The Spirit of Accounting: The faulty paradigm problem
We’re in the midst of a series about the flawed and otherwise inadequate financial accounting paradigm that has mesmerized so many minds and left them unable to even perceive the myriad shortcomings in GAAP financial statements, much less attempt to fix them.
Even though we believe that, in the aggregate, the financial statement user community acts as if they comprehend the statements’ incompleteness and other flaws, we’re focusing this month on the likely truth that many individual users are unfortunately caught in that paradigm’s clutches. Probably because nothing else is available to them, they’re erroneously convinced that the statements are fully useful.
There’s plenty of blame to pass around, with a lot of it falling on accounting and finance faculties for teaching a curriculum that doesn’t confront the statements’ shortcomings or otherwise prepare their graduates to be leery of them.
A STANDARD-SETTER’S EXPERIENCE
Early in October, we traded e-mails with a senior person at the Financial Accounting Standards Board about what information users want to be presented in statements. It didn’t surprise us to hear that many users who participate in the board’s due process say that they want standards left unchanged.
We suspect these people are perfectly content with the status quo simply because their paradigm doesn’t embrace the possibility that GAAP financial statements’ usefulness is highly limited.
WANT OR NEED?
That conversation also touched on the difference between what users want (or say they want) and what they need to make better decisions. In fact, those needs can be uncovered only by stepping outside the current financial accounting paradigm and then identifying the most effective analysis models and their information inputs.
Once those decision-supporting needs are discovered, the next phase would aim to find ways to gather and report suitable information. We’re fully confident that those inputs would include many things that aren’t reported today and exclude many that are reported.
DON’T BOTHER ASKING
We’re also very sure nothing helpful would be learned by just asking present users what they want, because their existing worldview doesn’t even allow them to think differently.
That point is sardonically communicated in a quote often attributed to Henry Ford that asserts people would have said “faster horses” if he had asked them what they wanted. Of course, he changed the world forever with his paradigm-destroying decision to mass-produce horseless carriages instead.
Now, that’s the kind of boldness we’re calling for.
A PERFECT ILLUSTRATION
A recent item in the online newsfeed from Accounting Today took us to Richard Clough’s Bloomberg News article dated Oct. 16, 2017. The story’s prolix title is “GE’s accounting for earnings is unfathomable, and investors and SEC are noticing.”
The most newsworthy part was several quotes from what we would have otherwise considered to be fairly sophisticated folks. Specifically, they described their rejection of information in GE’s 10-Q SEC filing for the second quarter of 2017. We think people should be surprised and concerned.
(As a disclaimer, we haven’t tried to verify the quotes; it’s possible their original contexts could put a different slant on their words.)
IT’S TOO HARD
Imagine, for example, that you’ve engaged Westwood Holdings to manage your company’s very large pension fund. We speculate your confidence in that firm’s competence would be shaken by Clough’s quote of these words from Scott Lawson, one of Westwood’s vice presidents: “GE’s numbers are complex” and “You may find that [complexity] is a challenge you don’t want to work through.”
Ouch! We would expect to hear that kind of timorous capitulation from a small-stakes investor, not someone with a firm that manages more than $20 billion.
We’re perplexed since we think GE’s management voluntarily provided supplemental non-GAAP data because they believe their GAAP statements are not fully informative. If so, Westwood’s high-priced financial analysts shouldn’t just give up and decide they “don’t want to work through” this potentially helpful information about one of the world’s largest and most widely held companies. If that’s the way they approach opportunities to get new insights, the two of us wouldn’t want them managing our money.
To return to the point, we think Westwood would choose to ignore GE’s supplemental information only if they believe that its GAAP financials are so good that any supplemental information would be superfluous. After looking at GE’s disclosures, we conclude Westwood would be plain wrong to leave them unused.
BETTER THAN WHAT?
Clough also interviewed Olga Usvyatsky, a vice president of research at Audit Analytics, a provider of audit, regulatory and corporate disclosure data and intelligence. Clough first explains that managers present non-GAAP results to “provide clarity for investors by giving a more accurate view of underlying operations and stripping away nonrecurring items such as merger costs, litigation or restructuring.”
Next, he paraphrases Usvyatsky as follows: “But [non-GAAP reporting] can also obscure issues by making earnings appear better than they are.” He then quotes her as saying: “When companies present non-GAAP metrics, in many cases [they] are trying to convey management’s point of view” and “In many cases, non-GAAP metrics are higher.”
What? Why should sophisticated analysts reject non-GAAP earnings numbers as irrelevant because they’re “better” or “higher” than the reported bottom lines? Wouldn’t it make more sense to withhold judgment until they assess whether the adjustments actually accomplish their purported objective? Instead, it appears that they think reported GAAP earnings and other statistics are so reliable and helpful that they shouldn’t be supplemented.
Ironically, we found that GE actually provided some very useful facts and backed them up with cogent details.
IMPAIRMENTS & OTHER EXAMPLES
We think these dismissive attitudes are rooted in the flawed assumption that GAAP results are useful despite the countless toxic political compromises reflected in today’s standards.
To illustrate why supplemental information can be handy, suppose a company is forced by GAAP to report a $200 million impairment loss for some productive assets but cannot recognize a $750 million gain from the appreciation of other productive assets. You decide which of the following would be more useful: the incomplete impairments-only story that depresses reported EPS, or a non-GAAP disclosure that tells the whole story by adding the unreported gain to GAAP earnings. It’s obvious the latter answer is preferable.
Also, select which of these two practices makes more sense: steadily recognizing systematic annual depreciation expense that reduces reported GAAP earnings while artificially eroding the reported asset base, or observing assets’ market values and writing them up or down according to what actually happened. We prefer the second because it relies on observed recent facts, while the former depends on biased assumptions and predictions made long ago in the past.
To continue, why on earth would anyone trust GE’s GAAP pension cost, which includes some gains and losses that occurred in prior periods while excluding those that happened this year? Nonetheless, that balderdash has been accepted practice since the mid-1980s, and FASB recently decided it should continue to be reported.
In summary, GAAP makes a complete mess of reported income and earnings per share. Thus, and contrary to Lawson and Usvyatsky, we offer plaudits to GE for reporting information that signals which revenues, expenses and cash flows can be expected to continue in the future. (We explained our views on additional disclosures more completely in “Non-GAAP reporting: Yes, it’s bad, but it doesn’t have to be,” Accounting Today, September 2016.)
WHAT TO DO?
On the one hand, it’s tempting to sit in the stands and complain that the Securities and Exchange Commission and FASB aren’t doing enough to create progress in financial reporting. On the other, it’s foolish to expect any noteworthy innovations to be accomplished by political bodies that were largely created and structured to keep things mostly intact.
Nonetheless, we challenge those regulators to either lead by helping those who can innovate or just get out of their way.
Further, we specifically urge the CFA Institute to proactively design a better training and testing curriculum that would warn their financial analyst members about the abundant defects in GAAP financial statements while also explaining what sort of non-GAAP information would help them. In addition, they could, and should, educate managers and auditors on what supplemental information they ought to provide.
Even more hopefully, we implore managers to try three new strategies about non-GAAP disclosures:
They should curtail their current practice that merely airbrushes away a few of their GAAP statements’ blemishes because analysts know it fails to tell the full truth.
Instead, they should break new ground by producing comprehensive, and comprehensible, non-GAAP financial statements that actually reduce users’ uncertainty and risk.
Instead of conference calls with a few analysts, they should host full-scale conferences to explain to many users exactly how to use non-GAAP information.
GAAP ISN’T GREAT
It’s way past time for all users, sophisticated and otherwise, to completely escape from the “GAAP is great” paradigm. After all, today’s financial statements are indisputably hazardous to the fiscal health of investors, the capital markets and the whole economy.
Come on everybody, it’s time to get real.