\n<\/p>\n
Draft Table of Contents<\/a><\/p>\n An Honest Financial Accounting: Draft of Introduction to Preliminary Edition \u2013 Part I<\/strong><\/p>\n Every report by independent auditors on the financial statements of US public companies must state that, in their opinion, said financial statements are \u201cfairly presented\u201d in accordance with \u201caccounting principles generally accepted in the United States of America\u201d \u2013 widely referred to as US GAAP.[1]<\/a><\/p>\n Is there even such a thing as generally accepted accounting principles? \u00a0Not really.<\/em><\/p>\n Are the financial statements published by US public companies fairly presented?\u00a0 Not even close.<\/em><\/p>\n A Thumbnail History of Financial Accounting\u2019s Descent into Madness<\/strong><\/p>\n Perhaps there was a brief period of time \u2014 almost one hundred years ago \u2014 when \u201cgenerally accepted\u201d had a literal meaning in accounting.\u00a0\u00a0 But, as politics dominated the development of US GAAP, the phrase lost all plain-language meaning.\u00a0 By 1992, the American Institute of Certified Public Accountants officially owned up to the fact that \u201cUS GAAP\u201d as used in an auditor\u2019s report had become a euphemism: nothing more than a \u201ctechnical accounting term\u201d to refer to thousands of pages of rules to be strictly obeyed by its members under any and all circumstances.[2]<\/a><\/p>\n The rules which today comprise US GAAP were initially set by two short-lived adjuncts of the AICPA.\u00a0 As might be expected from a trade association whose mission it is to promote the interests of its members, it conspired with the largest public corporations and their auditors \u2013 dubbed the Accounting Establishment by a congressional committee formed to investigate their behavior \u2013 to call the shots.[3]<\/a>\u00a0 \u00a0A prominent example of the havoc they would wreak still haunts all would-be accountants and business managers practically from the outset of their studies: to permit LIFO accounting for inventories (essentially a contrivance with no basis in reality) at any time, so long as the company had also elected that treatment for tax purposes.\u00a0 As another example, the accounting treatment of \u201cgoodwill\u201d \u2014 a euphemism for an account balance that means nothing and is widely ignored \u2014changes significantly about once a decade.<\/p>\n The FASB was established in 1973, to take over from the AICPA the responsibility for promulgating US GAAP, and purportedly, to be more independent.\u00a0 But, like the AICPA, it was beholden to the Accounting Establishment for the bulk of its financial support.\u00a0 It was difficult for everyone to keep a straight face for very long about the obvious conflict of interest being created: in return for their largesse, top donors would want to influence what the organization produces. \u00a0To quote General Motors\u2019 CEO at the time, Roger Smith, \u201cYou know, when we did this Wheat study [the\u00a0Wheat Committee[4]<\/a>\u00a0recommended the establishment of the FASB], I ordered chicken salad.\u201d[5]<\/a><\/p>\n But it must be said that others who didn\u2019t \u2018have a dog in the fight\u2019 attempted to view the creation of the FASB as a significant opportunity for reform.\u00a0 One of the most thoughtful and eloquent proponents for a fundamental change in standard setting philosophy was Stanford professor William Beaver.<\/p>\n In an article published by the AICPA itself, Beaver\u2019s message was essentially that the FASB should \u2018keep it simple.\u2019[6]<\/a>\u00a0 His reasoning was based on one plain fact, and two foundational ideas.\u00a0 The fact, which is widely taken for granted, is that federal law has long required public companies to make their audited financial statements public.\u00a0 Consequently, financial statements were made a \u2018free good\u2019 to the investing public.<\/p>\n Of the foundational ideas, one was normative and the other theoretical.\u00a0 The normative principle is that, even though financial statements are free to the public, like any other good or service, production of financial reports should be subject to a cost\/benefit test.\u00a0 \u00a0\u00a0The theoretical idea, which was relatively new and most critical to Beaver\u2019s reasoning, is \u201cmarket efficiency\u201d \u2014 simply stated that publicly-available information from any and all sources is rapidly reflected in securities prices.<\/p>\n Empirical tests of the \u201cefficient markets hypothesis\u201d (EMH) were already abundant and supportive, including many studies concluding that the relationship between specific components of financial accounting information and stock prices were consistent with EMH.\u00a0 Most especially, a nearly universal finding was that stock prices were unaffected by announcements of accounting information if the same information had been obtained earlier from another source. \u00a0There would be no marginal benefit to a financial accounting rule if it did nothing but produce information that an investor could have found elsewhere. <\/em><\/p>\n Consequently, Beaver recommended that the FASB cease the practice of its predecessors of engaging in protracted debates of alternative financial statement treatments (e.g., LIFO versus FIFO, or when\/how to report goodwill) if there would be no effect on the timing and nature of publicly available information.\u00a0 To add another example of historic importance, a controversy over the income statement treatment of an investment tax credit,[7]<\/a> which shadowed the FASB\u2019s immediate predecessor over practically its entire existence, should have been a non-issue.\u00a0 Each alternative being considered provided equivalent information. It so happened that the failure by the AICPA\u2019s Accounting Principles Board to find a solution to a problem that boiled down to nothing more than presentation of an ITC in a manner that would satisfy all of its stakeholders (principally the Securities and Exchange Commission versus corporate special interests) was the final blow that led to the establishment of the FASB.<\/p>\n We know with the benefit of hindsight that Beaver\u2019s evidence-based recommendations were given very short shrift. The Accounting Establishment has kept the FASB on much the same course as its AICPA predecessors. \u00a0Yet, it wasn\u2019t for decades, until the 2008 Financial Crisis that FASB rulemaking captured the public\u2019s attention and ire in any significant way: when dysfunctional accounting rules were exposed as the instruments of massive financial frauds. The Nobel laureate and long-time economics columnist of the New York Times <\/em>Paul Krugman characterized the rude awakening thusly:<\/p>\n \u201cSo here\u2019s what Mr. Summers [Secretary of the Treasury] \u2014 and, to be fair, just about everyone in a policy-making position at the time \u2014 believed in 1999: America has honest<\/em><\/strong> [emphasis supplied] corporate accounting; this lets investors make good decisions, and also forces management to behave responsibly; and the result is a stable, well-functioning financial system.<\/p>\n What percentage of all this turned out to be true? \u00a0\u00a0<\/em>Zero.<\/em>\u201d[8]<\/a><\/p>\n This book will show that Krugman\u2019s brutal assessment was, and 15 years later remains, accurate; and that there is nothing save the Accounting Establishment to thwart an honest financial accounting from public companies.<\/p>\n The public has a right to expect \u201chonest<\/em><\/strong>\u201d financial accounting from public companies.\u00a0 And, as Beaver clearly suggests, it shouldn\u2019t be hard.\u00a0\u00a0 Clearly, the FASB has been operating with a different agenda in mind, as may be best illustrated by two high-profile anecdotes: one being a cautionary tale of a prominent CEO with questionable accounting scruples; and the other of a courageous auditor in an international accounting firm just trying his best to be honest.<\/p>\n Jack Welch, CEO of General Electric Co. <\/em><\/p>\n Warren Buffet has referred to Jack Welch as \u201cthe Tiger Woods of management.\u201d But in Welch\u2019s best-selling memoir of his time as CEO of GE, he blithely blew the whistle on himself:<\/p>\n \u201cThe response of our business leaders to the [earnings] crisis was typical of the GE culture<\/em><\/strong>. [emphasis added] Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder [a recent acquisition] gap.\u00a0 Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise.\u00a0 Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people.\u201d[9]<\/a><\/p>\n Essentially and with evident impunity, Welch oversaw a \u201cculture\u201d of earnings management at GE. His subordinates would fill their own accounting \u201ccookie jars,\u201d and as team players they were expected to share them around the organization. Though few have so frankly acknowledged the practice, the fact of the matter is that it is not uncommon for CEOs to consider financial statement manipulation an honorable management activity. \u00a0Why is that?<\/p>\n Financial accounting has the potential to be part of an incentive structure for aligning the personal interests of C-suite executives with value creation for shareholders.\u00a0\u00a0 But in the practice<\/em> of corporate governance during a period of ever ballooning executive compensation \u2014 which has been as thoroughly documented as capital markets efficiency \u2014 there can be large gaps between \u201cneutral\u201d financial accounting and actual financial accounting.\u00a0 Supposedly, a manager\u2019s temptations to manipulate published financial statements would be mediated by competent and independent board members, who take their fiduciary duties to shareholders more seriously than amicable relations with the CEO.\u00a0 Such a BOD would put in place measures to prevent executives from \u201cgaming\u201d accounting numbers solely to their personal benefit.<\/p>\n But boards of directors are frequently not nearly as effective as they could be.\u00a0 Just as frank as Welch was about his lack of respect for financial accounting, there is often little to no attempt by CEOs to hide the fact that board members serve at their pleasure.\u00a0 The notion of board members being \u201cindependent\u201d of management is largely a myth.<\/p>\n Auditors are a potential backstop to weakness in corporate governance, but they also serve at the forbearance of the CEO.\u00a0 For example, at the time Jack Welch was the CEO of GE it had engaged the same \u201cindependent\u201d auditing firm for more than 100 consecutive years. One could speculate as to how forcefully a partner-in-charge of the GE account would push back against the CEO\u2019s accounting \u201cestimates\u201d and risk losing GE as a client for the firm.<\/p>\n Walter Schuetze, KPMG auditor and SEC Chief Accountant \u00a0\u00a0 <\/em><\/p>\n As Walter Schuetze has described it, the major accounting firms have been part of the problem that financial accounting is not as good as it could be (not even close) on at least two fronts: aiding the likes of GM and GE in pressuring the FASB (and its predecessors) to promulgate manageable accounting standards; and<\/em> performing lousy audits.<\/p>\n By way of background, the Securities and Exchange Commission has the legal authority to set and enforce accounting standards for public companies in the U.S.\u00a0 But as a matter of formal policy, it looks to the private sector (e.g., the FASB) to actually create the rules.\u00a0 The Chief Accountant is the principal adviser to the SEC on accounting matters.\u00a0 Schuetze left KPMG to become Chief Accountant in January 1992.\u00a0 Coincidentally, I also joined the SEC for a one-year appointment as Academic Accounting Fellow in August 1992.\u00a0 Two days before I was to show up for my first day at work, Schuetze gave a bombshell of a speech at an annual meeting of professors of accounting:<\/p>\n \u201cThe profession will not go to its clients<\/em><\/strong> and tell its clients that their balance sheets have to have realism in order to elicit unqualified opinions. Why not? Well, that could involve being tough with a client. \u2026<\/p>\n The profession, again with an exception or two, will not go to the FASB<\/em><\/strong> and support realism in financial accounting and reporting. \u2026 Why is that? Is it because the profession has become so beholden to its clients that it will not speak to them about realism and relevance and credibility in financial accounting and reporting? \u2026<\/p>\n I think that instead of thinking simply of its clients and itself, the profession needs to give some thought to the public that it serves, to the investors and creditors and employees who put up their money and their labor to make investments in the profession\u2019s clients.<\/p>\n I suggest that the profession go to the FASB and ask it to issue accounting standards that produce more relevant, more understandable, more useful, and more credible financial statements than what we now have.\u201d[10]<\/strong><\/a> <\/em>[emphasis added]\n<\/p>\n For added context, it is helpful to know that Schuetze\u2019s criticisms were leveled at the accounting profession in the wake of an earlier financial crisis fueled by lax accounting standards and compliant auditors: the costly government bailouts of savings and loan institutions:<\/p>\n \u201cI\u2019ve got scars on my back from when I \u2026 told my clients that they could not manage their earnings.\u00a0 My clients went to the Board of Directors of the firm and said \u2018get Walter off my account\u2014just get him off.\u2019<\/p>\n Earnings management was rampant \u2026 it was like dirt; it was everywhere and I think it\u2019s still everywhere because the accounting standards that we have today still allow management to have control of the numbers.\u201d[11]<\/a><\/p>\n While at the SEC, I learned from my colleagues that some of those \u201cscars\u201d Schuetze referred to were courtesy of his fellow partners at KPMG.\u00a0 They might have respected him for his technical expertise, but not all wanted to hear what he had to say.\u00a0 KPMG was a market leader in auditing the S&L industry. It lost a lot of business because Schuetze insisted that they could not bless inflated revenues and loan balances. \u00a0He became a pariah to many disgruntled partners, but he ended up being their prophet and savior.\u00a0 His hard line against dishonest accounting spared KPMG from the litigation losses that cost dearly every other major accounting firm.<\/p>\n Schuetze\u2019s stance was also prophetic of accounting\u2019s responsibility for later crises.\u00a0 There is no doubt that dishonest accounting was at the root of the wave of gigantic financial frauds around the turn of the century (e.g., Enron, Worldcom).\u00a0\u00a0 There is no doubt that dishonest accounting pervaded the financial statements of regulated financial institutions, leading up to the Financial Crisis of 2008. \u00a0Yet, the FASB\u2019s response has been tepid at best.<\/p>\n Former FASB chair Robert Herz, like many past and present board members, became \u2018qualified\u2019 for FASB membership by working in the national office of an international auditing firms.\u00a0 While there, he was actively involved in engineering \u2018creative accounting\u2019 solutions for his firm\u2019s clients.\u00a0 Even though Herz, while at the FASB, was among the most proactive of board members for the public interest, he remains reluctant to find much fault with the institution. In his memoir of his time as chair of the FASB he recounts how he repeatedly claimed that financial reporting did not \u201ccause\u201d the financial crisis \u2014 yet he grudgingly admitted that \u201c\u2026 it did reveal a number of areas requiring improvements in standards and overall transparency.\u201d[12]<\/a><\/p>\n But, as to those needed \u201cimprovements,\u201d as might have been expected, nothing much has changed since 2008.\u00a0 Projects to improve the accounting for loans, leases, revenues and the general incomprehensibility of disclosures were each debated ad nauseum <\/em>for more than 10 years, (fun fact: tenure on the FASB is limited 10 years) and very little was accomplished.\u00a0 In the words of David Mosso, a former FASB member:<\/p>\n \u201cEighty years of tinkering [with US GAAP] has not done the job. \u2026 In the case of business failures, the company\u2019s auditors are usually the scapegoats, but I suspect that\u00a0accounting standards are often more, or at least equally, at fault.\u201d[13]<\/a><\/p>\n It is no coincidence that accounting rules have become bloated and skewed toward the interests of the Accounting Establishment while at the same time the role of financial accounting in corporate governance has, for better or worse, also become more prominent.\u00a0 The fact of the matter is that corporate management wants to be able to control its own scorecard. Imagine a college professor permitting the students to grade responses on their own exams. \u00a0If the FASB has accomplished anything in the past 50 years, it has been to continue to allow management to do much the same thing.<\/p>\n In summary, fifty years after Beaver\u2019s recommendations to the FASB, we should now have a keener awareness of how much business managers care about the financial statements of their companies; and how little regard they have for the \u201cindependent\u201d auditors who might question their judgment.\u00a0\u00a0 On multiple occasions, their collective efforts at accounting manipulation have done great damage to the US economy. \u00a0Investors in an efficient market may be indifferent about the manner in which they receive information, but managers are not indifferent about accounting rules versus other forms of disclosure.\u00a0 Krugman was right: \u201chonest\u201d is the furthest things from their minds.<\/p>\n An Economic Basis for Honest Financial Accounting<\/strong><\/p>\n It so happens that around the time Beaver published his recommendations for the FASB, Harvard philosophy professor John Rawls took on the larger question \u2013 in which financial accounting surely plays a part \u2013 of fairness in politics and economics. His first major book, A Theory of Justice,<\/em>[14]<\/a> is regarded by many as the most influential work of political philosophy of the 20th<\/sup> century.[15]<\/a> \u00a0He was awarded the\u00a0National Humanities Medal\u00a0in 1999 for \u201chis argument that a society in which the most fortunate help the least fortunate is not only a moral society but a logical<\/em> one.\u201d[16]<\/a><\/p>\n Rawls\u2019 philosophy is derived from a novel thought experiment:\u00a0 How would \u201csocial justice\u201d be formulated by a convention of economically \u201crational\u201d individuals who otherwise knew nothing about themselves?\u00a0 From behind this \u201cveil of ignorance,\u201d these individuals wouldn\u2019t, among every other thing, know the color of their own skin, their innate capabilities, or to whom and where they were born.<\/p>\n Very broadly speaking, Rawls derives from his thought experiment standards of moral behavior that should be presumed to be just, given that they were derived by society\u2019s members before they knew how the standards would affect them individually.\u00a0 Of particular relevance, he reasoned that since the convention members cannot know whether they are on the giving or receiving end of any particular action, they should agree that anything less than honesty<\/em> is a prerequisite to just outcomes.<\/p>\n To illustrate from the tale of Jack Welch, let\u2019s consider whether individuals from behind a veil of ignorance would agree that Welch should be allowed to manipulate the earnings of General Electric. Even though they can be proponents of their own personal interests with impunity, they will rationally expect that earnings management is highly unlikely to add to their own well-being.\u00a0 For a very few would attain the enviable position of CEO of a public company. Thus, presuming that earnings management does not otherwise contribute to social good, the convention must conclude that permitting earnings management puts practically everyone \u2013 except for the Jack Welch\u2019s of the world \u2013 on the short end of the stick.<\/p>\n This book will show, among other things, that a simple honesty constraint imposed on financial accounting rules would produce a vast improvement over extant US GAAP.\u00a0 For there are a great many examples of US GAAP that fall short of an honesty standard in a great many ways.\u00a0 Notwithstanding, not all of US GAAP violates an honesty constraint.\u00a0 There are also many examples where a choice could be made between two or more honest accounting treatments.\u00a0 For those, this book is intended to be an example of a good-faith attempt to weight those relative costs and benefits from behind a veil of ignorance.<\/p>\n Accordingly, this preliminary first edition is the product of an iterative process to develop An Honest Financial Accounting (AHFA).\u00a0 Initial chapter drafts were exposed for comment in my blog The Accounting Onion<\/em>.\u00a0 Subject to constraints on civility and relevance, all readers\u2019 comments made through the blog have been considered and published.\u00a0 A \u2018final\u2019 first edition will follow that adds extensive examples of the application of AHFA, and a tabular presentation of the differences and similarities between AHFA and US GAAP.<\/p>\n Next section begins\u00a0here<\/a>.<\/p>\n Draft Table of Contents<\/a><\/p>\n [1]<\/a> At present, the majority of U.S. public companies domiciled outside of the U.S. (so-called \u201cforeign private issuers) furnish financial statements prepared in accordance with International Financial Report Standards.\u00a0 This book primarily refers to requirements of US GAAP, which will be regarded as substantially the same as IFRS, except where noted.<\/p>\n [2]<\/a> Insert reference to SAS 69<\/p>\n [3]<\/a> The Accounting Establishment: A Staff Study, <\/em>Subcommittee on Reports, Accounting and Management of the Committee on Government Operations, United States Senate (\u201cMetcalf Committee\u201d), 1976.<\/p>\n [4]<\/a> Insert reference to Wheat Committee report.<\/p>\n [5]<\/a> [As told by\u00a0Donald Kirk<\/a>, one of the original members of the FASB.]\n<\/p>\n [6]<\/a> William H. Beaver, \u201cWhat Should be the Objectives of the FASB?\u201d, Journal of Accountancy, <\/em>August 1973, pp. 49 \u2013 56.<\/p>\n [7]<\/a> [xxxinsert explanation of investment tax credit controversy here.xxxx\u00a0 The saga of the investment tax credit is somewhat of an obscure anecdote for today\u2019s accountants and users.\u00a0 But the story needs to be told as it was an inflection point in the history of accounting standards setting.]\n<\/p>\n [8]<\/a> Xxx\u201dThe Big Zero\u201d Reference here.<\/p>\n [9]<\/a> [Welch, 2003, p. 225]\n<\/p>\n [10]<\/a> Insert reference to speech at AAA conference.<\/p>\n [11]<\/a> Insert reference to SEC Historical Society interview.<\/p>\n [12]<\/a> Insert Herz book, p. 145.<\/p>\n [13]<\/a> Mosso, David, Early Warning and Quick Response: Accounting in the Twenty-First Century, <\/em>78.<\/p>\n [14]<\/a> John Rawles, A Theory of Justice, <\/em>Harvard University Press, 1971 (revised 1999).<\/p>\n [15]<\/a><\/p>\n [16]<\/a> Insert footnote.\u00a0 \u00a0Weinstein, Michael M. (December 1, 2002).\u00a0<\/em>\u201cThe Nation; Bringing Logic To Bear on Liberal Dogma\u201d<\/em><\/a>.\u00a0The New York Times.\u00a0<\/em>ISSN<\/em><\/a>\u00a0<\/em>0362-4331<\/em><\/a>. Retrieved\u00a0September 7,\u00a02021 <\/em>[emphasis supplied]\n<\/p>\n