Unnecessary Complexity in Accounting Principles

Historical cost–based financial reporting has traditionally served as the scorecard of business performance. FASB, however, has recently signaled its intention to force American companies to employ “fair value accounting.” The direction is not toward the commonly understood notion of “fair market value.”

In her keynote address to the annual meeting of the National Association of State Boards of Accountancy (NASBA) last October, Kayla Gillan, attorney and member of the Public Companies Accounting Oversight Board (PCAOB), acknowledged that, as a result of the enactment of the Sarbanes-Oxley Act, auditing standards for public companies now differ substantially from those of nonpublic companies. The differences are factual and no longer arguable. This writer thinks that the same reality applies to GAAP employed by public companies versus GAAP employed by nonpublic companies.

FASB is incrementally but inalterably pushing American accounting principles toward international accounting standards. First there was the implementation of SFAS 141, which mandated the use of the purchase method of accounting for business combinations rather than the commonly used pooling-of-interests convention. The purchase method typically results in recording “goodwill” on the books of the acquiring company. Next came SFAS 142, which provides for write-downs of “impaired goodwill” when management determines so. FASB mandates that management, using averages of probabilities of values, assess the impairment of goodwill on an annual basis and record the impairment in the company’s books and records. FASB admonishes that such write-downs apply only to intangible assets.

SFAS 144, effective in 2002, applies the same write-down logic to property, plant, and equipment (PPE)—tangible assets. “Impaired” PPE must now be written down to fair value on an annual basis. In the next logical step, FASB will argue for consistency: If write-downs are appropriate, it follows that write-ups should be recognized.

Colleagues in academe argue that the issue is one of reliability, as opposed to relevance, in financial reporting. Historical cost–based accounting is more reliable, they agree, but is it relevant? This writer posits that the answer is obvious. The reliability offered by historical financial reporting is infinitely more valuable to the vast majority of financial report users than the collective accumulation of statistical probabilities offered by fair value.

It may be arguable that a high-inflation environment, such as experienced by certain Third World countries, mandates fair value accounting. With an inflation rate of 1.6% to 3.2%, such as currently experienced in the United States, however, historical cost–based accounting more than meets the needs of American business. Hands-on owner-managers of small businesses need quick, reliable financial information to run their businesses. They lack the sophistication or inclination to generate “fair value” information that is irrelevant to successfully operating their companies.

This debate has a catch 22: Assuming that the adjustments to fair value are significant and therefore must be taken into consideration, the managements of private companies generally lack the sophistication to make the required adjustments. To whom, then, does FASB expect the client to turn to generate the required information? The logical answer is the accounting firm. If the firm generates the information that is a significant part of the financial reporting process, it would no longer be independent and therefore not able to provide attest services to the client. How can this be considered logical or beneficial to private company clients?

To whom is FASB pandering when it promulgates these principles? The answer is the international accounting firms, their multinational public clients, and the relative few financial analysts and investment bankers that say they need this kind of information. Understand this phenomenon for what it is. The historical record of economic activity in the United States is being replaced with a system tailored to these specific constituencies.

There is no evidence on FASB’s website that any of the seven members of the board has ever set foot in a local or regional accounting firm. The biographical information of the seven members indicates that five matriculated at the Big Four international accounting firms and two are academicians. FASB’s bias is obvious.

If it is true, as AICPA Chair Scott Voynich pointed out at NASBA’s 2003 annual meeting, that there are some 45,000 accounting practice units in the United States, 700 of which serve public clients, then it follows that there must be some 44,300 practice units not serving public clients. If it also is true, as it is according to Voynich, that 80% of new jobs created in the United States are created by nonpublic companies, then one must ask, Why is the tail wagging the dog? Why are accounting principles being set to accommodate the multinational entities that continually export their manufacturing activities and employment opportunities to the Third World?

What is the solution to the dilemma? This writer believes that the AICPA should immediately authorize and direct the executive committee of its Private Companies Practice Section (PCPS) to begin removing FASB accounting pronouncements the executive committee determines are inapplicable to nonpublic companies. Notice, the direction should be to remove—not add—accounting principles.

The intention is not for private-company GAAP to be less significant or less prestigious than public-company GAAP. It would be different, that is all. Auditing standards for public companies are not considered superior to those required for nonpublic companies. Neither should private-company accounting principles be considered less significant than those promulgated for multinational companies.

Some might suggest that a solution to the problem is already available to private companies: financial statements prepared under an Other Comprehensive Basis of Accounting (OCBOA). Generally, practitioners and their private-company clients consider OCBOA statements to be second-class financial reports. The bulk of practice units deserve a solution that grants prestige and status to their work product; OCBOA simply is inadequate to that end.

This writer believes that the proliferation of codified accounting principles has, in large part, led to the distress that the profession currently is experiencing. Codified principles issued by the Accounting Principles Board (APB), then by FASB, have led to a “cookbook” approach to financial reporting.

The application of codified principles has given rise to a curious cottage industry, very similar to the situation found in the tax arena. Accountants, investment bankers, and clients are structuring financial instruments around the provisions of highly technical, complex accounting pronouncements. The game is based on whether the security falls either inside or outside of the established principle. The predictable recipe resulting from this cookbook is what one observes in Enron, WorldCom, Adelphia, and so on.

At one time in the United States, public accounting was based on independence, objectivity, and integrity. The Uniform Accountancy Act, in large part, has emasculated the concept of independence, a term which the AICPA, largely as a result of its Vision Project, has virtually dropped from its lexicon. At NASBA’s 2003 annual meeting, Voynich listed the AICPA’s core values as objectivity, integrity, and competence. At no time did he mention independence.

If FASB succeeds in replacing historical cost–based financial reporting with fair value accounting, objectivity as an accounting concept will disappear as well. Fair value embodies the antithesis of objectivity. In just a few short years, there will be another failure similar to the Enron and WorldCom debacles. The failure again will, in part, result from “irrational exuberance” and its attendant market speculation. At that time the question will not be, Where were the accountants? The question will be, Why were the accountants aiding and abetting in the speculation? The final nail will then be driven into the coffin of the once noble profession. Our integrity will be lost forever.

In the event that the AICPA is unwilling or unable to authorize the recommended action suggested above, then state boards of accountancy, which have the authority to establish accounting principles within their jurisdictions, must immediately begin the process. While it would be preferable for the AICPA to take on the task so that uniform application of accounting principles would be preserved in the private sector, an alternative state-based solution is advanced, because the writer believes that the AICPA will ignore this recommendation. Boards of accountancy will be the only entities with sufficient power to implement the needed changes. Balkanized accounting principles undoubtedly would result; but even this would be preferable to allowing FASB to continue its headstrong march into oblivion.

In such a scenario, the membership of AICPA that is not engaged in public-company work should then resign from the Institute and start an association whose interests more closely parallel its own and those of its clientele. Eventually this new entity could coordinate and monitor private-company accounting principles.

I realize that there are many who will strongly disagree with what I am proposing. The cognoscenti will no doubt find my position naïve and simplistic. I would posit that some of these same people are responsible for some of the failures that have so harmed the profession in recent years. It is up to those of us who still believe in the traditional core values of the public accounting profession to preserve its integrity.

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