The Aug. 23-Sept. 5, 2004, issue of Accounting Today reported on several seemingly unrelated controversies that nonetheless were connected in our minds. They were:
* Congress voting to rein in FASB's efforts on options expensing;
* The EITF preparing to treat contingent convertible bonds (CoCos) realistically; and,
* The European Economic Union announcing its intent to require compliance with international standards, except for those that require mark-to-market accounting for financial instruments.
Can you find the connection? Here are a couple of other examples of the same thinking:
* When structured in certain ways, long-term lease agreements are kept off the balance sheet; and,
* SFAS 87 puts defined-benefit pension assets and liabilities in the footnotes and smoothes out all volatility.
Are you getting closer to seeing the problem? Here are two more:
* Research and development expenditures are expensed, regardless of whether any worthwhile knowledge is gained; and,
* Gains and losses from foreign currency exchange fluctuations are reported in equity, not in earnings.
Not there yet? Try one more:
* Gains and losses from changes in the value of available-for-sale securities are reported in equity, not in earnings.
Give up?
Here is the recurring theme: "Just 'cuz it ain't on there, doesn't mean it ain't there."
In every one of these mainstream cases, generally accepted accounting principles have been written or overridden (or attempted to be overridden) in such a way as to keep truthful facts out of the financial statements. In some cases, this result is the inadvertent consequence of a misbegotten quest for procedural simplicity, while in others it is the deliberate result of political effort to distort financial statements at the expense of the broader public interest in full disclosure.
The problem with omitting these real items is that the financial statements provide misleading signals about profitability and risk. While the capital markets as a whole are not fooled by this deception, some individuals are.
Whether fooling occurs or not, the omissions increase uncertainty and drive security prices to undesirably low levels.
Even more troubling is the blaring announcement from the advocates of omission (including standard-setters over the years) that financial reporting is about something other than truth-telling, with the consequence that credibility is eroded while uncertainty is increased. Once obfuscation is given a social blessing, it's only a small step until some justify short-sighted, ethics-impaired reporting practices like those that occurred at Enron, WorldCom and others, both discovered and undiscovered.
Some minimize the negative effects of opaque reporting by declaring that the capital markets are already quite efficient and don't need better reports. But who could really believe that the markets are more efficient than management in uncovering the complete facts? Indeed, that is not the case, and it is unarguable that more complete and forthcoming financial reports will enhance the markets' efficiency. Apart from the few who don't mind taking money under false pretenses, isn't that the ultimate goal for everyone involved in financial reporting?
Just in case there are any lingering doubts that the highlighted GAAP practices work to keep useful information out of users' hands, here is a bit more about each of them.
Enough has been written about stock options to fill half a dozen thick books, but we'll say it again: Options have value and granting them to anyone (whether employees or not) creates an expense. Leaving the liability off the balance sheet and the expense off the income statement does nothing more than obscure useful information about these wealth transfers from shareholders to option holders.
To those who wail that expensing options will force managers to curtail their use, we say so be it. If accurate and complete reporting of real consequences causes them to change their behavior, it is a change for the better, because inferior accounting practices encouraged managers to make bad resource allocation decisions.
CoCos are convertible debt instruments with the twist that the holders' ability to convert is constrained until a contingency is met, usually when the issuer's stock price rises above a designated threshold. Because of the 30-year-old GAAP for convertible debt, the real interest cost of CoCos is kept off the income statement. In addition, the dilutive effect for existing shareholders is not revealed, either on the balance sheet or in earnings per share. (The Emerging Issues Task Force is closing only the last of these loopholes.)
Of course, omitting these useful facts from financial statements doesn't mean that the interest cost and dilution aren't there. All it means is that analysts have to spend time and money trying the guess the real information that management already knows.
Bottom line, those costs and the resulting uncertainty about management's integrity drive the stock value down, despite the higher reported earnings per share.
For our friends in Europe, we explain that financial instruments have real market values that go up and down. Not reporting that information in public financial statements makes the capital markets guess what the values are, which increases risk, which decreases the value of securities, despite stable reported earnings.
Whether leases are capitalized or not, they create real assets and liabilities. If they're left off the balance sheet, investors must spend time estimating something to put into their analysis, losing trust in management along the way. Once again, the uncertainty drives stock prices down, not up.
Pension liabilities are real drains on cash and liquidity; pension assets provide relief from that drain. Both are the employer's, and both belong on the balance sheet, and analysts drag them out of the footnotes onto their version. As to smoothing the expense, it's like painting over a crack in the wall - it doesn't fool anyone with an ounce of brains.
Expensing R&D simplifies the accountant's job and protects auditors from ambiguity, but it makes financial statements impossible to believe or use because expenses are surely overstated and assets are surely understated, but nobody knows by how much. Unbelievably, accountants and standard-setters haven't given this problem a second thought since the convenient rule was written 30 years ago.
And, where is there any convincing proof that unrealized gains and losses on investments don't belong on the income statement? We grant that cash hasn't flowed, but the whole idea behind accrual accounting is to report economic effects without waiting for cash to change hands. The same analysis holds for foreign currency fluctuations - they're real, as any currency trader well knows. The transparent purpose for this treatment is to produce nontransparent financial statements.
There you have it - eight mainstream examples of delusional and misleading GAAP financial reporting. The principles have been patched together to make financial statement readers believe one thing when everyone knows that the other is true.
All this nonsensical pretending that real things don't exist and that real events haven't happened only makes the markets work harder to find the truth and more skeptical of the reported information. The ultimate combined result is that money is diverted from investing and risk premiums are raised, driving securities' market values down, not up.
The solution doesn't lie in a sudden inspiration by everyone, including standard-setters, that it's time for reform. We think it will happen one manager at a time, and that success will bring others along. Some will never get it, preferring instead to take comfort in the status quo, buffered from reality by the hallucinatory haze of denial.
What an incredible state of affairs.
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
