The Spirit of Accounting: Potpourri
We're writing about three topics that individually don't add up to a whole column, but collectively provide plenty of food for thought.
IASB vs. EU Parliament
October's accounting news reported that the European Parliament was threatening to withhold an $11 million contribution to the International Accounting Standards Board if it refuses to water down its conceptual framework. Although Chair Hans Hoogervorst bravely called the situation "worrisome," we're not sure he and the board have enough political support to face down that much power and avoid the loss without retreating.
We find two lessons in this whole affair.
AN OLD AND BAD PARADIGM
The news revealed that Parliament members want "prudence" to be a quality of useful information, hoping it would take the steam out of advances toward more value-based measures in financial statements. We believe that their typical politicians' paradigm leads them to perpetuate the anachronistic idea that more stable capital markets will be created by standards that aim to help managers merely look better by hiding the truth.
We're always perturbed when otherwise intelligent and respected leaders display such stunning naivetÃ©. Specifically, a policy that leads to reporting artificially stable financial numbers won't do away with real instability any more than retouching a photo to remove a facial imperfection eliminates the real blemish. Instead, they need to comprehend that markets relish the truth, and know when they aren't getting it. Investors react to that uncertainty by attributing more risk to their investment options and demanding higher returns and lower security prices. The outcome is more instability, not less.
If the politicians were prudent themselves, they would compel the IASB to put more values into financial reports.
A GREAT ESCAPE
We think that everyone in the U.S. should breathe a big sigh of relief and send thank-you notes to Mary Schapiro because the movement to adopt International Financial Reporting Standards instead of GAAP (and replace the Financial Accounting Standards Board with the IASB) came to naught. This episode shows that implementing that idea would have put U.S. reporting standards under the sway of inept European politicians.
It also proves that George Washington was totally right when he advised against pointless relationships with other nations lest we get pulled into their squabbles that mean nothing but trouble for us.
In addition, it confirms how wrong (or wrongheaded) IFRS advocates really were, including the four largest firms, former Securities and Exchange Commission Chairman Christopher Cox, Paul Volcker, textbook publishers, many academicians, and the American Institute of CPAs.
We think the evidence already shows that Schapiro adopted the best strategy of studying the proposal long enough for it to collapse under its own weight. Even the most ardent supporters of adopting IFRS should acknowledge that it was a bust.
M. Prada stumbles
Although we wish the IASB the best in its fight, Michel Prada, the IFRS Foundation chair, put his pied dans sa bouche in a November speech in Japan.
To display his Gallic wit, he conjured the image of ordering Ã la carte from a menu to disparage countries that use only selected parts of IFRS. To him, Ã la carte may be gauche, but his analogy lost something in translation because his hosts often build a meal from an array of little plates. One of us remembers a great Tokyo dinner that included German sausages, grilled beefsteak, tempura vegetables, and baby eels dredged in batter and plunged alive into hot oil.
Our point: He should be pleased anyone is using IFRS, period.
Prada boasted about the IASB's improved status since 2001 by saying, "The part-time IASC was replaced with a full-time and well-resourced IASB, and the rest is history."
Actually, we suggest that it's his politically ambitious dream to make the IASB the sole standard-setter that is history. Despite much evidence, he is yet to comprehend that the SEC has clearly communicated it won't go there. We doubt he understands that the IASB would have to do these things just to get the SEC's attention: submit to the commission's oversight; accept funding from fees paid mostly by American public companies; and promptly deliver help whenever the SEC asks for it.
Our point: It won't happen.
After Prada declared, "I am not always comfortable with the notion of cultural specificities in [accounting]," he asked this rhetorical question: "If the accounting preferences of France, Germany and the United Kingdom could be bridged by IFRS, then why not the EU, Japan, the United States and other parts of the world?"
Actually, it's no mystery at all.
First, France, Germany, and the U.K. have similar Western cultures. Second, he should know that different cultures have radically different attitudes toward the truth. For example, Americans worship truth-telling, especially when someone prominent is caught lying. Europeans' so-called "prudence" is aimed at keeping those outside the inner circle from learning what's going on. Other cultures easily tolerate leaders who avoid embarrassment by saying things everybody knows aren't true.
Our point: We regret Prada's dismissive attitude toward problems created by such cultural differences and know that it is not characteristic of everyone at the IASB.
LA CARTE BEFORE THE HORSE?
Prada lamely described his goal as "a single set of high-quality global accounting standards." We think that all he really wants is to get the single set, and that he doesn't care about the "high-quality" part.
The obvious clue is his proclamation that, "By the way, ... I'm not involved in technicalities." If he isn't technically competent, how can he judge whether IFRS have high quality?
Our point: He should have done his homework or just stayed at home.
GAAP reporting as perjury
We've been thinking about this next point as a way to identify some "opportunities for improvement" in financial reporting. Specifically, a TV show's trial scene started us wondering whether a set of GAAP financial statements could be found guilty of perjury for violating an oath to "Tell the truth, the whole truth, and nothing but the truth."
This evidence could be presented to the jury:
- Because balance sheets report original costs for assets, they are telling the truth but not the whole truth because those numbers aren't timely descriptions of current conditions.
- We find no truth whatsoever in expenses and book values produced through systematic depreciation because those numbers are just made up.
- Although reporting impairments below book value tells a truth, it's obviously not the whole truth because it deliberately omits equally reliable market value increments above book value.
- Because balance sheets omit some assets, such as marketable R&D ideas and many leased assets, they and their accompanying income statements certainly aren't telling the whole truth.
- When any off-balance-sheet financing occurs, balance sheets obviously aren't telling even a partial truth.
- Financial statement measures for defined-benefit pensions pretty much miss on all three counts because they aren't true, obfuscate the facts, and depend on fabricated assumptions.
- Preferred stock is classified as equity but we're convinced that it's really unpreferred debt, in which case there's no truth about it on its issuers' statements.
- We think stock options are also misrepresented as equity because they're actually derivative liabilities; also, reported compensation expense is only partially truthful because it never includes amounts over and above the options' initial grant date value.
- Hiding unrealized gains and losses on available-for-sale investments within equity isn't telling the whole truth; income statements are also botched up because they don't recognize value changes that produce realized gains and losses as income in the years they really occur, but do report them as income in the years they don't occur.
- The cash flow statement is guilty as charged by reporting nothing but non-cash items in the indirect operating cash flow presentation; including all income tax payments in operating cash flow even if they aren't caused by operations; not reporting interest payments in the financing section; and excluding interest and dividend receipts from investing inflows. The whole thing is a mess of untruths and half-truths.
Bottom line, any fair-minded jury would find that current financial statements do not tell the truth, the whole truth, and nothing but the truth and recommend a long sentence without possibility of parole.
We speculate that some will defend GAAP and excuse its practitioners by claiming that they shouldn't be held to the same standard as trial witnesses. It has to make you wonder why financial statement users aren't entitled to as much truth as members of a jury are.
A MANDATORY DISCLAIMER
In conclusion, we suggest that this disclaimer should accompany all GAAP financial statements: "WARNING - the issuer of the accompanying financial statements makes no representation that they contain the truth, the whole truth and nothing but the truth. The user assumes full responsibility for any and all consequences of relying on their contents."
Before someone gets hopeful that they could use this disclaimer to limit their litigation exposure, we confess we're being sarcastic. Sort of.
Summing it up
Kudos to the former SEC chair for keeping the standard-setting process here at home and free from the intricate inanities of European politics. Best wishes to our colleagues at the IASB as they fight a crucial battle for their independence. We strongly encourage them to focus first on significantly improving financial reporting before they indulge their not-so-secret ambition of being the only authoritative standard-setter in the whole world.
Finally, we offer a "Get with it" admonition to the profession to first acknowledge and then eliminate the many obvious flaws in reporting standards so they'll produce useful and truthful financial statements. Until that change is accomplished, accountants will not offer as much value to their clients and the capital markets as they should. And to that, your honor, we object.
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 or Accounting Today. Reach them at email@example.com.