In our preceding five columns, we have expressed our concerns to our good friends at the Financial Accounting Standards Board about their May 2005 exposure draft on the hierarchy of accounting principles.We confess that we yawned when we first saw this document superficially. However, a closer, more careful look made us sit upright and kick into gear. We don't think they meant anything sinister, but we found great hubris in their words.
Our previous columns focused on the board's proposition that there is no longer any place for a policy that would allow managers to take exception to published generally accepted accounting principles, even if they believe that compliance will produce inferior financial statements.
We have been dinging this presumptuous position that GAAP is as "good as gold." For support, we have described numerous examples showing that GAAP is so short of that benchmark that it is not very good at all. Our bottom line is that FASB's confidence in GAAP is misplaced and unjustified. In fact, we find it mystifying.
Just to be sure that everyone is on the same page, here is the exact language of paragraph 10 from the Basis for Conclusions of the Exposure Draft. Note especially the second sentence (our emphasis added):
"A10. In light of Rule 203 and FASB's and the IASB's goal to converge their concepts and standards, the board discussed whether an enterprise should have the ability to depart from the GAAP hierarchy in the unusual instances in which selection of an accounting policy in accordance with the GAAP hierarchy results in financial statements that are, in management's judgment, misleading. The board believes that the selection of accounting principles in accordance with the GAAP hierarchy results in relevant and reliable financial information. Therefore, an enterprise cannot represent that its financial statements are presented in accordance with GAAP if its selection of accounting principles departs from the GAAP hierarchy set forth in this Statement and that departure has a material impact on the financial statements."
We want to analyze this proposition by looking at its implications if it were, indeed, true. If the consequences are reasonable and desirable, then perhaps it is worthy of support. However, if the implications turn out to be unreasonable and likely to lead to further issues, then it should be abandoned.
The political process is perfect
If it is true that complying with GAAP always produces relevant and reliable information, then it follows that FASB's due process works perfectly, including the massive pressure brought to bear on the board members. It also follows that any political compromises are key to bringing about relevant and reliable information.
But, if it were so, this comment in SFAS 87 on pensions would have never been made: "The board acknowledges that the delayed recognition included in this statement results in excluding the most current and most relevant information from the employer's statement of financial position."
Neither would this comment have been made in SFAS 123: "The board chose a disclosure-based solution for stock-based employee compensation to bring closure to the divisive debate on this issue - not because it believes that solution is the best way to improve financial accounting and reporting." In other words, the standard was a pure political compromise, far short of usefulness.
In fact, the process does not produce standards that generate relevant and reliable information. It does just the opposite by creating Politically Expedient Accounting Principles (PEAP), and FASB's premise must be false.
All methods are equivalent
If applying GAAP always produces relevant and reliable information, then it must be true that completely different descriptions of the same events and conditions will lead to the same rational decision outcomes. How else can FASB justify continuing to give managers unrestricted choices among methods (like LIFO and FIFO or straight-line and accelerated depreciation), when they have varying income statement and balance sheet consequences? Apparently, whatever management chooses to put in the financial statements will always be equivalently relevant and reliable, as long as they comply with GAAP.
That conclusion is obviously spurious. There are so many acceptable but divergent alternatives in GAAP that it can be called Whatever You Want Accounting Principles (WYWAP). Drastically different measures cannot all be relevant and reliable, and they cannot all be useful. FASB's premise is false.
Market needs don't change
If it's true that published GAAP always produces relevant and reliable information, then it must also be true that financial analysts are applying the same analytical models that they've always applied and will always apply, forever. FASB's premise essentially holds that today's GAAP provides all that analysts will ever need.
However, the capital markets are highly competitive. Every worthwhile analyst is looking for an edge on the others, probing to find something that no one else knows.
If the business of financial accounting is providing information that serves users' needs, and if those needs are continually evolving, then it follows that financial accounting should also be in a constant state of flux, always seeking new ways to support better decisions.
As we have shown, however, today's GAAP are so "pitifully old and obsolete" that they are POOP. It's clear that FASB's premise is false. The profession cannot adequately serve dynamic capital markets with static standards.
Technology doesn't matter
Sitting on one of our desks is a 2.5Mhz dual-processor computer with a 160-Gigabyte hard drive and a broadband connection to the Internet. Why would GAAP produced in the 1940s, or even the 1990s, to accommodate the information technology of that day still be considered suitable today? Isn't it possible to generate information that is far more reliable and less expensive than back then? Isn't it possible to produce information that is more useful because it's more timely?
Of course it is, but the political standard-setting process is designed to inhibit change, making only such minimum progress as can be eked out against concerted opposition from those who mistakenly believe that their power to send biased messages to the capital markets also allows them to control what those markets use. One outcome of this myopic view of financial reporting is that amazing real technological advances have been ignored, and GAAP has lagged far behind. FASB's premise is patently false.
Only FASB knows
If it is true that complying with published GAAP produces relevant and reliable information, and, as FASB implies, that not complying produces irrelevant and/or unreliable information, then it means that only the board has the ability to determine what is - or is not - useful. Unless FASB changes them, we would have to believe that all bulletins, opinions, interpretations and standards are infallibly perfect. That is, until the board makes them more perfect.
Of course, such is not the case, and the premise is fatally flawed.
Why have FASB?
If existing published GAAP always produces relevant and reliable information, then it would be true that no new GAAP is ever needed. Here, then, is the biggest newsflash of all: If existing GAAP is perfect, then FASB has declared itself to be expendable!
In effect, this exposure draft essentially announces that FASB might as well close its doors. If GAAP is as flawless as FASB presumes, then why spend millions of dollars on an organization to improve on perfection? It is clear that FASB's assertion is just as misled as the century-old proclamation that the patent office could be closed because there was nothing left to be invented.
In fact, a great deal of reform is needed to replace virtually all published GAAP with new guidance that really does provide relevant and reliable information. The world desperately needs FASB, and the International Accounting Standards Board, with the significant difference that their members and constituents simply must approach their mission from the perspective that the status quo is grossly deficient. It doesn't need tinkering - it needs massive transformation to get in tune with today's realities, instead of yesterday's fantasies.
After all these words in these six columns, we hope and expect that our friends at FASB have grasped their faux pas in expressing this premise about the infallibility of published GAAP. Because we know them well, we are confident that they really don't believe what their statement implies. In fact, they are more committed to pursuing reform than most.
That point aside, however, their assertion flies in the face of the history of standard-setting. Going at least as far back as APB Opinion 6, all other standard-setters have acknowledged that they did not have a monopoly on wisdom. Instead, they advocated departure from their pronouncements if managers or auditors figure out that compliance won't fully reveal the truth.
We sincerely hope that the board members arrived at their declaration with good intent, but without fully considering its implications. If so, the world can soon be put back in order.
On the other hand, if they really think that today's GAAP produces useful financial statements, then the profession, the capital markets and the world economy, not to mention the public, face a long and dark future in which the truth will not be honored or reported.
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