This semester, Paul Bahnson is using a new textbook (Business Analysis and Valuation, by Palepu, Healy and Bernard) in his financial analysis course. We mention it because it includes a case about the Harnischfeger Corp. that challenges students to analyze the company's numerous accounting changes made during 1984.It was written a long time ago, but the earnings quality issues raised in the case are timeless, making it more than suitable for discussion today.
The way we were
But, for Paul, reviewing Harnischfeger's 1984 statements and footnotes was taking an enlightening walk down memory lane, because it led him to ponder how much generally accepted accounting principles have changed. Despite our frequent lament that GAAP-based financial statements aren't good enough, we have to admit that they have gotten a good deal better since 1984.
Back then, they included no recognition or even disclosure of the projected benefit obligation for pension plans, nor did they report much if anything about the shareholder resources transferred to employees by option grants. Lest you've forgotten, back then, the only information reported about trading investments was based on lower of cost or market.
Of course, pooling could be used for business combinations, and finance subsidiaries could be excluded from consolidated financial statements, if management chose to. And they always did, hoping that the capital markets would be so inefficient that they wouldn't notice all the debt left off the parent's balance sheet.
A particularly striking and progressive change is evident when looking at the statement of changes in financial position, which was the ill-conceived predecessor to today's cash flow statement. To those who may be so old that they have forgotten or others who may be too young to remember, the only information about funds flow that users received in the old days was expressed in terms of the change in working capital, which was measured as the difference between current assets and liabilities.
The ostensible purpose of the SCFP was to analyze the changes in noncurrent accounts, but the way it did it was by explaining the change in the aggregated total working capital during the year. Another strange thing back then was that all the statement did was describe the direction of the working capital flow (as a source or a use) and did not clearly describe the activity as operating, financing and investing.
After spending a few minutes with the old format statement, Paul was reminded of how abstruse it was. He actually laughed out loud when thinking about the struggles that users must have had as they tried to discern important changes in a company's financial structure from a statement that described only its working capital changes. Granted, the important information is there, but it takes real work to extract it, sort of like one of those computer-generated pictures that you can't see until you cross your eyes and block everything else out of your consciousness.
Reviewing this old statement format also brought back memories of the blank faces in the classroom as he saw even the most diligent students in those days struggle to make sense out of this poorly structured and unintelligible presentation. Those memories make us grateful that we now have the more sensible cash flow statement structure that provides insights about the flow of funds that even novice students can quickly understand. (Well, except for the indirect depiction of operating cash flow.)
While this nostalgic introspection reveals that there has been some important progress in financial reporting, we know it has not been enough.
Cash flows and other issues
First, SFAS 95, which requires cash flow statements, was developed in direct response to an unprecedented and overwhelming demand expressed by a variety of financial statement users. We can only imagine how enthusiastic they were over winning the Financial Accounting Standards Board's ear and actually getting a financial statement that promised to provide the information they wanted. It takes less effort to imagine their disappointment upon learning that the board didn't have the will to mandate reporting their preferred content when it backed off from requiring managers to disclose gross operating inflows and outflows using the direct method.
Second, many issues other than cash flow reporting are still waiting impatiently for progressive reform. We spent last summer writing about the long list of current deficient practices that leave users empty-handed. For fun, we called them PEAP (Politically Expedient Accounting Principles), WYWAP (Whatever You Want Accounting Principles) and POOP (Pitifully Old and Obsolete Principles).
Getting real
The common thread of these questionable practices is that they cause financial statements to fall short of describing economic reality with reliability. The reasons vary.
It may be the paradigm of conservatism, which to some is a time-honored cautious approach intended to keep statements from being too optimistic. We hold a different, less reverential perspective. To us, conservatism is simply a euphemism for creating a systematic bias to protect auditors against later recrimination. Adjusting reported numbers to be cautious is the responsibility of analysts and other users, not statement preparers and auditors, and certainly not standard-setters. Whether well-intended or not, the policy of conservative reporting creates a departure from economic reality. The practice of recording impairments but ignoring enhancements produces slanted information that is not useful.
Policies that smooth out volatility constitute another deteriorated plank in the GAAP platform. Evidence of artificial smoothing is evident throughout practice: pensions, stock options and investment accounting are all examples. Again, the prime objective should be reporting economic reality as reliably and completely as possible. If some major shock really occurs, it's analysts who should decide whether and how to normalize the data to support predicting the future.
We can only shake our heads in the midst of this incredible information-driven age at the thought that policy-makers and intelligent entrepreneurs would hold to the Neanderthal-like concept that highly efficient markets consume smoothed out accounting numbers like babies gulping down strained cereal. These markets want steak and potatoes and chunks of raw vegetables, not homogenized gruel produced by such things as allocated depreciation, allocated interest, and deferred unrealized gains and losses. Reality drives the markets, not fantasy numbers in GAAP financial statements. Again, if smoothing is to be done, let it be done by analysts using reliable representations of the truth.
GAAP, with its reliance on historical costs, is also all about "once upon a time" accounting, reporting outdated amounts for important assets like inventory, and property, plant and equipment. Recovery of costs is only one reflection of management's good stewardship, but it pales in significance with the markets' need to know about current performance and the resources that are in management's hands. What good does it do to learn that the historical cost-based income produces a 10 percent return on the book value of 15-year-old assets? Users - and managers, for that matter - will be better off if they know what real return is being earned with the value currently inherent in the companies' assets.
The future: Make or break
So, what's our point? Over the years, GAAP reporting has indeed gotten better, but the progress has been tediously slow. As a result, today's financial reports fall way short of describing the economic reality of corporate financial condition and performance. To us, GAAP reporting looks more and more like a compliance exercise and less and less like a mechanism for delivering important, timely information to shareholders and other users. In other words, financial reporting is in danger of becoming obsolete, if it isn't there already.
Accountants and auditors aren't about to lose their jobs, but they enjoy that security only because of regulatory requirements for GAAP, not because they add real value to financial reports. As a result, careers in auditing and reporting do not and will not offer the financial rewards that they have in the past, nor the intrinsic benefit of knowing that the work is meaningful to society.
We don't have a crystal ball, so we wonder what we would see if we could look 20 years into the future, roughly the same interval we looked back in reviewing the Harnischfeger financial statements. We hope that efforts to reform GAAP will make much greater strides going forward than were made during the last two decades, for the sake of all of us who call ourselves accountants, for financial statement users who need high-quality information to make informed decisions, and for our society, which needs and benefits from more capital market efficiency.
Paul B.W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.
