Lately, the Financial Accounting Standards Board has publicized its efforts to simplify financial reporting with claims that it’s reducing costs while maintaining quality. However, what we keep seeing are mostly modest cuts in compliance costs incurred by statement preparers, traditionally the board’s most vocal constituency.
In contrast, statement users need and are eager for a different brand of simplification. Specifically, they want useful financial statements that report the simple truth.
However, they’re not getting them.
We remind everyone that FASB’s primary purpose is to improve financial information’s quality. To reflect that goal, we refer to user-oriented simplification as “qualitification” (qwa-LIT-uh-fah-kay-shun).
For the board and managers to actually qualitify (qwa-LIT-uh-fie) financial reports, they must increase users’ access to useful information and otherwise enhance their analysis and comprehension of its contents. These reforms should introduce new kinds of information while eliminating existing practices that obscure the truth and compel users to expend extra effort. This higher quality will encourage users to accept lower rates of return and thereby reduce capital costs for reporting companies.
In contrast, simplification that only reduces preparers’ compliance costs without significantly reducing their cost of capital is like picking pennies up out of the gutter while ignoring $100 bills lying on the sidewalk.
Therefore, we encourage the board to adopt more radical reporting strategies that will reduce preparers’ capital costs more than they increase preparation costs. As a matter of fact, we think smart reforms can actually reduce both costs.
FASB’S RECENT EFFORTS
Here are brief summaries of four practice areas where FASB has pursued simplification without qualitification. We expound on them momentarily.
- The first concerns deferred borrowing costs. The board proposes changing this balance sheet debit account that masquerades as an asset to instead be disguised as a contra-liability. This lateral move won’t help users or generate significant savings for managers.
- The second modifies lower-of-cost-or-market inventory accounting by discarding the time-honored “ceiling” and “floor” constraints on the market value that’s compared with cost. Although this change relieves the grievous pain and suffering imposed on accounting instructors and students, it won’t greatly improve users’ comprehension or reduce compliance costs.
- The third simplifies the equity method of accounting by putting an end to identifying and amortizing goodwill implied by the investor’s purchase price. Management might have some savings but users will experience no real benefit.
- The fourth proposes eliminating current/noncurrent classifications of deferred tax liabilities, a practice that has always seemed out of whack. We don’t expect it to affect users’ benefits or managers’ costs.
In every case, FASB has encountered sparse opposition but we don’t think that’s happened because these tweaks are worthwhile. Rather, we think it’s because they are of no real consequence. Whether on purpose, or not, the board has avoided controversy by not addressing real problems or harvesting real opportunities.
Managers neither acquire an asset nor reduce a liability when they incur debt-initiation costs. In fact, all they get is expert help for executing one-time transactions. Thus, FASB’s decision to merely reposition these costs on the balance sheet neither reduces compliance efforts nor helps users decipher the truth.
Clearly, the simplest and highest-quality approach would expense these costs immediately, just like SFAS 141R requires for pre-acquisition costs for business combinations. Further, sending these costs straight to the bottom line creates a benefit by encouraging management to avoid overspending. That’s good.
LCM FOR INVENTORY
FASB’s simplification effort for LCM merely fine-tunes a biased (and therefore useless) practice that’s almost 70 years old.
Instead, we suggest that marking entire inventories to market would be both desirable and feasible. (Before anybody panics, we’re calling for reporting their pre-marketing wholesale value, not retail.)
Mark-to-market is qualitifying because it will create new information that’s helpful for internal and external decisions. Specifically, income statements will recognize the value added by manufacturing separately from the value added by marketing in the periods those activities occurs. The current status quo mashes them together in gross profit associated with the period of the sale.
We’re confident that mark-to-market is feasible because LCM has always used replacement cost. All that’s needed is acknowledgement that it’s just as reliable whether it’s below or above original cost. Further, ration- al managers use intermediate valuations of work-in-process inventories for their decisions. Surely they can be made sufficiently reliable for external reporting without significantly increasing compliance costs.
Even if implementing market values were to increase preparers’ costs, users’ costs would plummet and the resulting reductions in their risk would cut the reporting company’s capital costs. A healthy bonus would occur when better informed management decisions boost profits. It’s win-win.
We’re sure the anachronistic equity method was concocted mainly to avoid reporting market values.
Conventional rationalization holds that the investor’s influence over the investee disqualifies dividends as an unbiased measure of return. Instead, the return is described with an adjusted pro-rata share of the investee’s reported earnings, thus sabotaging the amounts reported for both the investment and its income.
Alas, FASB’s tiny tweak eliminates only one arcane earnings adjustment while ignoring a host of problems.
In contrast, pursuing qualitification would lead to reporting the investment’s market value because it provides the most complete descriptions of the investor’s results and the asset’s present cash flow potential. Users would be delighted to have this information and compliance costs would shrink, perhaps even dramatically.
Some preparers are sure to object that they don’t know what their investments are worth. Because effective financial management practice demands that they have reliable estimates of their holdings’ value, we suggest that they should be replaced by more responsible stewards.
We also think that reporting market values will compel managers to make more astute acquisition and subsequent decisions. In other words, everybody wins except for the incompetent.
We find that FASB’s move to combine current and noncurrent deferred tax liabilities doesn’t begin to address the real problems that desperately need attention and correction. For example, it’s troubling that not discounting deferred tax payments causes tax expense and deferred liabilities to be reported at amounts that exceed the economic value of the contingent future outflows.
To us, however, far and away the most significant issue asks whether deferred tax liabilities have actual economic substance. Contrary to otherwise unchallenged conventional rationalizations, we’re persuaded the better answer to this question is a resounding “No!”
We reached this conclusion after looking at the long history behind deferred taxes. We believe it shows that the original reason for this method’s general acceptance was its ability to de-volatize annual tax expense by forcing it to equal a consistent proportion of GAAP pre-tax income. As a result, users have been disadvantaged because they’re presented with filtered information that management wants to report, instead of the straightforward facts they need for their analyses.
If FASB wants to qualitify accounting for taxes, it should adopt the flowthrough method that sets the year’s reported expense equal to the amount of tax computed on the return. Doing so would cause both users’ and preparers’ costs to decline immensely. If managers don’t like the volatility, then they can do better tax planning to actually smooth out the expense, instead of covering it up with today’s engineered GAAP.
In addition, we think it’s no accident that the status quo creates a politically advantageous impression that a company is paying taxes at the statutory rates when it really isn’t. (To be clear, we don’t object when any taxpayer pays the least amount the law requires. However, we are offended when a larger reported tax expense diverts attention from the smaller amount that is currently paid.) Therefore, using flowthrough would squelch managers’ disingenuous claims that their GAAP income statements prove they’re paying the full statutory rate.
We also note that tax deferral surely complicates assessments of tax policies. Thus, flowthrough would also be beneficial because it could potentially help Congress set those policies using more valid data about who is paying how much tax and when. After all, deferral accounting was invented to conceal these facts, instead of revealing them.
Of course, an eventual outcome of reporting this new information could be a reformed tax law with higher rates. However, before everyone reflexively shrinks back from this possibility, we assert that it would be a great innovation to build policies and the Tax Code using useful facts, instead of GAAP’s pseudo-information.
TWO MORE EXAMPLES
Beyond the previous four examples, qualitifying changes are urgently needed for defined-benefit pensions and available-for-sale investments.
In both cases, standards that aimed to satisfy preparers’ demands for smooth reported income produced the double whammy of increasing compliance costs, while also requiring users to exert immense extra effort to tweeze useful facts out of financial reports.
It’s inarguable that just reporting what actually happened would make both users and managers better off, thus creating a real win-win situation.
THERE YOU HAVE IT
We hope everyone reading these words understands that we strongly support simplifying both accounting standards and financial reports.
To be clear, though, we favor simplification when, and only when, it also genuinely increases quality by providing users with additional useful information. We favor it even more when this new information helps policy-makers make better policy while also guiding managers to better decisions while reducing their compliance costs.
Unfortunately, we reluctantly find that FASB’s simplification efforts, even with its sincere and enthusiastic board and staff members, are falling short of what should and can be done. We strongly encourage them to always strive to accomplish authentic qualitification and not quit when they merely reduce preparers’ costs.
Doing anything else wastes everybody’s precious time and needlessly prolongs market inefficiency.
Paul B. W. Miller is emeritus 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 firstname.lastname@example.org.
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