We're still at work on our big project and it has us reflecting more than ever on the many limitations in GAAP financial reporting and the reasons why there is so little political momentum for reform. These thoughts led us to rerun this column from June 2010 that analyzes the prevalent yet disturbing inertia that keeps so many dependent on GAAP from seeing the need for drastic reform, much less leading any sort of effort to make financial reports useful, instead of being mere compliance documents.

George Orwell, the English satirist and novelist, is known for his dark view of politicians and others who use clever language to mislead those around them to their own advantage. A student recently applied an Orwell quote to financial accounting: "In a time of universal deceit, telling the truth is a revolutionary act." We think this young scholar is right on target in drawing this connection, and that Orwell would approve applying his words in this context. As we see it, everyone involved in financial reporting should commit to uncovering, describing and reporting useful truth for the benefit of all. No good purpose can be served by squelching, withholding or otherwise hiding the truth.

Nonetheless, we observe that truth in financial reporting is vilified when it should be magnified. That is, virtually everyone seems to think that it's good enough to report in accordance with GAAP (or IFRS), even though the sure result is suppressing truth, instead of openly declaring it.

 

USERS ARE MYSTIFIED

Based on what we've seen, virtually all amateur statement users and many professionals are totally mystified by the arcane intricacies of GAAP, to the ironic point that they behave as if they actually believe what's in the statements. Paul M. remembers consulting for an experienced analyst who wanted to understand a company's pension footnote. When Paul began to describe how the reported annual cost had no connection with what really happened, the client cut him off, explaining that he just wanted to know how the next year's reported cost would affect the next year's reported earnings. We fear the same naive, uncritical attitudes toward GAAP are prevalent, and the impact can be nothing but uninformed and inefficient investment decisions.

One solution, of course, is better education for analysts and increased coverage in their professional exams of the unsuitability of GAAP-based information for its intended use. An even better solution would be for everyone involved in financial reporting to raise their awareness and then address the real issues. Who are they and what's wrong with their current efforts? We'll take you through them, one by one.

 

MANAGERS ARE MOLLIFIED

A key reason that truth is smothered in accounting is that many, perhaps most, and maybe even virtually all, managers are mollified by that outcome. They cling to the foolish and false assumption that what they don't tell the capital markets won't hurt them. Thus, they withhold relevant information, manipulate within GAAP (off-balance-sheet financing, for example), and obfuscate what they do report, apparently expecting financial pats on the back in the form of higher stock prices.

In fact, their failure to honor truth only heightens the markets' uncertainty and risk, raises their companies' capital costs, and drives down stock prices. Telling the truth usefully, openly and frequently would have the opposite effects.

 

AUDITORS ARE OSSIFIED

Another explanation for truth's scarcity in financial statements is that auditors are so intent on maintaining their positions as gatekeepers to the capital markets that they resist new ideas that would make their clients' statements more useful. This tendency shows up in perennial objections to recognizing market values and otherwise clinging to age-old practices based on costs and systematic allocations instead of real-world observations.

Their ossified perspective causes them to overlook the indisputable fact that the main outcome of their audits is certification that their clients' statements are not useful because they conform with GAAP. They're missing the opportunity to add real value by attesting to the reliability of non-GAAP information that would actually reveal the truth and reduce uncertainty and risk.

 

STANDARD-SETTERS HAVE CODIFIED

While the Financial Accounting Standards Board's Codification is commendable for increasing efficiency in accessing the contents of GAAP, we confess deep misgivings that codified standards may make FASB reluctant to subject them to the drastic reform they so desperately need.

We think the project should have had two phases:

1. Finding and fixing inadequacies produced by existing standards; and,

2. Integrating and indexing those amended standards.

It appears nothing like the first phase was even contemplated, much less attempted, such that FASB now has codified practices that don't produce useful truth.

Of course, that shortcoming can be undone, but only with greater effort. The biggest obstacle for board members and staff will be coming to grips with flaws in such settled but gravely deficient areas as cash flows, tangible assets, stock options, other derivatives, stockholders' equity, earnings per share, investments, pensions, and leases, to name just a few that need modification far more than codification.

 

REGULATORS ARE PACIFIED

By their silence, it seems regulators have no great interest in bringing more truth into financial reporting. Instead, they have focused on streamlining reporting processes, rather than improving the relevant content of the reported information. It's as if they've washed their hands of issues about usefulness, choosing instead to be pacified when managers comply with GAAP, when auditors attest to that compliance, and when standard-setters follow established protocols.

Instead, the Securities and Exchange Commission should strive to make capital markets more efficient by proactively advocating more frequent and more informative reports.

 

PROFESSORS ARE MORTIFIED

In the 1970s, a sea change swept through academic accounting when researchers were persuaded to become empiricists who were so focused on studying existing practices that they would never contemplate making normative statements about what ought to be done.

We're sure there were many good reasons for this change, but it has produced a new culture of fledgling scientists who aspire only to observe, quantify and equivocate their findings without daring to recommend any reforms that might put new useful truth into financial reports.

Our point is that many academics are mortified when it comes to making any prescriptive proclamations as to what ought to be done to magnify useful truth. Ironically, their aversion exists in the context of financial reporting, which is itself a highly structured normative activity where managers and auditors are compelled to do what standard-setters and regulators tell them to do.

Professors' reluctance, however well-intentioned, has surely deprived the field of helpful contributions from a large number of capable people.

 

STUDENTS ARE STULTIFIED

In addition, the move in academe toward empiricism has also produced accounting teachers who don't know how to introduce students to needed reformation in practice. Instead, they seem content to accept GAAP at face value.

Textbooks, especially at the introductory and intermediate levels, are descriptive, not prescriptive, because they accept what's going on and describe it uncritically without prescribing any desirable changes.

Even if the authors wanted to prescribe changes, their publishers would discourage them because other professors, not students, select books for their classes. Bottom line: If teachers don't think about what might be, they will forever teach only the status quo.

As a result, we see that accounting students are stultified because they are not challenged to learn anything beyond what is being done and may feel compelled to repress any new ideas about what might be done instead.

In addition, we have seen our own graduates, who we certainly introduce to critical thinking, go out into the very unreal world of financial accounting practice that does not welcome questions about what's being done.

Again, they are stultified and forced to either embrace petrified practices or move along to some other livelihood. Either way, impetus toward reformation is stifled.

 

ALL SHOULD BE HORRIFIED

So, there you have it. The current state of the financial reporting world illustrates Orwell's observation that, "In a time of universal deceit, telling the truth is a revolutionary act." We will leave it to others to prove whether the nearly universal current practice of deceiving financial statement users is the unfortunate accidental result of various social and political forces, or has been deliberately engineered by managers and auditors and unwittingly embraced by regulators, standard-setters and academics.

Regardless of the reason, all accountants should be horrified that GAAP's fiction is presented as truth, and even terrified that untruthful statements remain the primary source of information for supporting capital markets' financial decisions.

 

ALL CAN BE GRATIFIED

We close by proclaiming that a culture of deception is embedded deep in our profession, even to the point that few grasp its existence, with fewer still willing to acknowledge it. Unfortunately, only a small band of reformers is calling for the inevitable revolution that will seek out and report the truth and make it the goal of financial reporting practice. Elevating truth to that level will make everybody gratified.

So, three years later, here we are and nothing much has changed. GAAP is still woefully deficient when it comes to telling anything like it really is, and there is plenty of blame to go around. Yet nobody is bothered or talking about it. The sorriest part is that criticisms of GAAP's deficiencies are often dismissed as "theoretical" or "academic." That lazy rationalization fully reveals that the status quo's apologists are unaware that the capital markets are substantially less efficient than they otherwise would be if GAAP financial statements provided their users with a more transparent and (dare we say it?) useful view of entities' financial position and performance.

The payoff from avoiding these real negative consequences should be enough to motivate everyone to do all they can to bring about the changes that are so desperately needed but so completely disregarded.

 

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 or Accounting Today. reach them at paulandpaul@qfr.biz.

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