Our previous column described flaws in generally accepted accounting principles, in which real things and events are left off the statements because powerful political interests like it that way. Our theme was, "Just because it ain't on there doesn't mean it ain't there." Examples include options expense, off-balance-sheet leases, pension accounting, research and development assets, and unrealized gains and losses.
How disappointing it is that the Financial Accounting Standards Board, the Securities and Exchange Commission and the rest of the financial community keep overlooking these shortcomings. Only an "out of sight, out of mind" attitude could allow these huge holes to continue unchallenged.
In contrast, this column goes after other flaws that report things and events on the financial statements that aren't really there. In this case, the practices arose under circumstances in which it may have seemed worthwhile to report imaginary amounts to either facilitate preparation and auditing, or to promote a false image of financial stability. Either way, the result is fictional reporting.
What do we mean? Consider these items:
* Reporting assumed depreciation expense based on predicted future lives, salvage values and patterns;
* Reporting realized gains and losses for the difference between selling price and cost;
* Reporting the excess paid over the value of acquired assets as goodwill; and,
* Reporting equity method earnings.
Here are two items related to taxes:
* Reporting income tax expense and deferred tax liabilities as if the full (undiscounted) amount is immediately due instead of far in the future; and,
* Reporting tax expense without including the savings created when employees exercise stock options (as per the Financial Accounting Standards Board's proposed standard).
Of course, the most imaginary number of all is earnings per share, which is nothing more than one spurious result divided by another.
Let's look at these things more closely.
Depreciation would be a joke if it weren't such a disgrace. Imagine golfers filling out their scorecards on the first tee, writing down what they expect to shoot, and then settling up without regard to their real scores. Imagine a casino handing out free chips to those customers who expect to win and just taking money from others who expect to lose.
Ludicrous? No doubt - but that's precisely what happens when accountants calculate depreciation expense in advance and then report it on future income statements. There is no valid justification for reporting assumed depreciation instead of actual observed amounts (including appreciation). At least, no justification based on providing useful information for decisions.
We have often criticized the omission of unrealized gains and losses from income statements. As held assets change in value, the owner experiences changes in real wealth that could and should be reported as income.
As bad as it is to omit those gains and losses, we think it is worse to report the full changes in value, since acquisition, as realized gains and losses on the income statement for the year of the sale. Where is the usefulness in a system that deliberately fails to report events when they happen and that reports their effects in periods in which they don't happen?
Suppose you buy land in 1994 for $1 million, watch it appreciate steadily to $20 million through the end of 2003, and then sell on Jan. 1, 2004. Altogether, you omit $19 million of gains from income statements for 1994 to 2003, and then falsely report the whole amount in 2004, when absolutely none of it occurred. That practice can be embraced only if you're disconnected from reality.
Goodwill is merely a plug figure equal to the difference between what was paid for an acquisition and the acquired identifiable assets. Now, if management scores a genuine bargain purchase, real goodwill is understated. To fix the problem, the company should report a gain on purchase. If, instead, management paid too much, GAAP accounting overstates the goodwill, which can be fixed simply by reporting a loss on purchase. While FASB did some good by requiring impairment tests, users are dead right when they're leery about this most intangible "asset."
Equity method earnings are egregiously bogus. In reality, investors have gains and losses only when the shares' market values change. A longstanding fear of market values has caused accountants to retreat to a fantasy world in which the investee's reported income (adjusted for depreciation and whatever) is mistakenly deemed to be a more reliable description of the results of holding the investment than simply reporting what has happened to the stock's market value. This method is a long-entrenched compromise struck among auditors who pursue their own safety instead of users' needs. They would rather report make-believe numbers than real facts. What humbug!
With regard to deferred taxes, we are baffled by the longevity of a practice designed to create a false smoothness for what is often a highly volatile expense. At their core, taxes are involuntary payments to the government with no direct return. They are an artifact of the year's tax return, and perhaps it makes sense to just report the paid amount as the expense.
We acknowledge that it isn't always that simple, because present tax savings are often achieved only by mortgaging the future. Even when we embrace that idea, we're mystified at FASB's insistence that it's useful to report the full amount that would be paid without acknowledging the economic benefit of postponing the payments. Everybody defers payments because of the time value of money, yet nobody gets to report what they gained.
To increase usefulness, deferred liabilities should be discounted down to their real value. Just because they are on the balance sheet at the amount to be paid does not mean that they are really that large, or that the expense is as large as it is represented to be. Discounting only makes sense - which probably explains why it isn't part of GAAP.
With regard to options, FASB's much-awaited move to mandate expensing has an obvious flaw that deprives users of useful information by unplugging income tax expense from reality. Suppose a company issues options that are worth $100 million dollars at the grant date and $400 million when exercised. Applying a 40 percent tax rate, the issuer accrues a deferred tax asset of $40 million over the vesting period under FASB's approach. When exercise occurs, the company gets a $400 million deduction and $160 million tax savings on its return.
However, FASB insists that the unexpected $120 million savings doesn't reduce tax expense! Instead, management credits paid-in capital, and the savings never ever hit the bottom line. To make it worse, the board isn't allowing the $120 million to show up as an increase in net operating cash flow, but wants it to be presented as a financing inflow, as if the government invested in the company.
Then there's earnings per share. Everyone focuses on it, but hardly anyone dares to criticize it. The numerator is totally dicey because of the allocations, assumptions, predictions and wild guesses that go into net income. The denominator isn't much better, especially when hybrid dilutive securities are outstanding. We get tickled when folks go gaga over mere pennies between predicted and "actual" EPS, as if that kind of precision were possible. This fixation emerges from a vain hope that a single statistic could summarize something as complex as a multinational company's activities for a period. Just because EPS is on the income statement doesn't mean it's worth using.
So, there you have it - through decades of compromises between management and auditors, GAAP statements are ineffective because they first omit useful information about real things, and then present numbers and words associated with unreal things.
Our bottom line? Any managers who want lower capital costs and higher stock prices should never count on GAAP statements to adequately inform the capital markets.
The only solution is to go beyond GAAP to tell the truth, the whole truth, and nothing but the truth about what is and isn't there.
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
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