This column is the third in our series on why we think the Financial Accounting Standards Board is mistaken in its exposure draft on the hierarchy of accounting principles. For those who may have missed it, the draft proposes doing away with the clause in Rule 203 of the American Institute of CPAs' Code of Conduct that is intended to force financial statement preparers and auditors to consider whether they're producing financial statements that are misleading, even though they comply with generally accepted accounting principles.
Our first column described the existing clause as an essential avenue for progress. Importantly, we challenged the board members' presumptuous premise that they, and they alone, have the insight to know the best accounting now and forever. We also questioned FASB's ability to produce innovative and timely standards in response to new situations.
Our second column reprinted a 2003 column that showed how Andersen's failure to exercise the Rule 203 exception enabled Enron's quest for engineered financial statements. It shows that the seeds of destruction for both firms (and the collateral damage) included Andersen's complacent decision to vouch for Enron's strict compliance with generally accepted accounting principles, instead of demanding that the statements reveal truth.
We feel so strongly about FASB's erroneous premise that compliance with GAAP automatically yields useful financial reports that we're producing three more columns that show how today's GAAP is too compromised, flexible and outdated to produce what the capital markets need. If GAAP is that bad, then FASB should not be boldly proclaiming that it's as good as gold.
PEAP
This week's column addresses the fact that most, if not all, of today's GAAP has emerged from an ugly political process that protects the interests of managers and auditors far more than it promotes the public's interest in capital market efficiency.
In light of the compromises and poor results, we often refer to much of today's GAAP with the acronym PEAP, which stands for "Politically Expedient Accounting Principles." Alas, there are way too many examples for us to list them all, but we will analyze the most glaring ones to make our point that FASB is mistaken when it claims that GAAP always produce relevant and reliable financial statements.
* LOCOM. Can there be any doubt that the ubiquitous practice of lower-of-cost-or-market is a political compromise that elevates auditors' interests above all others? Early recognition of losses with late recognition of gains can only make sense for protecting auditors against recrimination. It certainly isn't what managers would choose, and users cannot possibly be better off when they are presented with deliberately incomplete information.
How pervasive is LOCOM thinking? Very. Just think of inventory, goodwill and other asset impairments, and all contingencies. The only result of biased reporting is unreliable information, and unreliability robs financial reports of their usefulness.
* Leases. In June, the Securities and Exchange Commission's Office of the Chief Accountant released a blistering report that attacks off-balance sheet accounting. It focuses in part on leases, noting that the accepted bright-line criteria for distinguishing operating and capital leases cause virtually identical agreements to be accounted for totally differently.
We, too, have long asserted that all leases produce assets and liabilities that should be accounted for as such. We're not alone, either; FASB joined with other standard-setting bodies in preparing two research reports a few years ago that argued that current GAAP for leases should be changed to recognize assets and liabilities.
However, today's board is strangely silent on this point; we can only guess that the reason is the lack of interest in upsetting preparers who like to avoid recognizing debt. Politically incomplete financial statements look good but smell bad.
* Pensions. We've dealt with pensions numerous times, and they can't be left out of a discussion of PEAP. When SFAS 87 was issued, FASB groused in the basis for conclusions that a better answer would put the assets and the projected benefit obligation on employers' balance sheets. So, why wasn't that practice mandated? The board explained that the preparer constituency wasn't ready to tell the truth.
So, why did FASB issue the standard? Because, the members said, the changes were at least better than nothing. No kidding. So, here we are, nearly 20 years later, watching one pension surprise after another get unloaded on the public, politicians and all others who innocently trust financial statements to reflect reality.
Instead of revealing volatility from risky investing and borrowing activities, the standard conceals it. Oh, yeah, it treats deferred losses and employee goodwill like assets comparable to money in the bank. We shouldn't forget that the same model is applied to medical benefits, too. Two PEAPs for the price of one!
* Investments. When FASB issued SFAS 12 on investments in 1975, it refined how to apply LOCOM to these assets, and promised a better solution as soon as the Conceptual Framework was finished. Well, the board got around to it only 18 years later, proposing mark-to-market with gains and losses flowing through earnings, just like the old Accounting Principles Board had proposed but didn't implement before shutting down in 1973.
Despite its potential for truthful accounting, bankers hammered the exposure draft because they didn't want volatile reported earnings. They constantly bombarded the board until the members folded and issued SFAS 115, which keeps most unrealized gains and losses off the income statement. It perpetuates bad accounting by reporting realized gains and losses on the income statement as if the change in wealth occurred in the year of the sale. Pure PEAP.
* Cash flows. A rare thing happened in the early 1980s, when FASB was presented with a noncontroversial project in that preparers were not objecting to a budding demand for a cash flow statement. In fact, they were voluntarily changing from a working capital statement of changes in financial position to cash.
The board sought to tidy up its requirements, but it didn't move fast enough, and some managers dug up a problem: They didn't know how to prepare statements that met the users' preference for the direct method. Rather than taking on the challenge of learning something new that would lower their cost of capital, the complainers convinced a skinny majority of four board members to allow the indirect method, while recommending the direct.
Here is our paraphrase of the board's reasoning: "We know the most useful answer, but it will make some managers innovate. Because we don't want to upset them, we'll just ask them to please change." Well, they didn't, and the markets are still scratching their heads while they search for useful information in the indirect method presentation.
* Stock options. We were hoping we'd never have to write another word about options, but here we are. The story is much the same as for pensions, because the board members knew in their heart of hearts that options produce expenses that should be on the income statement. However, they caved in to immense pressure and gave managers the choice between expensing and not expensing.
Last year, a mere decade later, the board mandated expensing. However, the SEC has intervened and postponed implementing SFAS 123R, and tongues have been wagging over the points that SEC chair-designate Rep. Chris Cox (a) comes from California, the heart and home of the anti-expensing lobby, and (b) introduced legislation that would have sidetracked FASB's effort to require expensing.
No one knows what's actually coming, but we're betting that the issue will not be resolved in accordance with the public's best interests. Watch out when professional politicians produce accounting standards. Pure PEAP.
Summary
We could go on and on. These examples are just the highlights, and it's only going to get worse as FASB tries to converge with the International Accounting Standards Board, because international politics are even more unpredictable than ours here in the U.S.
With all the PEAP out there, it's impossible to swallow the board's conclusion that GAAP is as good as gold. We don't see how that can be. And we don't want to hear another PEAP out of them.
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.
