Friday, November 27, 2009

Why Accounting Matters

Last week, we reported that two amendments relating to the Financial Accounting Standards Board were approved by the House Financial Services Committee (HFSC) during markup of its systemic risk bill. The bill, more formally called the Financial Stability Improvement Act (FSIA), is part of a broader set of bills being introduced as part of financial regulatory reform, aimed at preventing another credit crisis.

The first of the FASB-related amendments, the Perlmutter/Lucas amendment, would require the systemic risk council created under the FSIA "to review and submit comments to the Securities and Exchange Commission and any standards setting body with respect to an existing or proposed accounting principle, standard or procedure."

The second accounting-related amendment, the Garrett amendment, would require the FASB to study the impact of the minimum credit risk retention rules in the FSIA in combination with the new securitization accounting rules under FAS 166 and FAS 167 (which eliminate off-balance sheet treatment previously available under FAS 140 and FIN 46R), and that FASB "make statutory and regulatory recommendations for eliminating any negative impacts on the continued viability of the asset-backed securitization markets and on the availability of credit for new lending," and report the results within 90 days to the banking regulators and the SEC.

The ultimate fate of the FASB-related amendments approved by the HFSC is not yet known, since the full House still has to consider the entire financial regulatory reform package, as does the Senate. (See Sen. Chris Dodd's (D-CT) earlier comments on the initial version of the Perlmutter/Lucas amendment, which would have transferred oversight of FASB from the SEC to the systemic risk council. The amendment that eventually passed the HFSC was significantly softened, to require review and comment of accounting standards, but did not change the current oversight structure of FASB.) Continued focus on the financial regulatory reform legislation will take place in December.

A Civil War Over Accounting?
The battle over the Perlmutter/Lucas amendment in particular -which, as approved by the HFSC last week was significantly softened ('watered down' per's Sarah Johnson; 'gutted' per the Denver Post's Michael Riley) from its initial version proposed in March - rose to the level of Civil War in Corporate America (Ryan Grim, Huffington Post).

Some may have wondered how this level of agitation could occur in a profession that still harbors, in the eyes of some, a "milquetoast" image (Michael Riley, Denver Post).

This post attempts to provide some insight into why emotions can run so high in debates about accounting, by exploring the question of "why accounting matters." I remind you of the disclaimer which appears on the right side of this blog, which applies to the entire content of the blog, including (but not limited to) when posts have sections marked off as 'my observations' or 'my two cents.'

Cent 1 : What Accounting Is Not About: Undue Influence (Undue Pressure)
In a letter dated Nov. 5, 2009 (during the heat of the debate over the original Perlmutter/Lucas amendment, which as originally proposed in March, would have removed the SEC's oversight power over FASB, and transferred that oversight power to a Federal Accounting Oversight Board consisting of banking regulators and the SEC), SEC Chairman Mary L. Schapiro told Rep. Barney Frank (D-MA), chair of the HFSC:

I am deeply concerned about the possible consequences of changing [the current] system to one that would subject accounting standard setters to the supervision of entities with other regulatory missions. It is not that those missions are any less vital to the public interest than the mission entrusted to the SEC. It is just that they are different -- and I fear the potential consequences for our capital markets if investors come to believe that accounting standards serve any purpose other than to report the unvarnished truth. [Note: the reference to 'unvarnished truth is discussed separately later in this post.]

In closing her letter, Schapiro said: "Accounting should be about accounting, and nothing else." When I first read that closing statement, I thought it was a very powerful statement, or sound bite, if you will, but just as sound bites often convey a deeper meaning, I found myself thinking there are other interpretations about what accounting is about, and what it is not about.

Given the subject of the letter, I thought to myself, the sentence could be read to imply, "Accounting should be about accounting, and not about politics." Or, more precisely, substituting in language from the IASCF Monitoring Board's Sept. 22 statement on accounting standards and accounting standard-setting (the SEC is a member of the Monitoring Board), one could end the sentence this way: "Accounting should be about accounting, and not about undue pressures from political and corporate interests."

The word "undue" (as in "undue pressures") as used by the Monitoring Board is very significant: the group did not call for the total exclusion of dialogue with political and corporate interests; on the contrary, the Monitoring Board stated: "Interested parties must be afforded the opportunity to provide input to inform the standard setter’s evaluation of pertinent issues."

In fact, specific to the topic of fair value accounting (which some view as the driving force behind the Perlmutter/Lucas amendment) the Monitoring Board stated:
The IASB and FASB have benefitted from informative input into their financial instruments and fair value measurement standard setting initiatives from a broad range of stakeholders. The recommendations of some constituencies often contradict the strongly held views of others, reflecting the diversity of uses for and desired outcomes of financial reporting... robust participation of interested parties is an essential element of a standard setter’s transparent due process. Equipped with this input, it is the responsibility of the standard setters to evaluate the knowledge they have gained against the overarching objectives of financial reporting and the principles that reinforce those objectives, in a manner engendering independent decision-making.
Understanding the Role of Neutrality and Due Process
While we're on the subject of soundbites, some journalists over the past six months have characterized comments made by FASB and IASB board members and related advisory groups (such as the FASB-IASB Financial Crisis Advisory Group) as calling for no "meddling" by politicians (see, e.g. Politicians Accused of Meddling in Bank Rules (Floyd Norris, NYT, 7.28.09), and Europe Must Stop Its Meddling, Says FASB Chief (Mario Christodoulou, Accountancy Age 10.15.09). More recently, I've seen the word 'tinkering' used by some, in place of where 'meddling' was previously the term du jour.

Although 'meddling' or 'tinkering' are not defined in FASB's Conceptual Framework (which serves as the foundation for standard-setting), the term 'neutrality' is the operative term specified in Concepts Statement No. 2; i.e., the FASB is to exercise 'neutrality' in setting accounting standards. The IASCF Monitoring Board's Sept. 22 statement repeats the importance of neutrality.

In understanding the role of 'neutrality' and independence, of particular note is that it does not require FASB to be walled off from dialogue with outside parties, just that it act in a neutral fashion. See, e.g. Volcker Heartened by Regulators Reaction to Crisis Warns Against Isolation (Steven Burkholder, BNA Daily Report for Executives. Reproduced with permission from Daily Report for Executives, 208 DER I-4 (Oct. 30, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033)

More recently, BNA's Burkholder reported in, FASB Members Warm to Revised Perlmutter Amendment; SEC Supportive, that FAF spokesman Neal McGarity stated after the revised Perlmutter/Lucas amendment was approved by the HFSC:
The FAF recognizes and is respectful of the need for Congress to maintain and advance the safety and soundness of this country's financial system... The FAF does not oppose the recently adopted Perlmutter amendment because it acknowledges the due process [of accounting standard-setting] which is the backbone of the FAF mission.
The reference to 'due process' in the FAF spokesman's statement above is key, as is transparency of that due process, in engendering confidence in the process. The role of due process was also noted in the IASCF Monitoring Board's Sept. 22 statement, and in the IASB-FASB Nov. 5 joint statement, as follows:
IASCF Monitoring Board statement Sept. 22, 2009: "Visibility into the standard setting process should be sufficient to enable users to trace the evolution of the standard from thoughtful consideration of alternatives to final positions".

IASB -FASB Joint statement Nov. 5, 2009: "We aim to provide a high degree of accountability through appropriate due process, including wide engagement with
stakeholders, and oversight conducted in the public interest. We are consulting widely and will continue to draw on expertise from investors, preparers, auditors, standard-setters, regulators, and others around the world. ... We will set standards following our robust due process procedures that provide visibility into the standard-setting process and require proactive consultation to ensure communication of all points of view and the expressions of opinion at all stages of the process".
If we all were to agree on what accounting should "not" be about (i.e., that it should not be about undue influence or undue pressure), then what would we say accounting "is" about?

Cent 2: What Accounting Is About: Decision-Useful Information
Consistent with FASB's mission statement, the IASCF Monitoring Board's Sept. 22 statement defined what accounting (more generally, financial reporting) is about as follows:
We view the primary objective of financial reporting as being to provide information on an entity’s financial performance in a way that is useful for decision-making for present and potential investors. To be considered decision-useful, information provided through the application of the accounting standards must, at a minimum, be relevant, reliable, understandable and comparable.
The operative words are that financial reporting information aims at being decision-useful, by providing information that is relevant, reliable, understandable and comparable. All of these terms are longstanding fundamental concepts in FASB's Conceptual Framework (specifically, in Concepts Statement No. 2). (Note: an amendment to CON 2 was previously proposed and is set to be issued in final form 4Q2009 according to FASB's current technical plan.)

In considering the concepts noted above, people do not always agree on what 'decision-useful' means in particular contexts, and reasonable people may not always agree on how an accounting standard should be constructed to produce the most "relevant" and "reliable" information (and how to balance those two sometimes opposing forces).

For example, some people may say that fair value information is always the most relevant information ("measurement attribute"), period. Others, however, may question if fair value information in an illiquid, inactive or disorderly market, is any more relevant than information measured by some other means, such as discounted cash flow, or how much emphasis to place on 'market' quotes (e.g. broker quotes) vs. internal cash flow models, in such a market.

Thus, an 'inconvenient truth' in accounting is that, even if there were agreement among reasonable people as to which measurement attribute (e.g. 'fair value' vs. 'historic cost') is more relevant, there is not necessarily going to be universal agreement on which valuation method is most reliable to arrive at 'fair value' for all financial instruments, or how to balance relevance and reliability, in producing 'decision useful' information. You will see such debates if you review the comment letter file on the original proposal for FAS 157, and on current proposals out for comment by FASB and the IASB. It is and always has been a natural and healthy debate across all of standard-setting, as to how to develop standards that result in the most relevant and reliable information.

Since relevance and reliability, as well as understandability and comparability lead to decision usefulness, real world investing and financing decisions take place based on accounting information provided. And that is "why accounting matters."

Accounting Has Economic Consequences
Further on this topic of why accounting matters, Prof. David Albrecht was the first person to write publicly during the heated debate over the Perlmutter/Lucas amendment on the issue of why politics has historically had some role (indirect if not direct) in accounting standard-setting.

Although I disagree with Albrecht's choice of words in captioning his Nov. 18 blog post, I agree with his point that the economic impact of accounting standards has historically driven the engagement of constituents, including their elected representatives, and I urge you to look beyond the caption of his post, and read it for substance in his blog, The Summa.

Indeed, on the subject of economic consequences, in 1978 (5 years after FASB was formed, replacing a series of predecessor boards) FASB issued a call for research on, held a conference on, and produced a related report on, The Economic Consequences of Financial Accounting Standards. (Although I could not find a public link to the original 1978 report, if I recall correctly, it was inconclusive as to the role, if any, which economic considerations should play in accounting standard-setting, although views ran high in both directions; if I'm wrong, I invite blog readers to post a comment on this point.) Further reading on this topic can be found in:
Separately, I'd like to point out that Albrecht's criticism of some recent SEC statements on accounting standard-setting (in his Nov. 18 blog post) was based on part on a Reuters article reporting on SEC Commissioner Kathleen Casey's remarks at FEI's Current Financial Reporting Issues Conference on Nov. 17, which cited only a portion of Casey's remarks, which were subsequently posted on SEC's website. Refer to the full text of Casey's speech (also available on FEI's website) in which she speaks of, e.g. the need for independence and accountability:

Thus, the goal of standard setting must be to develop high-quality and unbiased accounting standards that promote transparency and that are, in turn, viewed as
credible by our markets. If, however, the standard setting process is subject to undue commercial or political pressure, market participants may lose confidence
in the financial information reported by firms. But while accounting standard setters must be independent, they must also be held accountable. The standard setting process is a delicate balancing act that highlights the importance of the Commission's oversight function. The Commission strives to ensure that this process is not compromised by inappropriate pressure and, at the same time, that the process produces high quality standards that elicit information meeting the needs of investors and other users.

Accounting as Art vs. Science, and the Role of Professional Judgment
As noted further above, SEC Chairman Mary L. Schapiro said in her Nov. 5 letter to Rep. Barney Frank:
"I fear the potential consequences for our capital markets if investors come to believe that accounting standards serve any purpose other than to report the unvarnished truth."

Although I believe the reference to 'unvarnished truth' was meant to express that investors expect accounting standards to be free from bias, the words 'unvarnished truth' trigger a visceral reaction among some in and around the accounting and auditing standard-setting profession, who believe, as stated by Prof. David Albrecht in his blog post noted above: "There is no such thing as universal accounting truth."

Indeed, the notion that information provided by accounting standards represents the absolute 'truth' has been described as an expectation gap, since accounting is replete with estimates and judgment calls. Thus, many believe accounting is more of an art, than a science.

The issue of accounting 'truth' was referenced in remarks of then-SEC Chief Accountant John C. ("Sandy") Burton in a speech in 1973 (at the time FASB was founded to replace its predecessor, the Accounting Principles Board or APB.) Significantly, Burton also refers to FASB's quasi-legislative role (and he is not the only person who has characterized it as such), provides some background on why emotions run high concerning accounting standards, and describes the nature of the relationship between the SEC and FASB. Here is an excerpt of Burton's remarks:

We at SEC are very confident that [FASB] will improve the standards of accounting measurement in a significant fashion. We believe this because we think it is institutionally more appropriately structured for dealing with problems facing it than was the old Accounting Principles Board (APB). The APB was originally designed by a committee that was convinced that research would produce Truth and that the only thing that would be needed after accounting research was done was a body to simply anoint the truth that had become apparent....

Accordingly, it was necessary to develop a body which will be more appropriately structured to perform the required quasi-legislative function than was the part-time APB....

There are a number of areas which deal with financial measurement where people are deeply involved, because their pocketbooks are deeply involved; and there is nothing more emotional than money: So that it seems very likely that as the new Board gets underway; those that find themselves ill at ease with its initial exposure drafts will probably bring the same kind of pressure to bear as they brought against the APB. And I don't think the fact that the members of the FASB are not current practitioners of accounting is going to shield them from this pressure to any great . . extent.

Nevertheless, I am optimistic that they will be able to move expeditiously....It is certainly the intent of SEC and the accounting staff of the SEC to work with the new [FASB] Board as we have worked with the APB. I have characterized our relationship [with FASB] as one of mutual nonsurprise where we both must advise
the other of how we are thinking and what we are doing.

Similarly, in a speech in 1959, then-SEC Chief Accountant Andrew Barr noted:

"Mr. May was an important witness in the hearings on the Securities Exchange Act of 1934. In these hearings his objections to a uniform system of accounting were developed after his opening remark that "The fact of the matter is that accounting, especially industrial accounting, is essentially a matter of judgment, and you cannot put judgment in strait-jackets."

Returning to the present time, but also on the subject of professional judgment, SEC Chief Accountant Jim Kroeker and Division of Corporation Finance Chief Accountant Wayne Carnall were asked in a press session at FEI's Current Financial Reporting Issues Conference about the status of the recommendation of SEC's Advisory Committee on Improvements in Financial Reporting (CIFiR) regarding establishment of a professional judgment framework. (See Recommendation 3.5 regarding a professional judgment framework in CIFiR's Final Report.)

Kroeker replied:
Regardless whether there is any more formal action on a judgment framework [that the points outlined by CIFiR are] the kinds of things we look for in the preclearance process [in the Office of the Chief Accountant], and in the Corp Fin comment process."

The points identified by CIFiR include, noted Kroeker, include whether the accounting transparently reflects the substance of the transaction, whether all relevant accounting literature was reviewed, and the consideration of alternative accounting treatments.

Further commentary on the subject of professional judgment was provided in two Fireside Chats sponsored by Deloitte, broadcast by the SEC Historical Society on Oct. 22, 2009 (featuring Deloitte Deputy CEO Robert J. Kueppers, and former SEC CIFiR and PCAOB SAG member Greg Jonas, moderated by USC Professor and former SEC Deputy Chief Accountant Zoe-Vonna Palmrose), and Oct. 28, 2009 (featuring Kueppers and former SEC Deputy Chief Accountant Scott Taub, moderated Georgetown Professor and former SEC Academic Fellow Patricia Fairfield). These two webcasts can be found under SECHS archived webcasts.

Also on the subject of professional judgment, I asked Prof. David Albrecht (author of blog post cited further above), if, given the increasing emphasis on principles-based accounting, (including, but not limited to, a potential move to IFRS) if accounting theory should be added as a required course for undergraduates majoring in accounting. (My perspective is no doubt influenced by the fact that Dr. David Solomons was my accounting theory professor.) Here is Albrecht's reply:

Should there be a theory class? Probably, as it could deal with broader issues of economics and/or reporting strategies. Will there be? No. Undergraduate and graduate accounting programs won't have any more free space in them than before.
And professors will not change their approach to teaching. [Note: Albrecht separately explained that many accounting professors still heavily rely on lecture-oriented classes vs. cases, with knowledge-oriented tests that promote short-term memorization, but not necessarily retention.]

It is interesting that you mention cases as a preferred tool or approach. I am an enlightened teaching professor. I don't use cases. I tend to use simulations and carefully constructed "what-if" types of problems. Most professors, however, would do a better job of teaching "principles" based financial accounting if they were to switch to cases.In the long run, I think that IFRS will turn into U.S. GAAP. Then we'll be back to where we started.

To wrap up this post on why accounting matters, I'd like to note remarks of then-SEC Chief Accountant Lynn Turner in a speech he gave in 2000, in which he said:

What people too are often saying when they argue that the FASB does not listen, is that the FASB did not give them the answer they wanted, that they did not "obey". In those cases, I challenge both the constituent and the FASB to sit back and say, does the standard faithfully represent the economics of the events and transactions being reported on, in a consistent, comparable and verifiable fashion?....

I believe that high quality accounting standards must be practical and operational, not only in the literature, but in the real world. In fact, I believe we must be able to apply a "litmus test" to each new accounting standard: that it must be operational at all levels, from the CFO, controller and accounting staff who have to implement the standards in practice, to the auditors who have to attest as to whether the company has correctly applied the standards, to enforcement bodies such as the SEC and similar securities regulators around the globe, who are charged with reviewing financial filings and judging whether such filings follow the standard.

Turner's remarks cited above, in a speech given nine years ago, continue to resonate today, as emotions run high over accounting standard-setting. If you'd like to read more on this particular subject, we've posted a few excerpts from past SEC speeches on accounting. (And the SEC website now has speeches posted going back to the 1930's.)

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Barrett Peterson said...

I agree, unsurprisingly, that accounting is important as the field is my livelihood and expertise. Decision usefulness is crucial, as is the old "true and fair view" notion. The "unvarnished truth" idea always makes me uneasy as it implies a level of precision not inherent in the concepts or mechanics of accounting, but the true and fair view should be as unvarnished as possible. I appreciated fair value and believe it has its uses, but it does not work well in illiquid markets and credit crises, as we have re-confirmed. Fixed asset values are not usually at fair value for precisely this reason. I still prefer cash flow evaluated measures - "follow the money", as the combination of earnings power and its conversion to cash flow is the critical measure of life for an entity.

Accounting by itself will not tell an investor everthing they need to know, any more that a blood test and blood pressure will tell a doctor everything, but accounting should perform the function of vital signs indicator.

Political intervention is least desirable, as the objective of politics is power and re-election, with far less of an emphasis on either decision utility or a true and fair view.

Barrett Peterson, CPA

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