It’s vacation season, and we’re buying some relief from the never-ending stream of deadlines by republishing our all-time favorite tongue-in-cheek column that sheds light on how ludicrous many important features of GAAP are.If financial statements really are scorecards for business, reporting real outcomes, as well as sources of information for predicting the future, it’s essential that they usefully describe what actually happens instead of what someone hoped would happen.
Most everyone who plays golf engages in a little self-deception now and again to make their shortcomings a little more tolerable to their egos. Mulligans, for example, allow them to harmlessly pretend that they really didn’t hit the first ball out of bounds. That kind of fudging is OK if all that’s at stake is bragging rights at the 19th hole. But it’s an entirely different story in the club championship or a televised tournament, where a mulligan would lead to the disgrace of disqualification as a breach of the strict rules.
When it comes to fulfilling accounting’s social responsibility for providing useful facts, it’s also true that every stroke counts. After all, the “financial reporting tournament” is about making the capital markets more efficient engines of economic growth and stability. There should be no tolerance for failing to describe exactly what happened, instead of what managers want to report. In golf or management, it’s bad enough to hit a poor shot. It’s even worse to use creative scorekeeping to cover it up. The worst of all is foolishly pretending that the cover-up didn’t occur when everyone knows it did.
We hope that this column gives you a few ironic laughs while providing a serious-as-can-be insight into how bad GAAP really is.
For several reasons, we have been thinking about golf lately, and it’s occurred to us that the game would be a lot different if players kept score using something like GAAP. Along those lines, we’ve imagined that a standard-setting agency for scoring might create guidelines for a “Generally Accepted Golf Scoring” system called GAGS.
Of course, one conspicuous difference would be that the scorecard would include 10 pages of footnotes.
Included in GAGS would be the practice of allocating a predicted number of putts per round among the holes expected to be played, all without regard to the actual number. For example, it might be common to allocate two putts to each hole. While this practice would eliminate all fear of the three-putt, it would also do away with one-putts and chip-ins, but that would be the price of eliminating both volatility and the risk associated with reporting what really happens.
Another GAGS principle would allow off-scorecard sand-shots when certain criteria are avoided. Even though anyone could observe that a ball landed in the trap and that the golfer took several shots to get it onto the green, the rules would allow players to leave those strokes out of the score simply because they didn’t intend for the ball to wind up in the sand and make them look bad.
One popular feature of GAGS would be deferral of strokes in excess of par. Under this system, players would record no score higher than par on any hole despite actually having a bogey, double bogey or worse. The excess strokes would simply be deferred until they could be offset against birdies or eagles in rounds to be played in the future. Again, the goal would be to eliminate volatility by destroying any connection between the carded scores and actual results.
Still another GAGS standard would apply the lower-of-past-or-present-score method. Under this practice, golfers would maintain records of the lowest score ever achieved on each hole. Then, during a real round, they would enter an actual score on a given hole only if it was lower than their previous low score.
One more feature of GAGS would include pairs of alternative practices, one preferable and the other merely acceptable. For example, consider shots into water hazards. When players hit a ball into the drink, they would have the option of adding that stroke plus a penalty to their recorded score, or merely disclosing them in an arcane footnote that shows the pro forma score computed as if the shots had actually been counted.
Now, try to imagine what would happen when golfers using GAGS tried to compete in tournaments with players who apply the strict rules of golf. Further, suppose that all spectators are aware of the limitations in GAGS but want to know the real number of strokes taken, because the prize money will go to the players who have the fewest actual strokes, instead of those who merely report the smallest number.
It doesn’t take much imagination to see the connections between GAGS and GAAP.
* The really helpful information appears in the footnotes, not the financial statements.
* Accountants allocate assumed depreciation charges equally among years without ever checking to see what happened to the asset’s real value.
* Carefully crafted agreements allow lease liabilities to be left off the balance sheet.
* Lower-of-cost-or-market is still applied to inventories; even though it is no longer applied to investments, the Financial Accounting Standards Board requires managers to write down impaired assets and goodwill but forbids writing them up.
* The deferral method causes companies that actually pay income taxes to postpone reporting the expense until later years if and when reported pre-tax income is higher. We personally gag that undesired gains and losses for defined-benefit pension plans are deferred simply to avoid reporting the volatile truth.
* SFAS 123 allows managers to describe options-based compensation in pro forma footnotes, instead of deducting it from reported earnings. [Note: Even though 123 was revised to eliminate this off-income-statement expense treatment, the fact that it ever existed is a reminder that GAAP (and IFRS) are full of political compromises that cover up the truth.]
What’s important to realize is that the capital market doesn’t consist of ignorant or complacent spectators; instead, you can be sure that at least several sophisticated participants watch each public company carefully and develop their own scorecards based on actual events without believing the compromised, predicted, smoothed, deferred, and grossly incomplete and misleading numbers in GAAP reports. The prize money goes to those who create greater future cash-flow potential, instead of those who fabricate the highest reported earnings.
This analogy shows that anyone is foolish to believe that GAAP statements even approximate actual results and conditions. Just as the winner in a strict-rules tournament has the lowest number of actual strokes, winners in the capital market are managers who are most likely to achieve the highest real earnings and cash flows. Even if they report occasional bad news with candor as soon as it happens, the gallery cheers them on, and they are still eligible to compete in the future. The only permanent losers are cheaters who are likely to be banished from competing at the highest level.
It’s long past time for a change in outlook and practice. Because the standard-setting process is so compromised by political pressure and so characterized by ducking hard issues (like goodwill and options), the financial statements don’t reflect much about what really happens or exists. The capital market knows it and stock prices reflect it. Smart managers should stop fooling themselves, because they sure aren’t fooling anyone else.
In closing, let’s go to the first tee for the final round of the Open: “Fans, the championship is over. Lyon Forrest and Mel Michaelson have just compared their anticipated scores for today’s rounds and Michaelson has won the tournament because his predicted score of 62 is lower than the 64 that Forrest expected to shoot. What an amazing turn of events and a great victory powered by one of the sport’s greatest imaginations!”
Nonsense. But then so are most managers’ GAAP earnings announcements.
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 firstname.lastname@example.org.
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