SUPPLEMENT C

What’s So Difficult About Setting Financial Accounting Standards?

Accounting standards change so slowly, they often seem relics from another era.

—Dean Foust

Accounting standards (essentially GAAP), which explain how transactions and other events are calculated, recorded, and reported, can be difficult to establish, frustrating to make sense of, and likely subject to change on future standard-setting agendas.¹ Major reasons are summarized in Table S-C.1. Simple bookkeeping (single entry) works okay for basic operations, especially when determining periodic income is not important. Double entry become useful for more complicated operations, especially when periodic income calculations are essential—critical for most commercial organizations of any size. Double entry has limitations when operations and risk become extremely complex. The standard solution is a detailed annual report complete with footnotes on specific topics and descriptions of operations. However, a financial analyst typically discovers a frustrating lack of detail on several topics, and accounting methods and reporting of limited use.

Two key factors are: (1) specific methods used obliterate the information available from other alternatives and (2) the bottom line number, net income, is an accounting artifact rather than a true indicator of performance. If, for example, stock options are not expensed as compensation, they can be considered “free.” The solution (under FASB Statement 123) was to record the “real cost” in the footnotes (that is, stating the compensation expense), giving the analyst the ability to recalculate income. In most cases, however, recalculations were not possible. Mergers were accounted for under a specific method and the acquisitions quickly lost their separate identity.² Thanks to footnotes, some information can be “recovered”; for example, pension accounting requires substantial footnote disclosure.³

Table S-C.1 Why are accounting standards difficult?

Presumably, the primary focus of an income statement is to arrive at a specific number for an accounting period, usually net income. Because valuations (especially PE ratio) typically are based on net income, that single number becomes immensely important—and therefore subject to manipulation. The validity of that number is open to speculation. Standard setting attempts to limit recording alternatives, suggesting that at least relative performance is comparably measured (i.e., compared to other companies and across time). With standards more or less based on the FASB’s CF, the “preferred method” of reporting all transactions is presumed. Having said that, there are hundreds of ways to manipulate income statement numbers. Operations can be changed, such as reducing research and development cost or laying off workers.⁴ Alternatively, allowances and reserves can be adjusted to increase or decrease income, such as bad debts expense or any of the hundreds or thousands of other accrual-related accounts.⁵ Finally, timing affect earnings. Sales near the end of the period often can be considered revenues of this period or the next depending on such factors as “title passing.”⁶

Alternative earnings summary numbers are presented on the income statement and other parts of the annual report (or easily calculated). Some users may find gross margin, income from continuing operations, earnings before interest and taxes, comprehensive income, or earnings per share more informative than net income. For example, comprehensive income is net income plus or minus specific gains and losses not reported as part of net income (such as foreign currency translation gains and losses). Thus, additional information is provided, but this does not affect the major point that income numbers are arbitrary and subject to manipulation. Take a simple example, inventory—presented in Table S-C.2. The results for both the income statement (cost of goods sold) and balance sheet (inventory) depend on the method used, especially when price changes are substantial.

Accounting Theory and the Conceptual Framework

The concepts of accounting theory and especially the FASB’s CF are important considerations for the standard setting process. Early on economists were more interested in “accounting theory” than accountants, generating models involving economic income, marginal revenues and costs, economic rents, how supply and demand determined both selling price and quantity, and so on. Economic income was central to microeconomics, so the relation of marginal costs to economic income, for example, was a key concept. Some concepts proved useful to accounting: marginal cost, sunk cost, opportunity cost, and so on. Others not so much, mainly because determining specific revenues and costs did not match up to economists’ perceptions of such things as income maximization. Assumptions were made, for example, that accounting income numbers matched economic income concepts.

Table S-C.2 An inventory example

Many early accounting academics got advanced degrees in economics and other fields, including accountants/economists of the 1920s and 1930s such as John Canning (Stanford),⁷ Thomas Sanders (Harvard), and Henry Hatfield (Berkeley). The AIA published Sanders, Hatfield, and Underhill Moore’s A Statement of Accounting Principles in 1938 which basically surveyed existing practice rather than build a comprehensive theory. After the accounting problems discovered during the Great Depression, historical cost and conservative accounting (mainly based on practice) would be stressed. William Paton and A. C. Littleton’s An Introduction to Corporate Accounting Standards⁸ was a theoretical analysis of historical cost accounting which provided a framework for half a century. The Paton or Littleton view placed greater weight on the income statement, which created a somewhat less useful balance sheet that included items that are hard to justify as assets or liabilities (deferred taxes for example; goodwill also is a tough sell). Other assets such as patents developed in house were (and still are) not recorded as assets.

A Statement of Basic Accounting Theory, issued in 1966 by the American Accounting Association (AAA), developed the concept of data expansion, in this case to present financial statements on both a historical cost and replacement cost basis.⁹ Because historical cost has limitations, additional information is provided on fair value.¹⁰ A key point is that multiple perspectives can be presented on the financial statements rather than in footnotes only. A key concern is whether this leads to better decision making by users.

The Trueblood Committee¹¹ was established by the AICPA and created Objectives of Financial Statements in 1973.¹² The basic financial statement objective to the report was “to provide information useful for making economic decisions.” Trueblood used the concept of “earnings power” as a measure of past performance to determine future earnings. Also considered were fair value alternatives including exit value and discounted cash flows.

The FASB decided to create a completely new CF project rather than rely on Trueblood or any other existing model. FASB issued a DM on the CF in 1976 as: “a constitution, a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements.”¹³ The CF identified five expectation areas, for which concept statements were eventually issued (and revised). These are summarized in Table S-C.3. Miller et al. identified three purposes for developing a CF: to describe existing practice, to prescribe future practice, and to define common terms. The CF project attempted to do all three.¹⁴

The DM introduced two sets of interrelated conceptual issues, earnings measurement and capital maintenance. Alternative frameworks of earnings measurement were: (1) revenue and expense, (2) asset and liability, and (3) nonarticulation. Capital maintenance could be viewed as: (1) financial capital maintenance or (2) physical capital maintenance.

Table S-C.3 Conceptual Framework summary

The traditional view of earnings measurement is revenue and expense, consistent with Paton and Littleton and the first half-century of standard setting (i.e., historical cost). The focus is on earnings and earnings power, the effective use of inputs to sell outputs. Earnings measurement includes recognizing revenues when earned and matching expenses with revenue— including the critical issue of timing. Expense recognition includes three alternatives: (1) direct product costs such as cost of goods sold, (2) allocations (period costs) such as depreciation, and (3) immediate recognition of administrative costs having no future benefits. This process may distort balance sheet presentation, such as creating deferred charges and credits.

The asset and liability view, more consistent with economic income, considers earnings as the change in net assets (total assets minus total liabilities) for the period. Definitions and calculations of revenues, expenses, gains, and losses are derived from definitions of assets and liabilities. Assets are economic resources and proponents prefer current value rather than historical cost, since current cost emphasizes economic value.

Both methods require articulation: assets equal liabilities plus equity, revenues minus expenses equal earnings, earnings increase equity; the financial statements stay “balanced.” Common transactions stay the same under both views (sales are recognized as revenue, cost of goods sold as expenses).¹⁵

Capital maintenance is the concept that firms continually reinvest their net assets (equity) to maintain invested capital. Earnings (return on capital) result only after cost recovery (return of capital), that is, capital has been maintained. Under financial capital, equity is the value of owners’ net assets at the time contributed plus retained earnings (essentially, maintaining invested dollars), basically consistent with historical cost. Physical capital maintenance requires that assets be maintained at the same productive capacity (but not easy to determine). Inventories and fixed assets would normally be stated as replacement costs. Differences between historical costs and replacement costs could be treated as holding gains and losses.¹⁶

An analysis of the eight concept statements issued is beyond the scope of this essay (but summarized in Table S-C.3). The CF “answers” seem a bit puzzling. The framework apparently relies on the asset and liability view to determine elements, financial capital maintenance, and a general focus on fair value—while the focus of GAAP mainly relies on historical cost, with financial assets the major exception. The asset and liability view is a dubious fit to financial capital maintenance. Although recent standards on financial assets and liabilities incorporate fair value, GAAP is more consistent with the revenue-expense view and historical cost. For example, deferred charges and deferred credits such as income tax allocation items are now redefined as assets and liabilities, but don’t meet the CF definitions of assets and liabilities.

The FASB seems to use the CF in many circumstances, but not consistently—in part because the Board changes over time and strong-willed people have different perspectives. New statements refer to the various concept statements to support specific positions, but ignore the concepts for others. A common criticism of standard-setting still exists: Various assets and liabilities are difficult to defend under the CF definitions (or other definitions for that matter). Some obvious assets and liabilities like internally-generated patents are not recorded. Other issues like human resource accounting (potentially capitalizing labor costs such as executive and tech training) have proponents.

What Is Fair Value?

Virtually all assets are initially recorded as acquisition cost, transactions-based historical cost.¹⁷ After that, what? Inventory usually stays put, with different methods of determining which goods are sold (i.e., first in, first out or FIFO; last in, first out or LIFO; or other method) plus adjustments for declining values in the name of conservatism such as the rules followed for lower of cost or market or obsolete inventory. Plant and equipment are depreciated over their useful lives. Goodwill can be written off when value declines (whatever that means for an asset that in some sense represents a plug figure). Financial assets at the balance sheet date are often recorded at market value or other attempt at fair value. Marketable securities can be recorded at acquisition price or fair value (with the gains and losses recorded either as part of net income or only part of comprehensive income). Derivatives are recorded at fair value, although calculations have statistical problems (e.g., use of normality) and the unexpected catastrophic losses in market failures (such as the financial collapse around 2008). Pensions have complex accounting rules that use fair value for invested assets and various estimates and discount rates for liabilities. In other words, very different rules for each category of assets. (Alternative asset measures are compared in Table S-C.4.)

Table S-C.4 Alternative asset measures

How did this happen and to what extent is it a problem? The simple answer is it’s complicated. Researching railroad accounting, for example, gives some sense for the alternatives tried over a hundred plus years. The railroad experience plus big manufacturing concerns and later tax laws eventually resulted in the relatively simple, but arbitrary depreciation rules. The problems discovered during the Great Depression with companies using all forms of historic-based and fair-value accounting (such as seen in utility pyramiding) led the SEC, IRS, and accounting profession to focus squarely on historical cost accounting (with those adjustments above such as lower of cost or market).

That single focus started to change when inflation became a growing problem beginning in the 1960s. A dollar in 1990 was worth less than a fifth (18.7 percent) of a 1950 dollar—true for cash and monetary assets and liabilities such as bonds. Nonmonetary assets such as stock, inventory or property, plant, and equipment usually increase in value but at different rates from inflation. By the late-1970s the annual inflation rate measured by the CPI hit double digits (over 10 percent) for several years and, consequently, during this period the FASB and SEC considered moving to inflation-adjusted financial reporting. The SEC in ASR 190 (1976) and the FASB in Statement 33 (1979) required additional inflation-adjusted disclosures by large companies. Accounting researchers searched high and low for market responses to this additional and presumably useful information, but could find no evidence that investors used the disclosure. Of course, by the mid-1980s, inflation was no longer a major problem area and these projects were dropped.

International Accounting Standards

Historically, each country developed its own accounting rules.¹⁸ Commercial accounting in countries based on English common law (Anglo-American countries including the United States and Canada) differed from countries using code-based legal systems (especially from France’s Napoleonic code). Because commerce and accounting became increasingly global, different accounting systems could be inefficient or worse. The United States favored historical cost, while the United Kingdom, Australia, and New Zealand could revalue property, plant, and equipment. At one time, New Zealand allowed only straight-line depreciation. In Japan, income tax rules drove accounting practice, while Germany also had a tax-oriented approach. France established a National Accounting Plan in 1947 which codified accounting regulation (tax-oriented) and this was adapted by several countries. Other countries had few rules and limited disclosure requirements. Many countries were weak on audits and regulator enforcement.¹⁹

The movement to eliminate country differences started in 1973 (the same year the FASB was founded) with the creation of the International Accounting Standards Committee (IASC), an underfunded part-time board with no jurisdictional powers. Sir Henry Benson (later Baron), senior partner of Coopers Brothers (now PricewaterhouseCoopers) led the movement, beginning with IASC founded to promote international “harmonization” across countries.²⁰ Accounting professionals from nine countries were invited and sent representatives to the IASC.²¹

The primary purpose of the IASC was to issues accounting standards, initially “basic standards” to promote harmonization. A super-majority vote (initially 75 percent) was required to create new standards (International Accounting Standards or IAS). Early standards included IAS 2 on inventory (allowing FIFO, LIFO, and other common methods), IAS 4 on depreciation (again including typical methods), IAS 12 on taxes (allowing deferral and partial deferral), and IAS 16 on property, plant, and equipment (allowing both historical cost or fair value revaluation).

Initially, little attention was paid to the IASC by rule-making bodies including the SEC, FASB, or European Economic Union (EEC, later the European Community, EC). Slowly, various countries adopted some IAS standards and some international companies including General Electric and Exxon indicated their financial statements were consistent with IAS. Some stock exchanges allowed or encouraged adopting IAS standards including the Toronto Stock Exchange and the Tokyo Stock Exchange. The SEC took greater interest in the 1980s, agreeing to the intent of harmonization—a single global set of accounting standards. During the mid-1990s the SEC stated three key elements needed: comprehensive coverage of issues, high quality, and the need for rigorous application and enforcement.

As Europe moved toward a common currency and a greater need for equity investments through European stock exchanges (with Germany and France particularly interested), the EC pushed for adoption by member states of IAS standards. Zeff noted the problems with German standards and their lack of credibility for finance needs using capital markets. The 1993 Daimler-Benz reconciliation of German to American GAAP changed a DM 0.6 billion profit to a DM 1.8 billion loss, because German GAAP allowed “silent reserves” used to manipulate earnings.²² By 2000 several European multinationals switched from national GAAP to IAS (including Nestle, Deutsche Bank, Roche, and UBS).

The last standard was IAS 39 on financial instruments, also the most controversial. Prior to 2000 the IASC began to consider reorganizing into an organization more like the FASB, with a smaller full-time board, large research staff, and open due process. The restructured organization became the International Accounting Standards Board (IASB), approved in May 2000. It was led by a 14-member board, chaired by Sir David Tweedie (former chairman of the UK Accounting Standards Board). Somewhat surprising, five Americans sat on the original board and half the member were former Big 4 audit partners. The European Union was on board with the IASB and required EU-listed companies (i.e., on European stock exchanges) to adopt IASB standards by 2005—some 6,700 companies, most of which ultimately switched.

IASB agenda items included acquisitions, stock options, and related equity compensation, insurance contracts and so on. IASB issued International Financial Reporting Standard (IFRS) 1 in 2003, setting out the procedures for first-time adopters of IFRS. IFRS 2 (2004) tackled stock options and other share-based payments, including the expensing of options (roughly the same time the FASB did it in SFAS 123R). IFRS 16 issued in 2016 revisited lease accounting, while the FASB tended to be rules-based (and therefore often issuing long, complicated standards—especially true for lease accounting). The IASB was more concept-based, which was demonstrated in the relatively less cumbersome lease standard.

IASB board member Robert Herz, former PricewaterhouseCoopers partner, resigned in 2002 to become chairman of the FASB. The focus on GAAP convergence became more urgent and by the end of the year the Norwalk Agreement promised the move to fully compatible standards across the two boards. The SEC seemed to be in favor of convergence under Chairman Chris Cox. In 2007 the SEC dropped the requirement to reconcile foreign to U.S. GAAP for foreign companies listing on American exchanges in favor of IFRS. However, the new SEC chairwoman under the Obama administration, Mary Shapiro (2009 to 2012—after the subprime crisis and Great Recession), was less enthusiastic about convergence and progress took a back seat to other issues. One factor was the EC’s insistence that the IASB allow marketable securities to be categorized as “held to maturity” and recorded at historical cost, a major change from the IASB position on fair value. The IASB complied, retroactively, for financial institutions to avoid recording massive holding losses.²³

Future Issues

GAAP requires some set of allowed alternatives, perhaps arbitrary and not necessarily the “best” procedures (in the sense of economic income for example). FASB criteria for establishing standards include complex due process procedures and reference to the CF. Changes in GAAP have economic consequences (often unintended) that may be beneficial or detrimental to corporations and users of financial statements. Some standards such as pension accounting can have direct cash flow effects. Most standards affect accounting numbers, including net income. Since contract terms (e.g., sales contracts, executive compensation, or bond covenants) often are based on accounting numbers, changing standards can have significant indirect consequences. Consequently, standard setting is a political process, with organizations potentially affected by new standards lobbying for their economically preferred solution. Issues with significant economic consequences may be subject to the greatest lobbying and, therefore, considered the most controversial. Standard setting is a balancing act.

Why are new issues appearing and old issues reappearing? Each issue has a unique story. Some “solutions” sometimes seem puzzling (treating certain capital leases as operating leases based on complex rules comes to mind). Many new issues result from changing business conditions and new regulations. For example, once the United States went off the gold standard in 1971 foreign currency translation became an important accounting issue. As innovative debt and equity instruments are created, accounting standards must follow, attempting to capture the substance of these instruments.²⁴ Old issues may resurface because of new regulation or growing dissatisfaction with existing standards.