April 2002

Accounting that Adds Up

Testimony of Walter P. Schuetze before the United States Senate Committee on Banking, Housing, and Urban Affairs, Paul S. Sarbanes, Chairman, on February 26, 2002

The public's confidence in financial reports of and by corporate America, and in the audits of those financial reports by the public accounting profession, has been shaken badly by the recent surprise collapse of Enron; by recent restatements of financial statements by the likes of Enron, Waste Management, Sunbeam, Cendant, Livent, and MicroStrategy; and by the SEC's assertion of fraud by Arthur Andersen in connection with its audits of Waste Management's financial statements in the 1990s, which Andersen did not admit or deny in a settled SEC action last summer. The public's confidence needs to be regained and restored. Otherwise, the result will be that investors will bid down the price of stocks and bonds issued by both U.S. and foreign corporations; we have seen evidence of that phenomenon in recent weeks. That is an investor's natural response to increased risk or the perception of increased risk. This will reduce the market capitalization of corporations, which in turn will negatively affect capital formation, job creation and job maintenance, and ultimately our standard of living. So, we are concerned today with a very important matter.

You will hear or have heard many suggestions for improvement to our system of financial reporting and audits of those financial reports. In my opinion, those suggestions, even if legislated by Congress and signed by the President, will not fix the underlying problem, which is a technical accounting problem and rooted in our rules for financial reporting. Those financial reporting rules need deep and fundamental reform. Unless we change those rules, the problems will persist. Today's crisis as portrayed by the surprise collapse of Enron is the same kind of crisis that arose in the 1970s when Penn Central surprisingly collapsed and in the 1980s when hundreds of savings and loan associations collapsed, precipitating the S&L bailout by the federal government. Similar crises have arisen in Australia, Canada, Great Britain, and South Africa. There will be more of these crises unless the underlying rules are changed.

Under our current financial reporting rules promulgated by the FASB, management of the reporting corporation controls and determines the amounts reported in the financial statements for most assets. For example, if management concludes, based on its own subjective estimates, that the cost of an asset-say, equipment-will be recovered from future cash flows from operations without regard to the time value of money or risk, no write-down is required even when it is known that the current market price of the asset is less than the cost of the asset. The external auditor cannot require that the reported amount of an asset be written down to its estimated selling price; the external auditor cannot even require the corporation to determine the estimated selling price of the asset and disclose that price in its financial statements. So, when it comes time to sell assets to pay debts, there often are surprise losses that investors then see for the first time. Management also makes similar assessments in determining the amount of inventory obsolescence, the allowance for bad debts, and whether declines in the values of investments below cost are "other than temporary."

Under our current accounting rules, corporate management often records sales and trade receivables at 100 cents on the dollar, even though a bank or a factor would pay only pennies on the dollar for those trade receivables. We saw that phenomenon in the past few years during the telecom rage where sales and receivables were recorded followed several months later by write-offs of the receivables. On another front, we currently are seeing swaps of assets and the recognition of gains in what are effectively barter transactions, even though the fair value of what was exchanged is apparently negligible.

Except for inventories and marketable securities, none of these asset amounts in the financial statements-trade receivables, commercial and consumer loans receivable, real estate loans, oil and gas reserves, mineral deposits, pipelines, plant, equipment, investments-is subjected to the test of what the cash market price of the asset is. Yet, we know that most individual investors, and, in my experience, even many sophisticated institutional investors, believe that the reported amounts of assets in corporate balance sheets represent the current market prices of those assets; nothing could be further from the truth.

And under the FASB's definition of an asset, corporations report as assets things that have no market price whatsoever; examples are goodwill, direct response advertising costs, deferred income taxes, future tax benefits of operating loss carryforwards, costs of raising debt capital, and interest costs for debt said to relate to acquisition of fixed assets. I call these nonreal assets. Today's corporate balance sheets are laden with these nonreal assets; this is the kind of stuff that allows stock prices to soar when in fact the corporate balance sheet is bloated with hot air. Of course, when it comes time to pay bills or make contributions to employees' pension plans, this stuff is worthless.

The same goes for liabilities. Corporate management determines the reported amount of liabilities for such things as warranties, guarantees, commitments, environmental remediation, and restructurings. Again, this is as per the FASB's accounting rules.

The upshot is that earnings management abounds. Earnings management is like dirt: It is everywhere. SEC commissioners have made speeches decrying earnings management. The business press carries hand-wringing articles about earnings management. Earnings management is talked about matter-of-factly on the television business news programs. Earnings management is a scourge in this country. It is common in other countries as well because their accounting rules and the accounting rules promulgated by the International Accounting Standards Board are much the same as ours.

We need to put a stop to earnings management. But, until we take control of the reported numbers out of the hands of corporate management, we will not stop earnings management and there will be more Enrons, Waste Managements, Livents, Cendants, MicroStrategys, and Sunbeams.

How do we take control of the reported numbers out of the hands of corporate management? We do it by requiring that the reported numbers for assets and liabilities, including guarantees and commitments, be based on estimated current market prices-current cash selling prices for assets and current cash settlement prices for liabilities. By requiring that those prices come from, or be corroborated by, competent, qualified, expert persons or entities that are not affiliated with, and do not have economic ties to, the reporting corporate entity. And by requiring that the names of the persons or entities furnishing those prices, and the consents to use their names, be included in the annual reports and quarterly reports of the reporting corporate entity so that investors can see who furnished the prices.

Let me give you an example. Before September 11, 2001, the major airlines, to the extent that they own aircraft instead of leasing them, had on their balance sheets aircraft at the cost of acquiring those aircraft from Airbus and Boeing. Let's say that cost was $100 million per aircraft. The market prices of those aircraft fell into the basement after September 11 to about $50 million per aircraft and remain there today, although prices have recovered somewhat. Yet, under the FASB's rules, those airlines continue to report those aircraft on their balance sheets at $100 million and are not even required to disclose that the aircraft are worth only $50 million. Under mark-to-market accounting, the aircraft would be reported at $50 million on the airlines' balance sheets, not $100 million.

The S&L debacle of the 1980s is another example. If mark-to-market accounting had been in place and had the Federal Home Loan Bank Board (FHLBB) computed regulatory capital based on the market value of loans, bonds, and real estate projects, the S&L "hole" would not have gotten nearly as deep as it ultimately did. Instead, the FHLBB's regulations and the FASB's accounting rules let S&Ls report mortgage loans, bonds, and real estate projects at their historical cost, making the S&Ls appear solvent though they were really not. When it bailed the insolvent S&Ls out of the mess, the federal government paid for losses hidden on the balance sheet under the historical cost label and the operating losses incurred while the S&Ls kept their doors open because of their faulty accounting.

Various members of Congress have said in recent hearings about Enron that a corporation's balance sheet must present the corporation's true economic financial condition. But this cannot be seen when assets are reported at their historical cost amounts. The only objective way that the true economic financial condition of a corporation can be portrayed is to mark to market all of the corporation's assets and liabilities. Recall my example about the cost of aircraft being $100 million and the current market value being $50 million. Mr. Chairman and members of the committee: Is there any question that the $50 million presents the true economic financial condition and the $100 million does not? Moreover, following today's FASB accounting rules produces financial statements that are understandable only to the very few accountants who have memorized the FASB's mountain of rules. Indecipherable is the word Chairman Pitt has used in recent speeches. On the other hand, marking to market will produce financial statements that investors, members of Congress, and my sister, who also happens to be an investor, can understand. The various proposals that have been made to cure Enronitis will not cure the problem. The only cure, in my opinion, is mark to market.

I liken our current accounting system to bridges built from timber, which keep collapsing under the weight of 18-wheelers. The public demands that expert consulting engineers oversee the building of replacement bridges. But the replacement timber bridges keep collapsing under the weight of 18-wheelers. More expert consulting engineers will not make timber bridges any stronger. What is needed is bridges built of concrete and steel. The same goes with accounting.

In the 1970s, after the surprise collapse of Penn Central, the auditing profession instituted peer reviews, where one auditing firm reviews the work and quality controls of another auditing firm. In the 1970s, auditing firms also instituted concurring partner reviews, where a second audit partner within the public accounting firm looks over the shoulder of the engagement audit partner responsible for the audit. These procedures have been ineffectual, as shown by the dozens of auditing failures that have occurred since then. Coincidentally, the FASB also came on the scene in 1970s; it was going to write accounting standards that would bring forth financial statements based on concepts. What happened was that the FASB wrote a mountain of rules that produce financial statements that nobody understands and that can be and are gamed by corporate management. What all of that amounted to was continuing to build timber bridges that keep collapsing. We need to build concrete and steel bridges-we need to mark to market all assets and liabilities.

Now, you may ask: How much will concrete and steel bridges cost? Can we afford to build them? My response is that we cannot afford not to. How much of the cost of the S&L bailout was attributable to faulty accounting is unknowable but no doubt huge. How much does an Enron, Cendant, Waste Management, MicroStrategy, or Sunbeam cost? The answer for investors is billions, and that does not count the human anguish when working employees lose their jobs, 401(k) assets, and medical insurance and when retired employees lose their cash retirement benefits and medical insurance. By some estimates, Enron alone cost $60-70 billion in terms of the market capitalization that disappeared in just a few months. Waste Management, Sunbeam, Cendant, Livent, MicroStrategy, and the others also cost billions in terms of market capitalization that disappeared when their earnings management games were exposed. And, these costs do not include the immeasurable cost of lost confidence by investors in financial reports and the consequent negative effect on the cost of capital and market efficiency.

By my estimate, annual external audit fees in the United States for our 16,000 public companies, 7,000 mutual funds, and 7,000 broker/dealers total about $12 billion. Let's say that $4 billion is attributable to mutual funds and broker/dealers. (Incidentally, mutual funds and broker/dealers already mark to market their assets every day at the close of business, and we have very few problems with fraudulent financial statements being issued by those entities. Mark to market works and is effective.) That leaves $8 billion attributable to the 16,000 public companies. Assume that the $8 billion would be doubled or even tripled if the 16,000 public companies had to get competent outside valuation experts (not public accountants, because they are not competent valuation experts) to determine the estimated cash market prices of their assets and liabilities. We are then looking at an additional annual cost of $16-24 billion. If we prevented just one Enron per year by requiring mark-to-market accounting, we easily would pay for that additional cost. And, when considered against the total market capitalization of the U.S. corporate stock and bond markets of more than $20 trillion, $16-24 billion is indeed a small price to pay.

The question arises: Who should mandate mark-to-market accounting? I recommend that there be a sense of the Congress resolution that corporate balance sheets must present the reporting corporation's true economic financial condition through mark-to-market accounting for the corporation's assets and liabilities. I recommend that Congress leave implementation to the SEC, much the way it is done today by the SEC for broker/dealers and mutual funds. There will be many implementation issues, so the SEC will need more staff and money.

Walter P. Schuetze, CPA (Retired), is a former partner of KPMG and its predecessor firms, a charter member of FASB, a former member and chair of the AICPA's Accounting Standards Executive Committee (AcSEC), SEC chief accountant (1992-1995), and chief accountant of the SEC's Division of Enforcement (1997-2000). This article, adapted from Schuetze's U.S. Senate testimony, was adapted from an article which was published last year in Abacus, a University of Sydney publication, and which was the basis for the RJ Chambers Research Lecture that he presented last year at the University of Sydney.

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