Statement of Basic Accounting Principles

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

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

 

The Effect of Standard Setting without a Statement of Principles

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

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

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

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

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

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

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

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

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

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

Marking Loans to Model is Far Easier and Better than Estimating Loan Loss Allowances: It's Time to Hear from the FASB Members who Changed Their Minds about That

Tom

I'm [Osman Sattar,] a relatively new reader to your blog and I understand that you favour market values in accounting. In this article, you say that:

(1) "[B]oth models [the current incurred loss model and the proposed CECL model] are terrible because they both require estimates of future cash flows over a loan term of 5, 10 or even 30 years out".

(2) "How can the value of a loan at its inception be anything different than the net proceeds to the borrower?"

But, in arriving at a market value for loans (which are not generally traded in a market), surely there would be a need to use models, using estimates of future cash flows over the loan terms? And isn't it likely this would result in a value that is different from the net proceeds to the borrower?

Hi, Osman:

Thanks for reading my blog, and I hope that you will become a regular reader and correspondent. I want to take the opportunity of your comment to introduce you and other relatively new readers to my philosophy of financial reporting that leads to the conclusion you have noted.  Specifically, that some form of "market value" – inflation-adjusted "replacement cost" being my strong preference – is the most appropriate basis of measuring assets and liabilities.

Accordingly, here is my plan for the next three posts:

• I'll respond below to your specific questions about the value of loans at their inception and the use of models for estimating a market value. I'll also have something to say about the FASB members who switched over from market value to the dark side.
• In a post to follow in a few days (hopefully, by the end of this week), I'll list what I see to be the fundamental topics that standard setters must address; and the principles to which standard setters should hold themselves accountable.
• The current controversy is over current measurement of loans, and I am going to demonstrate that even low levels of inflation affect bank profitability. I am choosing to raise this issue at the present time because I believe it is much more important than the present back and forth over the formal details of that exercise in futility known as the accounting for loan impairment. (Impairment models in general are exercises in futility.)

Valuing a Loan at Inception

Osman, you ask, "Isn't it likely [that utilization of models to estimate loan market values that are not generally traded in a market] … would result in a value that is different from the net proceeds to the borrower [at the inception of the loan]?

The short answer to your question is "yes." Notwithstanding, it has no effect on my view that the only reasonable method to account for loans that are not generally traded is to have them appraised by an independent appraiser and/or to mark them to model.

To see this, let's assume that the only alternative to current practice or the boards' proposals is to mark to model. I want to step back from loans for a few sentences to consider first the well-established standards of accounting for forward contracts – which also are generally not traded in a market. Notwithstanding the absence of an active market for trading such a contract, both U.S. GAAP and IFRS specify that these derivatives must be marked-to-model at each balance sheet date; and consistent with my position for loan accounting, both sets of standards provide that if no consideration other than future promises to perform are exchanged, the value of the forward contract at its inception should be set to zero. Management will always believe that they negotiated a fair (or perhaps even better than fair) deal for the company, but according to the standards, that, or the output of any model that would support such a contention, may not be taken into account.

Moreover, in assessing the practical consequences of a disconnect between the economic value of a loan at inception and what any particular model has to say about that, we need to remind ourselves that the first point in time when a loan or a derivative must be "marked to model" would be at the first balance sheet date subsequent to the inception of the contract. However, good practice should validate the model being used at the balance sheet date by testing it against the conditions that existed at the date of loan/derivative inception. If the model yields a valuation that is significantly different from the value dictated by standard economic principles, then such a difference should raise questions concerning model choice and/or inputs used at the balance sheet date.

Is Marking to Model a Reason not to Measure Loans at Market Value?

I know that this is not a question you have specifically asked, Osman, but I sense that you believe it is worth asking.

Any expected loss approach will require estimates of future loan losses at every balance sheet date – an exercise which I have already taken pains to point out as being highly subjective, subject to manipulation, and not amenable to being audited. My view is that marking to model would be a lot simpler and more accurate.

But, I am not asking you to take my word for it. For starters, a perfectly good and reasonable methodology for marking loans to model has already been set forth in U.S. GAAP – albeit for disclosure requirements only:

"For certain homogeneous categories of loans, such as some residential mortgages, credit card receivables, and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities." [ASC 825-10-55-3 (originally SFAS 107), bold italics supplied]

Here again, the principle I have cited that the value of a loan at inception must be equal to the net proceeds is germane. The last sentence in the forgoing quotation needs it to form the conceptual basis for measuring the fair value of any loan. Specifically, the contractual cash flows, when discounted by the effective interest rate will yield the net proceeds – equivalently, "entry value" or "replacement cost" – of the loan at inception. Thus, at any subsequent point in time, discounting the remaining cash flows by the rate at which loans would be made to borrowers with similar credit ratings should yield a reasonable measure of that version of market value.

But, if the boards would recoil from my favored approach to market value, replacement cost, they should also consider the views of an FASB member on precisely the question I am pretending you have asked. Before his appointment to the Board, Hal Schroeder authored a comment letter to the FASB wherein he stated:

"… [B]anks have existing systems that can also be used to fair value loans. We know from our own experience that with the right systems, loans can be marked to market every day. In fact, within two hours after the US markets are closed our entire debt and equity portfolios are marked daily."

Mr. Schroeder was not on the FASB when it voted by a 3-2 margin to require fair value measurement for loans. The series of events that redirected the FASB from fair value back to yet another recipe for accounting sausage was an orchestrated comment letter campaign from irate bankers; the sacking of the FASB chairman (a proponent of fair value) by the Board's overseers; and the appointment of three new board members (including Mr. Schroeder), who could be reliably counted on to resoundingly overturn the vote for fair value.

And that, boys and girls, is how the anything-but-fair-value movement at the FASB got its start. If Mr. Schroeder and the other two Board members (Tom Linsmeier and Mark Siegel) who previously supported fair values for loans are continuing to act on their principles, it sure would be nice to know how they now came to sing in close harmony with the bankers on such short order:

• I see nothing in the current proposals that reflect Mr. Schroeder's views from before he became a board member.
• In the case of Mr. Linsmeier, I do know something about his background, but I haven't looked at his academic publications; but I can't imagine that the expected loss model looks anything like the views he would have come to independently as an academic. I am also compelled to point out that Mr. Linsmeier changed his vote only a short while before his re-appointment to the Board was announced.

The accounting for loans is important enough so that we should hear all seven board members express their views on all major aspects of the proposal. For starters, Mr. Schroeder should explain why, if fair value accounting for loans is as straightforward as he claims, he continues to align himself with the anything-but-fair-value bloc. Mr. Linsmeier should provide a justification for changing his views in a manner that is consistent with academic standards of intellectual rigor; and as a model for that, I would suggest that he examine the writings, dissents and speeches of Bob Swieringa while he was a board member.

FASB "due process" should not be used as an excuse to duck the hard questions.

 

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

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

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

The Expected Loss Model is a Move in the Wrong Direction

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

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

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

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

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

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

Pick a number … pretty much any number.

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

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

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

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

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

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

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

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

There is a better way.

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

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

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

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

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

"Anything But Market" is the FASB's Mantra for Loan Loss Accounting

At its August 22^nd meeting, the FASB came to some significant tentative conclusions regarding the recognition and measurement of loans:

"The Board decided that the model [of loan loss measurement] should utilize a measurement objective of "expected credit losses" and there should not be an initial recognition threshold that must be met before an entity recognizes a credit impairment. Expected credit losses are defined as the estimate of contractual cash flows not expected to be collected…"

Withholding judgment for a teensy moment, let's begin with a simple example. Let's call it Exhibit A in the case against the FASB:

• On December 31, 2007, Bankco (calendar fiscal year-end) originates a bunch of 20-year, fixed-rate mortgages for a total principal amount of $10 million.
• Under the "Current Expected Credit Loss Model" (CECL) proposed by the FASB, Bankco must not only be able to estimate the total amount of contractual cash payments expected to be uncollected, but also the timing of the non-collections. That's because the estimated non-collections are to be discounted at the "effective interest rate" to "reflect the time value of money."
• The application of the CECL model yields the following journal entry: Dr. Loan loss expense, $50,000; Cr. Allowance for loan losses, $50,000.  

OK, here comes the judge. This court finds the FASB guilty on the following counts: (1) misappropriation of the term "measurement objective"; (2) time value of money malpractice; (3) manslaughter of basic accounting principles; (4) reckless endangerment of auditors; and (5) obstruction of accounting justice.*  

Misappropriation of "measurement objective" — To establish motive to commit a crime, we begin by first noting that the FASB has not stated a measurement objective for the right of use asset to be recognized by lessees under its proposed lease accounting model; nor has it stated a measurement objective for performance obligations recognized under its proposed revenue recognition standard. We find the inconsistency suspiciously manipulative.

With respect to the charge of misappropriation in the instance of loan accounting, the term "measurement objective" is commonly understood to apply to measuring assets and liabilities in their entireties, and not merely the contra accounts that capture a component of the asset or liability. For example, the measurement objective for trade accounts receivable under U.S. GAAP is to produce the expected undiscounted cash flows to be received from customers. Accordingly, the allowance for doubtful accounts, adjusts the undiscounted contractual amounts such that the net balance meets this measurement objective.

But, by focusing only on estimations of amounts that are not expected to be collected, the CECL does not actually accomplish a legitimate measurement objective. The resulting net balance from this process ($9,950,000 in Exhibit A) cannot possibly be described in any systematic manner other than by the arithmetic that yielded the result. Thus, it cannot be said that loans are being measured with any particular objective in mind.

Time value of money malpractice — The aforementioned misappropriation of the term "measurement objective" is compounded (no pun intended) by time value of money malpractice. The FASB states as follows:

"…because the amortized cost basis of a financial asset represents the principal and interest cash flows discounted at the original effective interest rate, measurement approaches that estimate expected credit losses based on historical charge-off rates are an acceptable method of estimating expected credit losses in a manner that reflects the time value of money."

We honestly don't profess to understand the FASB's logic. What is clear, however, is that the FASB is discounting "for the time value of money" something that isn't money: i.e., contractual cash flows not collected are neither cash inflows or cash outflows.

The FASB could have required a reporting entity to determine the carrying amount of loans by discounting the expected cash flows to be collected using a rate of interest that reflects both the time value of money and the 'risk' that the actual amounts collected will be different than the actual amounts collected. But, to discount only the portion of the contract that won't be collected is a crime against finance. If it were left unpunished, then we shudder to think how condoning this kind of violation will be explained to future innocent accounting students who seek knowledge of principles and abhor being drowned by arbitrary rules to spit back on the CPA exam.

Manslaughter of basic accounting principles – Not only has the board not explained what the initial measurement of the loan could possible represent, they have not provided any defense for the crime of recognizing a Day 1 expense ($50,000 in Exhibit A), even before there has been any opportunity to generate earnings from the borrower.

In finding the FASB guilty on this count, we recognize that a loss on Day 1 could be justified for a trade receivable that arose from a product sale on which an operating profit is earned; however, that is not the facts of this case. It is impossible to make the argument that cash transferred on Day 1 to a borrower, in what is purely a financial arrangement, could exceed the value on Day 1 of the borrower's promise to make future contractual payments.

Reckless endangerment of auditors – Isn't it already enough that auditors put themselves at risk simply by attesting to the "reasonableness" of management's estimates of the allowance for doubtful accounts on short-term trade receivables? The CECL method is orders of magnitude more complex than that. It would require management to estimate expected losses for multiple periods extending out for decades.

Even under the best of circumstances (which the PCAOB has demonstrated through its inspections is far too often not the case), providing a reliable audit of the present value of expected loan losses under the CECL method will be an impossible task – for which auditors will no doubt be called to account should (or when) another financial crisis occur.

* * * * * *

As regards to the charge of obstruction of accounting standards, this court finds that inadequate accounting standards for loans and related financial instruments contributed to the Financial Crisis of 2008. Consequently, the FASB knew, or should have known, that loan accounting is the most urgent item on its agenda; and that it should have been prioritized above all else, including convergence. It is unconscionable for the FASB not to have a final standard that is clearly and straightforwardly crafted to protect investors from further overstatement of loan portfolios, or even just an exposure draft.

We note as a potential mitigating factor that the FASB has taken the step of disassociating itself with the IASB's "three-bucket" artifice; however, this is far from sufficient to justify an acquittal on any of the counts. The motives for the FASB's actions were clear: to ensure that bankers should be spared from having to measure their loan portfolios with current market-based information over which they have no influence.

Shame on the FASB for continuing to put investors at risk in order to serve bankers. And, most important to this judge, for insulting our intelligence.

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*An additional count of failure to adequately define "expected" will be adjudicated at a later date.

 

Revenue Recognition Sure Isn't Perfect – But Convergence will be much Worse

No one will ever say that U.S. GAAP revenue recognition standards are consistently principles-based, but few would say the system needs to be completely overhauled. Other than to achieve convergence of U.S. GAAP and IFRS, what will a new revenue recognition standard accomplish to improve financial reporting? And at what cost? Before the boards' issue their third exposure draft, they may want to answer those questions.

The sole reason for a joint revenue recognition project was that IFRS revenue recognition standards had huge holes, yet the EU would never have tolerated the details of U.S. GAAP and the attendant loss of wiggle room for the top line number of the income statement. The other side of the coin is that it would be unthinkable for the U.S. to adopt extant IFRS on revenue recognition, or anything even closely resembling that. In short, it wasn't that U.S. GAAP and IFRS were so fundamentally different as to necessitate starting from scratch, but that was the only way to avoid confronting differences that were not fundamental, but where the devil was in the details.

Thus, it comes as no surprise to me that no one has lit a fire under the boards to get a new standard out. Here's a quick list of off the top of my head of the questions that are still up in the air after ten years of "due process":

• Criteria for recognition of revenue;
• Constructive obligations;
• Measuring the transaction price;
• Allocating the transaction price to performance obligations under multiple element arrangements;
• Estimating and presenting bad debts;
• Warranty liabilities;
• Licenses;
• "Onerous" performance obligations;
• Discounting;
• Costs eligible for deferral; and last but not least,
• Whether the final standard should provide detailed examples, or just wait and see how practice 'interprets' general guidance.

I don't want to beat a dead horse, but it's astounding that practically nothing has been settled after more than 10 years by the discussion papers, draft standards, perhaps a thousand comment letters, hundreds of roundtables, hundreds of thousands of frequent flier miles, tens of thousands of man hours of staff research and the solemn deliberations of the ineffable amongst inscrutable board members.

Not Even Agreement on the Basics

There is indeed much I could choose to write about from the above list, but for starters, this post will focus on the most basic issue: the criteria for revenue recognition. I'll begin with a description of one of the bulwarks against abusive revenue recognition practices in current U.S. GAAP. We'll then review what appears to be the Boards' current tentative conclusion, and then ask whether it would be an improvement over U.S. GAAP.

In 1999, the SEC staff published Staff Accounting Bulletin No. 101 (subsequently updated in SAB 104 and codified as Topic 13 of the SAB Codification), which to my mind is a model of principles-based guidance overarching many disparate rules to be found in U.S. GAAP. It may not have been well-received by issuers, but unlike the FASB and IASB and to the staff's everlasting credit, it didn't seem to care near as much about that.

SAB 101 requires (more accurately, it interprets U.S. GAAP to require) that collectibility from the customer must be "reasonably assured" in order for revenue to be recognized. When goods have been delivered prior to the receipt of cash from a customer, this is taken to mean that there must be a high probability that the customer will pay the company all that it is legally entitled to receive. Hence, for example, "channel stuffing" is streng verborten – pumping goods into a full to overflowing pipeline to a middleman who has the option to return unsold goods to the manufacturer does not lead to revenue recognition merely upon delivery of goods to the middleman.

The "collectibility is reasonably assured" criterion also means that no sales are recognized from sketchy customers until their check clears the bank. To see why this is bedrock U.S. GAAP, take this simple example (which I first used here). Two companies, A and B, differ only in the credit quality of their customers. Company A estimates its allowance for doubtful accounts to be 2% of gross accounts receivable, and B's allowance is 30%. Without the SEC's "collectibility is reasonably assured" criterion, both companies could recognize revenue upon delivery of goods or services.

But, as is inevitably the case, both companies will err in their estimates of uncollectible trade receivables. Perhaps for both companies, uncollectibles were off by a third: that would make 3% for A and 45% for B. The premature recognition of earnings by Company A might or might not be material, but for B, it is hard to imagine that it would not be.

Now, let's begin to consider the boards' proposal. Would you feel better about company B recognizing revenues from its sketchy customers prior to collection if: (a) it was their long-established practice to sell to sketchy customers; and (b) management judged from its past experience that 30% was "predictive" (whatever that means) of the future bad debt rate?

It seems to me that many financial statement users would not be comfortable with B recognizing revenue prior to being able to cash the check, but what I just described seems to be what the boards are proposing – at least according to a Deloitte publication, for I can't even find much of a discussion of the Boards' current positions on their websites. (That by itself ought to tell you something about how well this project is going.)

Anyway, let's rely on Deloitte for the straight skinny:

"The Boards tentatively decided that when an entity satisfies a performance obligation, the entity should recognize revenue at the amount allocated to that performance obligation unless the amount is not 'reasonably assured' to be received. An entity would be reasonably assured to be entitled to the amount of consideration allocated to satisfied performance obligations only if both of the following criteria are met:

a)    the entity has experience with similar types of performance obligations (or has other evidence such as access to the experience of other entities); and

b)    the entity's experience (or other evidence) is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations. (page 7, italics supplied)

As a preliminary matter, Deloitte's description contains an ambiguity that I find necessary to deal with: "Reasonably assured to be received" (which sounds a lot like the SEC's current criterion that "collectability is reasonably assured") is not the same as the following sentence, which reads "reasonably assured to be entitled" to receive. Which is it?

The confusion may spring from the back and forth of the protracted deliberations. At first, the boards concluded that revenue should be recognized when the entity is legally entitled to receive (or keep) an amount from its customer*; therefore, they concluded, the revenue from a performance obligation ought to be measured at the expected amount to be collected. It follows further from this line of reasoning that trade receivables would be measured as a function of expected credit losses.

That was a pretty good decision, I thought, but the Boards yielded to pressure from issuers, who evidently decided that they didn't want the responsibility of being held accountable for the estimates – if they could make their earnings targets without them. So, the boards have backtracked towards something similar to current practice, but imbued with typical IASB-style wiggle room (my euphemism for 'management judgment'). If criteria (a) and (b), from above, are deemed by management to have been met, then it's okay to recognize revenue.

Say hello again to channel stuffing, sketchy receivables and even bill and hold sales.

 

After Ten Years, Has Any Progress Been Made?

There can be no arguing that the revenue project was begun with high aspirations. A new standard would provide greater specificity and consistency to accounting for multiple element arrangements, and it was going to resolve the inconsistencies in accounting for arrangements where performance would be satisfied over time – e.g., construction contracts, customized manufacturing, consulting, etc. All of this was supposed to happen in a principles-based manner, i.e., by treating revenues the same as expenses according to the 'asset/liability view' of recognition and measurement. Just as changes to assets and liabilities determine in which period expenses are recognized, increasing an asset or decreasing a liability would determine revenues for a period. (Under current IASB and FASB standards, for revenues it's always the other way around: meeting the revenue recognition criteria would determine whether an asset would be increased or a liability would be decreased.)

We didn't need to get into the gory details to see just how far short this project has fallen from the boards' stated goals. All we need to do is focus on the general revenue recognition criteria. In my opinion, if we were to jettison U.S. GAAP and adopt the revenue recognition criteria being proposed, it's quite possible that accounting mayhem would ensue. But whether my fears come to pass or not, I cannot think of a single area where U.S. GAAP would be improved by adopting the Boards' proposed replacement for current revenue recognition standards.

Unlike the other two major projects the Boards are grappling with – leasing and financial instruments – to the best of my knowledge, I don't believe a single user has asked either board for new revenue recognition standards. It's long past the time for the FASB to explain why its stakeholders can expect any benefit to come from a completely revamped approach to revenue recognition. No matter what a final standard will look like at this point, all I see coming out of new revenue recognition rules are mountains of wasted resources on compliance by issuers and lots of new "interpretive guidance" from regulators.

If the FASB can't satisfactorily explain how the revenue recognition project will benefit users, it should abandon the project and leave the IASB to take it where the EU wants it to go.

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*Assuming the absence of a "constructive obligation," a contrivance that I don't have the stomach to deal with today.

 

 

 

 

 

 

 

 

 

 

 

    

A Lesson in Loan Accounting from an Unexpected Source: Oil and Gas Companies

[This is my fourth consecutive post on loan accounting. Here are the first, second and third.]

I love finding accounting lessons buried in stories that on their surface seem to have little to do with accounting. See, for example, my post on the appalling politics of joint replacement databases, "No Escaping the Politics of Information." The example I'm going to describe here is a little bit closer to home than body parts: an August 11th, WSJ article headlined, "For Chesapeake, a Question on How it Counts Reserves."

Some background: in January 2004, Royal Dutch Shell announced that it would have to reduce its "proved" oil and gas reserves by 3.9 billion barrels, which was about 20% of their reserves. Another 2 billion barrels were written off in the ensuing months.

The gist of the WSJ article is that ever since the Royal Dutch Shell writedowns and the ensuing securities fraud claims, reserve quantity reporting practices evolved to obtaining some level of outside assurance from independent experts. Consequently, Chesapeake's share price may be discounted by investors because, "[Only] seventy-seven percent of the reserve estimates … reported for 2011 were produced by independent engineering firms, while the rest came from a growing team of in-house reservoir engineers. A survey of nine of Chesapeake's competitors in the same year showed third-party involvement in 89% of reserve estimates, on average."

Chesapeake challenges the claim that its share price is depressed by the possibility of unreliable reserve estimates. While "third-party involvement" could take the form of audits of in-house estimates, or independent estimates, a Chesapeake spokesman claims that its use of third party estimates is more heavily weighted toward independent estimates, while its peers go the other way.

 

An Analogy to Accounting for Loans

But, whatever the particulars of the facts and circumstances surrounding Chesapeake, there are interesting comparisons to be made about loan loss reserves and oil and gas reserves.

The first thing to consider is that accurate estimates of future loan defaults are extremely critical to any evaluation of the financial health of banks, just as "proved" oil and gas reserve quantities are to energy companies.

Second, I would argue that estimates of oil and gas reserves are inherently more reliable than estimates of loan loss reserves. Even though oil and gas reserves could be thousands of feet underground, they are tangible, and they can be sampled and probed. Please don't ask me to cite any of it, but there must be scads of theoretical and empirical scientific studies to support the validity of the methods employed.

In contrast, estimates of loan loss reserves are ineffable; and methodologies for predicting future losses are, to say the least, controversial.  It's a paradox that oil and gas managers engage outside experts to estimate reserves for financial reporting purposes; yet bank managers, who have the more subjective task, think they know enough to estimate loan loss reserves all by themselves.

Third, the SEC requires a financial statement audit of every public company, including banks and energy companies; however, it doesn't require an audit of oil and gas reserves [see Regulation S-K Item 1202(a)(7) and (8)]. Largely in response to the Royal Dutch Shell debacle, managers of oil and gas companies have voluntarily engaged independent experts, whose reputations must perforce depend on their track records, to provide a higher level of assurance to investors than required by law. Obviously, the same can't be said for banks' measures of loan loss reserves.

Fourth, estimates of loan loss reserves are much more critical to the global economy than estimates of energy reserves. Given the market forces that moved oil and gas company managers to act, it seems that another debacle like Royal Dutch Shell is unlikely; but if it did occur, it probably wouldn't shake up the markets as much as a major restatement from a too-big-fail bank.

And what's the likelihood of a bank having to correct its loan loss reserves? There are whole countries in Europe whose banking systems could be on the brink of collapse!

Are financial statement audits of banks helping to allay your fears? Not mine!

Consider as well that audits of loan loss reserves are at the top of the list of deficiencies uncovered by the PCAOB. Even setting aside the question of whether auditors are capable of evaluating bank managers' clairvoyance, all too frequently, it seems, auditors have not even adhered to their own protocols.

 

The Moral of the Story

If you buy into the analogy, and I believe it is quite compelling, then, just as energy companies employ independent scientists, banks should be required to obtain estimates of loan loss reserves or market values (I would much, much prefer the latter) from outside financial experts. Maybe then, market prices of bank stocks and book values would converge. As it is now, investors don't believe the banks' "audited" numbers. Investors surely understand that auditors can and should verify facts, but they are not qualified to predict the future, or even to merely offer an opinion that management's prediction of the future appears reasonable.

In the case of oil and gas companies, the vicissitudes of capital markets led to higher quality financial reporting. But alas, vested interests in entrenched and outdated regulations are preventing it from happening at banks. I am a strong proponent of securities regulation, but sometimes it can get in the way of needed improvements to the information available to investors.

This is one of those times.