One benefit of the academic life is flexibility to spend some time each summer catching up on our reading.
Admittedly, some of it is purely for pleasure, but many of the pages we turn are vocational in nature. This past summer, our reading list included the book, Indecent Disclosure: Gilding the Corporate Lily, by Frank Clarke and Graham Dean.
This thoughtful and provocative work was written by two well-known international accounting professors. Clark has had a long and illustrious career in the U.K. at the University of Newcastle, and Dean is a long-time faculty member at the University of Sydney in Australia, and also editor of the academic journal Abacus. The authors put a historical context around the new millennium's wave of accounting scandals in the U.S. (Enron, for example), as well as around the globe (Parmalat). They also carefully analyze and critique the regulatory responses to these fiascos.
We can't say that the book is an easy read, in part due to the unfamiliar form of English (in contrast to our American tongue) and more so because of its academic tone, with extensive references and footnotes that explain many subtle points. Nevertheless, the book's meticulous research and logic lead to conclusions that, for the most part, are quite compelling.
We want to comment on two of their major conclusions: first, that mere conformity with accounting standards, whether GAAP, International Financial Reporting Standards or any other, does not provide useful information, and second, that contemporary corporate governance systems are not up to the challenge of effectively leading and managing today's large and complex corporate entities.
In addition, we will also comment on another of their points that issuing standards to require expensing of employee stock options was a misguided attempt to punish corporations' managers for past unsavory actions.
We find each of these three points interesting, but for different reasons. In the first case, we couldn't agree more. In the second, this unique perspective on governance is one that Americans should give serious thought to as we evaluate recent changes made to our corporate regulatory framework through Sarbanes-Oxley. Our counsel is that Congress and others should consider Clarke and Dean's idea carefully when contemplating other changes.
In the third case, we find their conclusion about options to be aligned with conventional Conceptual Framework thinking that needs a jolt to catch up with the times, especially with regard to the ongoing explosion of ever-more complex financial instruments and engineered transactions that muddle the line between debt and equity.
Now for more on each of these points.
COMPLIANCE not = USEFULNESS
Clarke and Dean write that the accounting profession is at a crossroads because financial reporting is in a deep crisis. We agree wholeheartedly. In fact, we think they would find some truth and amusement in our alternative acronyms for U.S. GAAP: PEAP (Politically Expedient Accounting Principles), WYWAP (Whatever You Want Accounting Principles) and POOP (Pitifully Old And Obsolete Principles). It appears that we and they arrived at the same conclusion by independent paths - specifically, that adherence to contemporary accounting regulations, whether U.S. GAAP or IFRS, is much better described as a compliance exercise than as effort directed at providing useful information for external decision-makers.
We also agree that financial reports can be made more useful only by re-orienting measurement away from the last remnants of historical cost to one based on market values. Under the magnifying glass, we may quibble with them on some particulars, but we would gladly accept their or virtually any other market-based approach in place of the deficient and decrepit system currently in place.
INDEPENDENCE not = HONESTY
Second, Clarke and Dean offer a new perspective on the current state of corporate governance and the rightful obligations of corporate managers to society for the benefits they have been granted. Efforts to regulate managers and governance systems have tried to ensure legitimate corporate operations by creating independence requirements for boards and auditors. Clarke and Dean make a compelling case that they haven't worked and likely won't work in the future, despite the latest embellishments added by the world-wide proliferation of post-scandal legislation. In a nutshell, independence simply does not correlate with honesty, and there certainly is no guarantee that so-called independent directors will have the moral courage or organizational power to rein in managements that do whatever they want.
Clarke and Dean also wonder whether the vast size and complexity of today's corporate consolidated entities simply overwhelm any attempt to create effective governance from the outside. According to them, any governance model won't work unless it co-exists with a financial reporting system that results in full and honest disclosure of corporations' "wealth and financial progress."
The authors assert that the public has the right to insist that just such a reporting system be established. After all, corporations are created as a matter of public policy designed to increase economic productivity. Therefore, they operate at the pleasure of society, rather than through some divine right that allows managers to do as they wish with impunity. Because the limited liability status granted to corporations is an exceptionally valuable social franchise, the public has the right to ask for a great deal in return. This principle of full accountability for limited liability is good food for thought as the global capital markets look forward to a new financial reporting model imposed through international standards that will be used in the U.S. before you know it.
OPTIONS not = EQUITY
Finally, lest anyone think this column is an unfettered love fest for Clarke and Dean, we found one major issue where we totally disagree with them. Specifically, they argue that the drive to expense stock options was fueled inappropriately by public outrage over stratospheric executive compensation, as well as the scandals. They characterize the expensing standard as a misguided shotgun approach to punish all corporate managers for the past tawdry actions of only some of their number. This claim is based on a premise that options don't create expenses because they don't result in "the diminution of assets or the increase in liabilities" as described in the Conceptual Framework's expense definition.
As we have explained more than once, the more productive response to this contradiction is to fix the flaw in the conceptual definition of liabilities so that it includes derivative obligations, including options. Because options superficially appear to many, including the Financial Accounting Standards Board and the International Accounting Standards Board, as well as Clarke and Dean, to be equity instruments, they arrive at the logical but not optimal conclusion that an increase in their amount is not an expense.
However, if options and other similar instruments are analyzed for their substance, it becomes clear that they are derivative liabilities that obligate the issuer to sell shares at a discount. Because option values are highly volatile, their only useful measure is fair value and the only accounting approach that fully conveys that information is mark-to-market, with expenses and subsequent gains and losses reported on the income statement.
In SFAS 150, FASB acknowledges that some derivative obligations to issue shares at a discount are liabilities. By doing so, the members signaled their intent to fix the framework's liability definition. Notably, the board exempted employee options from SFAS 150 to avoid political mayhem. We're waiting to see how much progress is made in the new framework being produced jointly by FASB and the IASB.
As we see it, the scandals, outlandish compensation, and SOX tilted the balance of standard-setting power. This shift allowed FASB to require the expense treatment, just as most of its former members had wanted to do since the early 1990s. Rather than punishing egregious behavior, the new standard only allowed the current members to do what they knew should have been done long before.
LONG DAYS OF SUMMER
We know it's not just us who use the summer to catch up on reading. We hope you found some books that both confirmed and challenged your long-held beliefs about our shared profession.
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.
