Back in the 1960s, Arlo Guthrie arrived on the scene with a song that lasted about 40 minutes if every part was performed. The enduring refrain is, "You can get anything you want at Alice's restaurant."
The chorus about an endless menu reminds us of the issue we've been wrestling with in the last few columns, namely the Financial Accounting Standards Board's proposal to eliminate the Rule 203 exception that essentially calls on CPAs to depart from generally accepted accounting principles if compliance will create misleading financial statements.
We think the exception is crucial for bringing voluntary innovation to financial reporting. FASB, on the other hand, apparently sees the exception as a mildly annoying question mark hanging over its authority to determine the contents of financial statements.
Our previous column explained PEAP, our tongue-in-cheek acronym for "Politically Expedient Accounting Principles." We showed how most, if not all, GAAP emerges from a political process that produces convenient compromises that make financial statements less than useful. In other words, existing GAAP is not so good.
This column unveils another disturbing characteristic of many accepted practices, namely that they offer great flexibility in implementation. We suggest using the alternate acronym of WYWAP, or "Whatever You Want Accounting Principles," which we will illustrate with a series of examples, some of which were mentioned in the prior column as PEAP. It is no coincidence that they fall in both categories, because FASB feels the greatest political pressure from managers who want flexibility.
Comparability and uniformity
To set the stage, we want to talk briefly about comparability and uniformity. Comparability exists when events and conditions are reported in such a way that their relevant similarities and differences are unambiguously revealed. Comparability is obviously important in financial reporting because investors are comparing various opportunities.
Uniformity exists when all entities report the same events and situations in the same way. Although that sounds like comparability, it isn't. In fact, uniformity is necessary for comparability, but not sufficient for creating it, which is a fancy way to say that uniformity is never enough on its own.
In many cases, a practical but misguided uniformity may actually impede comparability. For example, consider research and development: Everyone is supposed to uniformly write off all R&D. That treatment would be fine if all R&D activity was unsuccessful. Of course, that isn't the case, but GAAP financial statements make it look as if every company lost every dime it spent, even though some will be better off than others and better off than they would have been if they had spent nothing.
To make things worse, the reported income results suggest that companies that incur no R&D costs are better off. In this case, uniformity doesn't produce comparable information, because the uniform practice is not representationally faithful. Uniformity is only a means to the end of comparability, and is not an end in itself.
Uniformity leads to comparability only when everyone accounts in the same useful way. To the dismay of many, pursuing this goal will inevitably lead to reporting market values, because doing so puts all firms on the same footing. But that's another story we've told before.
Unfortunately, we find that GAAP often falls short of even the meager (and misguided) goal of uniformity, because it embraces extremely different practices as equivalent.
Flexibility is demonstrated perfectly with GAAP for inventories. The authoritative guidance in ARB 43 was published more than 50 years ago; in fact, that bulletin merely restated what was included in ARB 29, issued in 1947.
It is pathetic by today's standards, saying simply that, "Cost for inventory purposes may be determined under any one of several assumptions as to the flow cost factors (such as first-in first-out, average, and last-in first-out); the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income."
No kidding. Just do whatever feels right!
If you want higher reported earnings, use FIFO; if you want lower taxes and higher real earnings, and don't mind incomplete financial statements, use LIFO; if you don't know what you want, use average; and, if you're really confused, use them all for different portions of your inventory. Preparers can choose anything they want, but users end up without useful information about inventory, cost of goods sold and earnings. When was the last time you heard a commentator indicate whether a company's EPS for the quarter was based on FIFO or LIFO? Probably never.
Inventory accounting is pure WYWAP, undetected by most.
By definition, "depreciation" means the "loss of an asset's value as time passes." However, in accounting, it means allocating original cost (less a predicted salvage value) over a predicted service life using some systematic predicted pattern. When you stop and think about it, this idea is totally outrageous - instead of reporting what you have recently observed, you report what you predicted, perhaps as long ago as ten or 20 years before.
You can choose straight-line, SOYD, one of the declining balance methods, a units-based method - whatever you want. And you also get to pick the salvage value and service life. You want a lot of depreciation or a little bit? You want more now and less later, or do you want to spread it out evenly? No problem.
Absolutely pure WYWAP. But do we hear any commentators describing a company's depreciation policies when they report earnings per share? No. And do we hear FASB talking about updating authoritative guidance that dates back to 1946? No. They're actually claiming that depreciation accounting is perfect. If they weren't so serious about it, we would call it laughable.
Imagine that a large corporation issues some 20-year bonds in a volatile environment that causes rates and the bonds' market values to change. Now suppose that three companies each buy a bond at par on the issue date and still hold it at the end of the year. Wouldn't it make sense for each investor to report exactly the same result at year-end? Or forever, for that matter? Well, yes, that would be reasonable for a reporting system that FASB has proclaimed to be perfectly fine.
However, this outcome is not guaranteed under SFAS 115. Suppose the first investor plans to sell the bond at any opportune moment, while the second one plans to sell it in the future, but the third plans to lock it away until maturity. The first company's balance sheet reports the bond at market with the change in value on the income statement. The second also reports the bond at market, but the value change appears in the equity section as unrealized. The third reports the bond at cost, without recognizing the changed value of the bond in income.
Each presents something different, even though they experienced exactly the same results and hold exactly the same asset. The only difference between their situations is what they plan to do. Pure WYWAP! Is FASB ready to change? Not on your life.
* Until lately, managers could expense options or not. They can still decide how to accomplish the transition to mandatory expensing. WYWAP.
* Leases can be deemed operating or capital simply by manipulating the expected useful life or the discount rate. Two assets doing the same work at the same time can be reported completely differently according to whether they're capitalized or not. WYWAP.
* Going back all the way to the 1930s, Treasury stock is accounted for with either the cost or par value method. Chapter 1A of ARB 43 indicates that it may be appropriate in some cases to report it as an asset. WYWAP.
* For 70 years, large stock dividends have been accounted for differently from small ones. If you read the original distinction in ARB 43 between large and small, you'll see that a stock dividend is small if it is, and we quote, "less than, say, 20 percent or 25 percent of the previously outstanding shares." WYWAP.
Again, we illustrate the unsound rationale behind FASB's proposal to do away with Rule 203 exceptions. Today's GAAP is not up to the task of creating useful information.
Two things are desperately needed. The first is an attitude that it is good to depart from GAAP if the result is telling more truth with more timeliness and clarity. The second is a standard-setting body that acknowledges that current GAAP is not up to the task.
It's long past time for wholesale reform, but our friends at FASB are now acting like there's nothing left to fix.
Stay tuned. We'll say more in the next column about the age of GAAP. We hope you will be amazed and even amused, if only by the irony of it all.
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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