Many claim that "principles-based" accounting standards are superior to "rules-based" standards.
For example, the chair of the International Accounting Standards Board, Sir David Tweedie, made this proclamation in a 2008 speech in Toronto: "The use of principles should eliminate the need for anti-abuse provisions. It is harder to defeat a well-crafted principle than a specific rule which financial engineers can bypass."
He and others are making a giant leap of faith that managers will suddenly change their personalities and start taking a higher road because of principles-based standards. They also mistakenly assume that such lofty standards could ever be constructed in a political process.
To the contrary, we have often stated that standards can only establish minimum reporting requirements that force unwilling managers to provide information beyond their self-serving inclinations, which are stubbornly rooted in naive ideas about how the markets work. We don't see how politically compromised mandatory "principles-based" standards will ever motivate them to change that behavior.
We're puzzled that Tweedie thinks otherwise, when history shows that managers universally rush to create misleading positive images by reporting as little as possible and otherwise obscuring the truth.
As theoreticians, we share Tweedie's idealism and hope for a better world, but our scars make us question whether the IASB's boast that it issues principles-based standards is actually public relations spin aimed at making a weak solution look strong. We are particularly concerned about the joint Financial Accounting Standards Board and IASB convergence projects under the gun of the unwise and unrealistic self-imposed 2011 deadline.
AGREEMENTS IN PRINCIPLE
Most negotiations start with a preliminary agreement between the parties. A potential buyer may say, "I'd like to buy that car," while the owner states, "I want to sell it." In diplomacy, two opposing sides may agree they don't want war. Management and a union may agree they want a new contract without a strike. We also observe that protocol leads the parties in crucial but stalled negotiations to announce interim progress by saying they have "agreed in principle," even when they're really miles apart.
Ah, but such agreements in principle are far short of real agreements that establish prices, draw territorial lines, and satisfy labor's demands. Real results are achieved only when both sides actually resolve tough issues.
In the accounting context, we suggest that a happy face has been painted on some proposed standards when the deliberations failed to develop a consensus on details. Frankly, we think that those involved are calling them "principles-based" in order to project a positive image, instead of admitting that their members could do no more than reach a broad agreement in principle. That is, they seem to want to make the world believe that they accomplished significant results, even though their intractable differences prevented tighter resolutions.
We find support for this view from two proposals in the joint IASB and FASB exposure draft on lease accounting published in August 2010. For decades, FASB repeatedly said that it wanted all leases to be capitalized. The IASB joined the chorus and a lease project went on the convergence agenda. To our eyes, the draft shows that they failed to produce definitive or innovative provisions that will lead to fully useful financial statements. Regrettably, it's the same decades-old accounting with new lipstick.
A simple lease has the lessee pay the lessor x annual payments of $y with a market interest rate of z percent, thus allowing precise estimates of the lessee's cost of the right to use the leased property, the liability's size, and interest expense. On the other side, the lessor would use identical numbers to report the sale of that right, its receivable, and its interest income.
However, most managers deliberately destroy their statements' usefulness by inserting confounding features that contort leases to create bogus reporting "advantages." Lessors are quite willing to enable their subterfuge in return for premium rents.
One of those devious devices is renewal options that allow lessees to extend the lease term. The issue asks whether those uncertain payments should be included in the leased asset's cost and the liability. While the options' ostensible purpose is to create more flexibility, the nefarious objective is to reduce the reported asset and liability, thus boosting the apparent return on assets and understating the lessee's apparent debt. In effect, they can create off-balance-sheet financing. For example, managers who really want a 10-year lease might fabricate a one-year lease with nine annual renewal options.
FASB and the IASB identified the problem but only came up with loose guidance that initial measures should include renewal options that "are more likely than not" to be exercised. While granting their theoretical point, we expect this fuzziness to give lessees inappropriate discretion in deciding what to include in the cost while auditors stand by helplessly (or helpfully). This "principles-based" standard strikes us as only an unspecific agreement in principle that will lead to manipulations that allow off-balance-sheet financing to persist and continue creating useless information.
To take away the inclination to play such games, we would require the capitalized cost to include all options, period.
Previously, the boards claimed that the lessor's accounting should parallel the lessee's. This agreement was apparently only "in principle," because the draft essentially falls back to the status quo distinction between operating and capital leases.
In some circumstances, it requires a lessor to recognize a receivable at a present value of future payments (including renewal options that the lessor considers more likely than not) and an equal but nebulous liability called a "service obligation." As the lessor collects cash, it reduces the receivable, reports interest income, and converts the obligation to lease revenue. The property's full original cost is depreciated (a nearly two-centuries-old traditional but anachronistic practice consistent with no sound principle whatsoever) with the expense netted against the revenues. Thus, entering a lease (a good thing) forces lessors to fallaciously report a larger base for the return on assets and a larger numerator for debt/equity ratios (two bad things). The outcome looks a lot like the lessor signed an operating lease and does not parallel the lessee's presentation.
In other circumstances, a lessor would record the lease as a sale and a receivable as if it sold a portion of the property. Part of the property's book value would be "derecognized" and deducted from the sale price to describe the gross profit or gain. Although we advocated this general approach ("The two evils of lessor accounting," April 19, 2010), we argued for reflecting the change in the underlying property's market value (up or down). Instead, the draft would have the lessor merely deduct an allocated fraction of the original cost, based on the relative fair values of the transferred and retained rights to the physical property. It is absurd that fair values are sufficiently reliable to use in the allocation but are somehow not reliable enough to be reported on the financial statements.
After identifying these two alternative treatments, the boards had to specify how to tell them apart. The answer was another broad agreement that the choice depends on "whether the lessor retains exposure to significant risks or benefits associated with the underlying asset." This loophole-prone test is essentially figuring out whether the lease is a rental or a sale of the physical asset, the same test that was unsuccessfully pursued in APB Opinion 7 in 1966 and SFAS 13 in 1976! This strikes us as an agreement without a principle.
Usefully resolving the lessor issue demands recognizing a sale in every case, because doing so is the only way to reveal the truth. When both sides report the truth, it inevitably follows that their statements will be symmetrical. The proposed standard will not achieve that outcome and utterly wastes the golden opportunity to bring progress to lease accounting after 34 years.
A BIGGER POINT
These ineffectual agreements in principle have clearly weakened the proposed standard. Its lack of specifics allows managers to continue indulging the fantasy that they will be rewarded by the capital markets for publishing misleading and incomplete financial statements. Instead, both common sense and rigorous research shout that they will be penalized with higher capital costs that in turn lead to lower stock prices.
But apart from this negative impact, we see a bigger point that the Securities and Exchange Commission definitely needs to comprehend. Specifically, this draft is likely to characterize the outcome of all the convergence projects, especially if the current deadline pressure is allowed to continue. More ominously, it epitomizes what would happen if FASB were to be replaced by the IASB. Without the teeth that come from having the SEC as a strong source of power backing up its decisions with scrupulous and otherwise rigorous enforcement efforts, the IASB cannot and will not produce definitive standards that impose tough new requirements.
So, if anyone needs additional evidence of the flaws in the idea that FASB and the IASB can work together to effectively converge GAAP with IFRS to produce rigorous standards, this exposure draft surely provides it.
No amount of lipstick can cover up that fact.
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 authorsâ views are not necessarily those of their institutions. Reach them at firstname.lastname@example.org
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