Consider this seemingly incontrovertible Feb. 24, 2010, assertion by American Institute of CPAs chief executive Barry Melancon: "Our increasingly global economy makes it clear that the U.S. should move toward a single set of high-quality, globally accepted accounting standards for public companies."

Actually, his contention is controversial and this column delves into the controversy by exploring the issue of "high-quality" standards. Our next will discredit the illusory advantages of "a single set" of global standards.

HIGH-QUALITY STANDARDS?

Melancon and his advisors should be careful when wishing for "high-quality accounting standards." While theoretically possible, hard facts reveal that nothing like them exists today and can't be created anytime soon. Further, if they were created, they wouldn't be familiar to accountants steeped in U.S. GAAP, or even International Financial Reporting Standards, for that matter.

To show we're not newcomers to this arena, here's what we said in May 2005 ("Convergence: Don't confuse the means with the end"): "It will do absolutely no good to converge on today's compromised and otherwise mediocre standards. Indeed, we're convinced the current brand of convergence will not just fail to produce better accounting but will inhibit the development of truly high-quality new standards. Once labor and political capital are sunk into getting mere convergence, no one will want to rock the boat by daring to bring entirely new solutions to bear on the problems. Yet it is entirely new solutions that are needed."

Melancon's flawed premise is that high quality will be achieved by merely merging GAAP and IFRS. If he and others really want high-quality standards, they face a mountain of work and substantive change, because the system doesn't need a few hasty tweaks but a complete rebuild that will take years to finish.

OBJECTIVES FOR REPORTING

To set the stage, here is the objective to be served by having high-quality standards: Financial reporting must provide capital markets with useful and timely information.

To produce quality, participants must adopt these behaviors:

* Standard-setters must continually raise the bar, because standards create minimum requirements, far short of everything users need.

* Managers must provide useful information voluntarily, instead of begrudgingly reporting only those bare minimums.

* Auditors must understand that their role is to protect the system's integrity, not their own positions.

* Regulators must encourage better minimum standards and enforce them to the maximum extent of the law.

Achieving high quality requires nothing short of relentlessly pursuing useful truth. Merely blending two sets of outdated and otherwise mediocre politically compromised rules won't get it done.

A "TO-DO" LIST

Here are 20 of our highest-priority reforms that will enhance quality. (We focus on GAAP, but IFRS shares most of these limitations.)

1. Cash: Existing rules permit reporting egregiously boosted cash balances by classifying outstanding checks from deliberately overdrawn checking accounts as liabilities (e.g., Abercrombie & Fitch). Instead, overdrafts should reduce reported cash, period.

2. Cash flows: The indirect format is indecipherable and useless. The preferable direct method should be required; also, investment income and interest don't belong in operating cash flows and income taxes should be allocated among operating, investing and financing flows.

3. Accounts receivable: Recognizing receivables at their realizable amount overstates their value while frontloading and misclassifying revenue by including future interest income in sales. They should be reported at market with interest recognized later.

4. Inventory: Today's practices obscure how much value is added through production by not reporting it separately from value added by marketing. Inventories should be marked to wholesale value to produce more reliable balance sheets and more complete income statements.

5. Investments: Accepted accounting for investments inadequately describes risk exposure and volatility. Useful information would follow from marking them to market with all changes flowing through income, regardless of management's intent or level of influence.

6. Combinations: Thankfully, pooling is gone, but the acquisition method uselessly mixes market and book values. New basis accounting would report all assets and liabilities for both companies at market.

7. Tangible assets: With its fallacious assumptions and unverifiable predictions, systematic depreciation should have been abandoned decades ago. Instead, tangible assets should be marked to market and all observed (not assumed) value changes, up or down, realized or unrealized, should flow through income.

8. Intangible assets: Not all intangibles are currently recognized, and those that are reported are carried at lower of cost or impaired value. Wherever possible, intangibles (including those generated internally) should be marked to market. If reliable values can't be found, management should disclose why they acquired the intangibles, how much they paid, and why they obtained them without knowing their value.

9. Accounts payable: Payables are booked at net realizable value, thus burying interest expense within the originating cost. They should be carried at market with interest explicitly reported later.

10. Bonds and notes payable: Debts are reported at deceptively stable book values and future interest expense is calculated at issuance without regard to subsequent market-induced volatility. In fact, value and interest vary when market rates change and when an issuer's credit standing changes. Instead of presenting illusory stability, marking debt to market unveils borrowers' enormous risks.

11. Convertible bonds: Convertibles are reported like nonconvertible bonds, leading to abuse by issuers of low or zero coupon contingent convertibles. They should be divided into their debt and derivative portions and marked separately to market. The conversion derivative should be reported among liabilities, not equity.

12. Contingent liabilities: Contingencies are perennially elusive, which means information about them is highly important; nonetheless, they're accounted for under very old and subjective rules. Management should recognize as many as possible and mark them to market. (Because it's often untenable to put litigation contingencies on balance sheets, extensive disclosures are needed.)

13. Stock options: Despite the hullabaloo over options, practice misclassifies the derivative liability as equity and misstates its value, thereby failing to recognize the full expense and the tax consequences. Like other derivatives, options should be identified as liabilities and marked to market, with value changes flowing into income as additions to or deductions from compensation. Disclosures should reveal how much the company owes each manager.

14. Derivatives: Today's unfathomable derivative accounting can be fixed by putting all derivatives on balance sheets as assets or liabilities and marking them to market with changes flowing through earnings. If they're hedges, they should not be offset; rather, their losses and gains will reveal their effectiveness.

15. Preferred stock: Despite being called "stock," preferred shares are de facto liabilities. Rather than being preferable equity, they're very bad debt because they're uncollateralized, fall in last place, and offer no contractual yield. Managers issue them to misleadingly boost reported equity, even though they're actually costly bonds with nondeductible interest payments. They should be reported as such.

16. Treasury stock: The concept of holding one's own stock is bogus. Because buybacks are discretionary distributions of corporate assets to only certain shareholders, management should immediately reduce equity and disclose how many shares were acquired, the prices paid, whose shares were acquired (especially insiders), why shares were bought instead of paying dividends, and what subsequently happened to the stock price. Because these deals are treacherous, complete information is essential.

17. Leases: Many now use leases to trick markets by keeping assets and debt off balance sheets; the only ones fooled are managers who don't realize they're actually declaring they're untrustworthy. To produce more reliable statements, leases should be reported as purchases and sales of rights to use property. Doing so improves cash flow statements by including lease payments among outflows for financing, not operations.

18. Pensions: We loathe the useless rules for defined-benefit pensions and other post-employment benefits that were forged 25 years ago when the Financial Accounting Standards Board depended on corporate charity (as the International Accounting Standards Board still does). Quality practice will put fund assets and benefit liabilities on balance sheets without offsetting. Costs for new benefits and interest would not be offset with investment income. Reporting unsmoothed results from investing, amendments and actuarial adjustments will unveil these plans' extreme riskiness.

19. Earnings per share: EPS is disingenuous malarkey designed to mollify clueless business reporters and mislead very, very lazy financial analysts. It's a myth that a single number can usefully describe performance, especially when it's calculated using a deeply flawed numerator (net income) and a denominator based on the simplistic treasury stock method. The best way to start fixing EPS is to make the numerator reliable.

20. Reporting frequency: Markets cannot be efficient if they receive information once every 90 days. Greater frequency is feasible and would help users while stabilizing markets. Are we alone in seeing the irony in using the Internet to instantly deliver outdated quarterly reports?

This list illustrates our point, but it wouldn't take much effort to make it longer.

TIME TO GET STARTED

To FASB, the IASB, the SEC, the AICPA, and large CPA firms: Be careful what you wish for. Before proclaiming that you want high-quality standards, figure out what they look like. We have the feeling that Melancon and others assume today's standards are already high-quality. It just isn't so.

We closed our May 2005 column with this thought: "So, here we are, calling for a paradigm shift toward looking at issues from the perspective of those who demand reports, instead of those who supply them. Until standard-setters choose to serve only users' needs, convergence will be nothing but an empty exercise that wastes the irreplaceable time and efforts of a great many highly talented individuals around the world, and what a shame that is."

We had it right and still do. If people really want high-quality standards, they need to stop wishing, and join the revolution.

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.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access