In November, Conrad Hewitt resigned as chief accountant of the Securities and Exchange Commission. In mid-December President-elect Obama named Mary Schapiro to replace Christopher Cox as the chair of the SEC. With the capital markets in disarray, we're hopeful that Schapiro will pick a top accountant who will lead the way toward significant reform. Given the turmoil, and the historical fact that more progress in accounting tends to occur under Democrat administrations, we call for her to cast a new vision for real reform and empower the next chief to get it done.With those thoughts in mind, we have identified the top eight things for her "to do" list.
Chief accountants can be only as good as their staff. Traditionally, the cadre consists of SEC regulars working alongside professional fellows from large accounting firms. That's fine, but the new chief should follow the Financial Accounting Standards Board's lead and add at least one knowledgeable financial statement user to the team.
All too often, accounting issues are defined, analyzed and resolved by accountants without considering users' needs. Beyond that, the chief must challenge the whole staff to look critically at the status quo and create meaningful change.
We're amazed at the legs of the anti-mark-to-market movement. We continue to hear people who should know better essentially proclaim that truth is detrimental to capital markets and the public interest. This poppycock needs to be put to rest.
Sure, some values can't be as reliably estimated when markets are in turmoil, but that is precisely when those estimates are needed. What opponents to mark-to-market seem to think is that users who don't get what they want from GAAP statements simply capitulate and use the bad information in those reports as if it's believable.
To the contrary, if their needs aren't met, users may choose to not invest in a company, may invest but only after deeply discounting the price, or may spend a lot of time and money trying to estimate values on their own, and then end up discounting the stock to justify their effort and uncertainty. In all three cases, stock prices wither.
The next to-do's involve getting FASB to act quickly on three big projects.
The new chief should encourage FASB to complete Phase Two of its project that aims to explicitly and immediately recognize pension-related effects on employers' reported income, while also considering any other needed improvements, such as disaggregating unlike things that are mixed together and offset, like operating expenses and investment gains.
This phase is likely to do away with the current Rube Goldberg processes that smooth reported income while real income gyrates. It's astounding that companies with 20, 30 or even 40 percent losses on their pension funds from the market drop will report their 2008 pension cost as if they earned their expected 8 percent.
The new chief should also push FASB and the International Accounting Standards Board to stop offsetting pension assets against liabilities, because doing so covers up some of the excessive leverage that helped bring on today's market struggles.
Another big hole in statement integrity is the shameful longstanding tolerance of using operating leases to achieve off-balance-sheet financing. In 2005, the SEC estimated that leases were being used to produce $1.25 trillion of OBSF (Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002, p. 8).
FASB is poised to finish a project that would put these leases on balance sheets, and the chief should protect the board against whiny opponents to this crucial reform. Speeches and other communications could help FASB move ahead, while informing managers why their arguments aren't addressing the key issue of transparency.
The only useful answer is retroactive restatement to put all lease liabilities on the balance sheet, while getting the assets in the base for assessing lessees' rates of return. The change will also upgrade the quality of income and cash flow statements.
5. LIABILITIES AND EQUITY
Speaking of liabilities, few realize that FASB is already almost convinced that all items on the right side of today's balance sheets are liabilities except for common stock. A 2007 preliminary views document (Financial Instruments with Characteristics of Equity) explained that the board favors shifting everything but the very last ownership component out of equity. Preferred stock? It's debt. Stock options and warrants? They're derivative liabilities, and should be marked to market to boot. Most convertible bonds will soon be divided into debt and equity (to be discussed in our next column) but this bigger project could be expedited to implement those tentative conclusions.
This new accounting is essential to boosting the balance sheet's integrity, which has been compromised away for decades. Of course, this shift will profoundly affect many other things, including the blithe assumption that liabilities are stable instruments.
6. SLOW THE TIMETABLE
The chief should demonstrate political courage by putting the brakes on Chairman Cox's last-minute project that laid out an ambitious timetable for converting from U.S. GAAP to IFRS. We think the proposal should be put to the side until later because confidence in corporate management is currently so low and because FASB is so close to implementing many key reforms.
Under these circumstances, it just isn't wise for the SEC to rush into delegating rule-drafting authority to an offshore board that depends on corporate largesse for funding and is pretty much beyond SEC oversight. We hope the new chief will feel the same way and slow down this runaway train. After all, the Republican engineer who opened the throttle won't be around any more.
7. BUILD UP IASB
At the same time, we encourage the chief to help the IASB enhance its financial and political independence, and hence its ability to serve users' needs. As we see it, a threat of dominance by auditors and statement preparers is looming over this board, just as it used to for FASB.
Specifically, the IASB's contribution-based funding model needs to be replaced. We think it would be far better if stock exchanges around the world would impose a minuscule charge per traded share and send it to the IASB. It's incongruous to have the regulatory process funded by managers, the regulated group. Everyone would be better off if users footed the bill for better accounting.
8. CHALLENGE AUDITORS
Our interpretation of history shows that auditors, despite expressed commitments to independence and integrity, have not only made the status quo inadequate for fully informing statement users, but also fought hard to keep it in place.
Without leadership from a new chief, we think they will cling to their outmoded paradigm and resist reforms that will open up vast new opportunities for them. Specifically, they accomplish relatively little by attesting to compliance with GAAP (or IFRS) when those standards don't put useful information in financial statements.
Thus, the chief should engage audit leaders to help them comprehend that their social mission is adding usefulness to statements so that users find them relevant, complete and reliable. This proposition is different from compliance with GAAP anchored in historical costs and other forms of biased and unreliable information.
Instead, auditors could add usefulness by assuring users that market-based information is reliable. This reform would be huge, no doubt, but it's going to happen sooner or later, so the new chief might as well help get it started now.
THE TIME IS RIGHT
To summarize: The time is right for significantly improving the status quo, and it's never been quite as susceptible to change as it is now because of the economy's struggles, strong public opinion against corporate management, and a new national administration that claims commitment to change. An opportunity like this comes only once in a generation or two, so we hope it isn't squandered.
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 email@example.com.
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