\n<\/p>\n
An Honest Financial Accounting: Draft of Chapter 1 \u2013 Part II<\/strong><\/p>\n Chapter Title: Financial Accounting versus Financial Reporting<\/p>\n Draft Table of Contents<\/a><\/p>\n \u201cFinancial\u201d Accounting<\/strong><\/p>\n In the Securities Exchange Act of 1934, Congress gave the new Securities and Exchange Commission broad powers to regulate the disclosures of public companies, including the rules of accounting. But sensing very soon that accounting rules would become a time-consuming political football, the SEC punted accounting standards setting to the private sector.\u00a0 Today, the financial reporting rules issued by the SEC amount to a few hundred pages.\u00a0 For historical reasons that are not particularly germane to this discussion, a few of the SEC\u2019s rules are financial accounting rules.[3]<\/a>\u00a0 That said, no one at time could have anticipated that the private sector would produce\u00a08,000 pages<\/em> of \u201cauthoritative guidance\u201d \u2013 many more pages than even the Internal Revenue Code.<\/p>\n Beyond authoritative guidance, the FASB has published numerous attempts at articulating a comprehensive conceptual framework to underpin its rulemaking.\u00a0 It has produced eight extensive \u201cstatements of financial accounting concepts.\u201d[4]<\/a> Yet, despite having been establish to be a financial accounting<\/em> standards board, what \u201cfinancial accounting\u201d is regarded to be by the FASB has never been addressed.<\/p>\n The FASB\u2019s concepts statements don\u2019t refer to \u201cfinancial accounting.\u201d Not even once. \u00a0Instead, the FASB refers to itself as the promulgator of \u201cgeneral purpose financial reporting\u201d standards. \u00a0It first used the term in 19xx, but it doesn\u2019t seem to have gained much traction outside of the Accounting Establishment: since then, scores of textbooks on the application of US GAAP have been published with \u201cfinancial accounting\u201d in their title; tellingly, not a single one with \u201cgeneral purpose financial reporting.\u201d<\/p>\n The difference between financial accounting and general purpose financial reporting is more than semantics.\u00a0 In one respect, there is a cost of redundancy that should be considered. How, for example, does it serve the public interest to disclose information about a potential liability for ongoing litigation in the financial statements, and to repeat<\/em> much the same disclosures in another portion of the same SEC filing (e.g., risk factors, legal proceedings, MD&A)? [5]<\/a><\/p>\n In an even more cynical respect, the failure to directly address the meaning of \u201cfinancial accounting\u201d is part of the Accounting Establishment\u2019s conspiracy to serve up \u201cchicken salad\u201d[citation omitted) instead of honest financial accounting.\u00a0 Referring again to our fable, its particular facts and circumstances are intended to produce several different accounting treatments from the students; hence, it will provoke a discussion in class of which of the several possible accounting treatments is most appropriate. Although several different treatments might be reasonable, even a newcomer to the discipline of accounting would see that the more specific one can be about users, the more straightforward it becomes to determine the most appropriate accounting treatment.<\/p>\n By definition, \u201cgeneral purpose financial statements\u201d address the needs of no one user in particular.\u00a0 To be fair, the FASB has stated that it should choose among accounting treatments by anticipating the predominant usage: through (1) identifying the \u201cprimary users\u201d of said general purpose financial statements; and (2) determining which treatment will \u201c\u2026 meet the needs of the\u00a0maximum number\u00a0<\/em>[emphasis supplied]\u00a0 of primary users.\u201d[6]<\/a> \u00a0Notwithstanding, the FASB has given no indication as to how it would \u2013 or even could<\/em> \u2013 do what it says it should do. \u00a0Does one individual trader for one\u2019s own small account, who may have only a high-level knowledge of the 8,000 pages of U.S. GAAP, count the same as a team of sophisticated analysts working for a large investment bank? \u00a0If the actual process that the FASB employed for weighing the pros and cons of accounting alternatives were that straightforward, then every major project listed above could have been resolved quickly, instead of each taking more than a decade.<\/p>\n In short, the stratagem of replacing \u201cfinancial accounting\u201d with the made-up concept of \u201cgeneral purpose financial reporting\u201d has helped the FASB to broaden its job description.\u00a0 Practically anything on which a number can be pinned, and which might provide some small clue about a company\u2019s future, is according to the FASB, fair game for making a new rule.\u00a0 \u00a0It permits, as suggested by the fable addendum, recognition of deferred costs as assets so long as they might<\/em> in some roundabout fashion be informative to someone for something.<\/p>\n It is also important to note that in order for the FASB to broadly defines its objectives through \u201cgeneral purpose financial reporting,\u201d it fails to recognize one principal reason for why Congress chose to regulate finance statements in the Exchange Act: for their value as a tool of effective corporate governance, e.g., to contract with directors and executives, and to hold them accountable<\/em> for their past actions.\u00a0 Accordingly, the Exchange Act doesn\u2019t simply require companies to file their financial statements with the Commission. \u00a0It also requires \u2013 in a section known as the proxy requirements \u2013 that current financial statements are delivered directly to shareholders prior to their meeting to elect directors, and for other corporate governance matters.[7]<\/a><\/p>\n The proxy requirements were far from an afterthought by Congress. \u00a0\u00a0It is broadly understood that financial accounting gained in importance over time as ownership\/management of larger enterprises evolved to become separate activities. When shareholders are not directly involved in running a company, they take steps to bind management contractually to act as stewards<\/em> of their investment.\u00a0 The FASB\u2019s concept statements make no mention of the fact that financial statements can also be the principal source of information to ownership for assessing how well management is acting as stewards of their investment.<\/p>\n The implications of stewardship on the formulation of a basis of accounting is much more straightforward than the vague notion of \u201cgeneral purpose financial reporting.\u201d Stewardship motivates a much clearer picture of assets and liabilities \u2014 and changes thereto \u2014 than U.S. GAAP.\u00a0 That said, however, the question whether the accounting rules applicable to public companies should be constructed to be more usefulf for \u201cvaluation\/prediction\u201d or \u201cstewardship\u201d is a valid one.<\/p>\n The position taken in this book for developing AHFA is that accounting is appropriately limited to reporting information about a clearly-defined subset of economic assets and obligations.\u00a0 It can provide valuable information for a broad spectrum of uses, but it is most directly related to the vital task of performance evaluation: of the economic entity itself and by extension, its managers.<\/p>\n AHFA will be stewardship focused, yet that focus should\u00a0not\u00a0<\/i>result in lower valuation\/prediction value.\u00a0 In addition to simply providing a more honest financial accounting by a public company, there are a host of SEC regulations that, taken in combination with AHFA financial statements, can provide even better information to current and potential investors.\u00a0 AHFA will be a significant improvement over US GAAP in every major respect: fewer detailed requirements, more detailed quantitative financial information, \u00a0less costly to produce, and more auditable.<\/p>\n AHFA will also curtail, if not practically eliminate, a CEOs ability to manage reported earnings. But even setting that benefit aside, it should be said that the evidence that financial statements are reliable sources of information for valuing a public company has never been strong. \u00a0And it is even weakening. \u00a0Baruch Lev and Feng Gu of New York University find that the correlation between reporting earnings and changes in stock market prices has been deminishing over time; i.e., not increasing as the FASB keeps adding to those 8,000 pages of \u201cauthoritative guidance.\u201d[8]<\/a><\/p>\n The collective effect of US GAAP on all stakeholders in US capital markets is profound, even in good times.\u00a0 But more bad times are inevitable.\u00a0 It remains to be seen whether financial accounting will help or make matters worse.\u00a0 MacArthur Fellow and economic historian Jacob Soll argues that the power and economoic welfare of nations throughout history has depended on a culture of using accounting to produce a\u00a0realistic view of what resources an enterprise controls, and what it owes.[9]<\/a><\/p>\n If so, and if critical financial institutions can continue to hide risk and overstate profitability by mere technical compliance with the FASB\u2019s version of \u201cgeneral purpose financial accounting,\u201d what will be the outcome of the next financial crisis?<\/p>\n