GLG News by Paul Miller, CPA

Implications: undefined undefined Listen to the message and don’t shoot the messenger if you think it’s bad news. And don’t endorse public policies based on deceptive reporting. undefined undefined

Analysis:

I don’t know the context in which Senator McCain offered up his comment, so I cannot fully analyze what he might have meant.  However, I have heard a great many others in the banking industry say even worse.

It is entirely possible that mark-to-market (MTM) accounting really has exacerbated the crisis.  That doesn’t mean that it created the crisis, nor does exacerbate mean that it made the crisis worse than it really is.  What I mean is that the truth revealed in the financial statements through MTM made it clear to the capital markets that the existence of extreme risk and the consequence of partaking in it are more widespread than anyone realized.  To put it another way, mark-to-market did exactly what it is supposed to do:  reveal the bad news as well as the good news.

As a student observed to me not long ago, blaming MTM for the credit crisis is like blaming the X-ray machine for your broken leg.  The bad news is your leg is injured; the good news is the X-ray reveals the nature of the injury.  The next step is to confront the bad news, and take steps to get it fixed.  If you deny you have a broken leg by telling people, “No really, I’m fine,” the certain outcome is that you’ll do more damage and make it even harder to fix.

Does MTM force banks to use estimated prices?  Of course, it does, and there’s nothing wrong with that, except that bankers may not want to report their estimates.

But look at it this way:  if the bankers don’t report estimated prices, the outcome will be that financial statement users will have to substitute their own estimated prices for the bad loans and investments.  The certain consequence of that effort will be very cautious estimates that are extremely low.  It would be far better if the bankers made realistic estimates and then carefully explained how they were produced. 

It would make no sense whatsoever to report original cost simply because it isn’t an estimate.  Cost is not reliable for describing the banks’ current holdings.  Anyone who wants to report that number simply desires to propagate meaningless numbers in hopes that users will believe them.  That is utter nonsense.

Should companies be allowed to suspend MTM? 

If they want to cut off their noses to spite their faces, fine.  But, why would they want to make the capital markets guess about what the investments are worth?  It would be an outrageous decision to adopt that policy, and it would be even more outrageous for regulators to endorse a practice that is misleading and incomplete.

Does a downturn force banks to recognize losses and impair capital?

The tone of the question strikes me as a bit askew.  The purpose of financial reporting is to provide the capital markets with access to useful information about what has happened and about what might happen in the future, based on the present situation. 

The accounting method doesn’t force the writedown.  What it does accomplish is getting more truth into the statements and into the capital markets.  What forces the writedown is management’s investment and financing policies that used extreme amounts of leverage to buy extremely risky investments without doing their homework.  Because their capital ratio is low (say 4% of assets), taking only a small loss (say 5%) of asset value is enough to wipe out the capital.  Putting the bank in that position is totally irresponsible behavior.  And it’s that behavior that forces writedowns and the impairment of capital.  MAKE NO MISTAKE ABOUT IT:  the losses and the impaired capital already exist.  All that MTM accounting does is reveal that result.  And all that suspension of MTM would accomplish is a thinly veiled cover up.

Does capital impairment trigger a “fire sale”?  I wouldn’t think so, but, even if it did, you couldn’t blame the accounting rules for the bank’s getting into this situation.  They merely revealed that the bank is in a desperate situation because of malfeasance on the management’s part.

TWO MORE THING WITH REGARD TO SUSPENDING MARK-TO-MARKET:

I am totally convinced that calls to suspend MTM are (either wittingly or unwittingly) calls to endorse deceptive reporting as a suitable public policy.  If MTM reveals truth about investments, then suspending it must be intended to keep truth out of the statements.  There is no justification for that kind of a policy.

The second point is that such a policy is based on a faulty premise.  That premise is that the capital markets make decisions based on reported numbers and reported numbers alone.  It is totally facile to think that bank stock prices are linked directly to reported earnings and capital balances.  No one can (a) make capital market participants use numbers that they know are not truthful or (b) keep those participants from using other data (including their own estimates) in place of the reported numbers.

In summary, calls to suspend MTM are at worst malevolent and misguided.  At best, they will do nothing but increase noise and friction in the capital markets and produce LOWER stock prices, not higher ones.

Implications: Maybe it's just me, but these quotes from Herz and Pozen are off-base. When they suggest there could be a pure historical cost system, they are talking about something that doesn't exist and hasn't existed in a 100 years, if even then. I have to believe that Herz was misquoted or misinterpreted; I can believe that Pozen would misunderstand. Nothing will come out of this. There will be no turning back to more costs. There will be a continuing progression toward fair value accounting for the simple reason that it produces the information that users want and that society needs them to have.undefined undefined

Analysis:

Pozen and Herz seem to think there could be a pure historical cost system. No such thing exists and maybe never has. 

What auditor, for example, would tolerate carrying assets at a cost that's known to exceed their market? A shift to pure cost would roll back 70+ years of lower of cost or market and impairment practices that have protected auditors against recrimination (while denying users access to useful facts).

Also, a pure historical cost system would have no systematic depreciation.  Something acquired would be carried at that amount until it was sold or completely consumed. Nothing could be allocated to intervening years' earnings, and nothing could be allocated to products manufactured with the assets.

Then, of course, there is the problem of the measuring unit. Would a pure system report costs in nominal dollars or constant dollars? What would be done about costs in other currencies? The system wouldn't be pure if you ever altered the exchange rate. 

Finally, a pure historical cost system would have no comparability whatsoever. Two companies holding identical assets acquired at different prices would not report identical amounts, yet they both have the same future cash flow potential. Where is the usefulness in that?

Here's the bottom line fact -- the only pure system that can ever be useful is one based on current fair values.

No lower of cost or market, just market (if the market value is reliable below cost, it's equally reliable above cost).

No systematic depreciation, just the change in market value between points in time. No assumptions about value behavior, just actual observations of what happened. 

No systematic allocations of costs to manufactured inventory. The output of the accounting system would be the value of the product, not the sum of the arbitrarily allocated costs of the consumed inputs. The result would be a measure of the value added in production, achieved by comparing the values of the products with the values of those inputs when they were consumed.

Comparability would be perfect because companies holding identical assets and liabilities would report identical amounts, and companies holding different assets and liabilities would report different amounts, thus allowing users to assess the future cash flow potential.

There are still measuring unit issues but not across companies, only over time, as in comparing the end of the year value with the beginning of the year value. Currency exchange rates are merely part of the formula for describing market values usefully.

THERE IS NOTHING USEFUL IN PURITY FOR PURITY'S SAKE, UNLESS THE PURE INFORMATION IS USEFUL FOR ASSESSING THE FUTURE.

Herz or Pozen were either misquoted, misunderstood, or terribly naive.

In any case, nothing will come of this. There will be no turning back to more costs. There will be a continuing progression toward fair value accounting for the simple reason that it produces the information that users want and that society needs them to have.

Any longing for a pure historical cost system is a nostalgic pipe dream that denies the realities that (a) one ever existed and (b) the resulting statements would not ever be useful.

Implications: This article reveals the bizarre mindset of managers who (a) want to take huge risks for a shot at high returns, (b) don’t mind reporting results when they succeed, but (c) don’t want to report their losses. To put it another way, they want to invest in risky securities but report income from their ventures as if they put money into certificates of deposit. There is no legitimacy in twisting the accounting to cover up the results, and no reason to blame the chief accountant or FASB for the problem, or to expect the regulators to take them off the hook by allowing the losses to be hidden.

Analysis: When managers choose to engage in risky behavior, the only certainty they face is that the distribution of possible future income effects will be widely dispersed.  While it is possible to make a large profit, it is also possible to have a large loss, with a variety of outcomes in between.  

This situation is quite different from engaging in less risky behavior where the tails of the distribution are curtailed; they can’t make as much, but they also cannot lose as much.

The task for accounting policy makers is to devise principles that allow financial statement users to distinguish between these two behaviors.  The clear solution is to force the recognition of all changes in market value when they occur.  This practice puts useful information on the balance sheet by showing the economic value at risk; it also puts useful information on the income statement by showing the consequences of the risk.  Specifically, the more risky the investment behavior, the more volatile the income.

Consider this quote from the unnamed “senior Wall Street executive,” who says: “We can explain why we took the writedown, but the fact remains that we will still have to take it on our profit and loss account and that is a big burden.”  

He is in denial.  He put his shareholders’ capital at risk, a great deal of risk, in fact, and lost a large chunk of it.  What would he have the policy makers do?  Relieve him of the responsibility for reporting the outcome of his bet?  The burden that he refers to is being borne by the shareholders, and it is his fault.  He should not expect to escape accountability, and he certainly should not expect the SEC to give him a free pass.

The writers clearly do not understand the problem either.  There is no “crumb of relief” in a policy that would keep the truth out of financial statements.  Allowing management to hide its mistakes by making up numbers would not be relief.  It would be a public policy that organized deception is suitable for protecting managers against themselves and against full accountability for their actions.  Without doubt, this sort of policy would destroy confidence in the capital markets.

If managers want to report smooth and growing income, then they should invest in guaranteed securities, like certificates of deposit, and watch them grow little by little each year.  They cannot invest in subprime mortgage-backed bonds and expect to account for them as if they are CDs.

This time, they bet on the wrong thing, and they bet big.  It’s time to face the music.  And, to mix metaphors, it’s also time for some of them to walk the plank because of their poor judgment.  They’re only making it worse by asking accounting regulators to let them cover up their mistakes.  That would do no one any good, not even the managers.  Instead, it would merely allow them to continue in their state of denial that something really bad happened because of their decisions.

Implications: You can never judge a book by its cover or a seminar by its flier, but Harris Solutions is on to something here.  If you have accepted the SCF as pure and not manipulable, you may very well want to attend to find out more about the sly maneuvers on the fringes of GAAP that pump up the operating cash flow.  A couple of examples appear below.

Analysis: I have come across two companies that have used GAAP idiosyncrasies to make their cash and/or cash flows look better.  If I have found these two through an unsystematic search, there surely are many others.

Hertz:  the trick used by management is to treat what are payments under de facto operating leases for vehicles into investing outflows.  This causes the operating cash flows to be presented at a much larger number while the investing section presents the appearance that management is investing that huge sum in productive assets.  The guise that’s used is repurchase agreements with the car factories in which Hertz “pays” a purchase price and the factor agrees to “buy” the cars back after 10-12 months for a fixed price.  The delta is obviously a cash outflow comparable to rent under a short term operating lease.  What happens is that Hertz calls this differential depreciation and adds it to net income to produce the operating cash flow.  Presto, a huge increase in cash flow!  How big?  In 2006, the SCF shows $2.6 billion of OCF after adding $1.8 billion of depreciation.  Because the depreciation is really paid in cash, the OCF is only about $0.8 billion.

Abercrombie & Fitch:  the management uses a different trick that presents a prettier picture than would appear if they used common sense and understood that their schemes are transparent.  Their guise is to show their outstanding checks at year end as a liability instead of a reduction in the cash balance.  They’ve written the checks against a “zero-balance” account that is technically overdrawn at the balance sheet date, although a deposit is made first thing the next day to take the checking account balance up to zero.  Under archaic rules, overdrawn accounts in one bank cannot be offset against positive balances in another bank.  The result at the end of the fiscal 2006 was a real $60 million cash balance that looked like it was $80+ million.  Worse yet is the impact on the operating cash flows because the change in the outstanding checks is treated as a financing flow, not operations.  Sometimes the result is an exaggerated reported OCF and sometimes it’s diminished.  It could be a trick or just the consequence of ignorantly following old-fashioned rules too closely, but the results (and management) cannot be trusted.

So, yes, it may be worth the time and cost to see what Harris can teach you.

Implications: Restatements are not triggered by Sarbanes-Oxley but are caused by management’s financial statement errors, either deliberate or inadvertent.  Thus, any arguments that restatements are unimportant are fatuous.  These opponents are asserting that it’s suitable public policy to allow managers to publish erroneous statements and then leave them that way. With regard to the lack of market reaction, the researchers face the persistent problem of figuring out when the market reacted.  It is unwise to assume the market doesn’t know about the errors until they’re announced with the result that it’s impossible to know exactly what the market reacted to.   As I see it, managers should embrace restatements as opportunities to clear the air of uncertainty that something in their statements is misleading.  They absolutely should not worry about the cost of restatements.  When compared with the potential effect on market cap, the out of pocket costs are negligible.     

Analysis: Several points in the comment-soliciting question deserve close attention because of bias they may reveal.

For example, I notice the use of the word “flood” to describe the volume of restatements.  “Flood” implies an unwelcome abundance.  Perhaps restatements are actually needed in order to bring more credibility to the markets; if so, this volume is not a flood but a welcome rain of relief.

I also notice that restatements are characterized as appropriate if they are “material to the financial statements.”  That is audit-speak.  What really matters is whether the restatements are material to those who use the statements.  When that perspective is adopted, restatements are relevant even if they’re small because they signal that management is trying to get everything in order, which is a good thing.  

I am curious as to how observers conclude that some restatements have been “clearly unnecessary.”  Because restatements are produced to correct errors (deliberate or accidental), how could any of them be obviously unnecessary?  To say they are not needed is to assert that erroneous financial statements are suitable, so why bother to get them right.

The question also uses the phrase “overly cautious.” One has to ask who is making that call and the consequences of doing so.  Given that security prices are the joint product of many factors, and that those factors include not merely financial statement content but also the credibility of the management, the auditors, GAAP, and the regulatory system, as well as volatile economic factors, how could any caution be excessive?  What comes forth is that the plaintiffs have virtually no understanding of the reasons for restating.

The fact is that restatements are important for two reasons:  providing new financial information and, perhaps more importantly, establishing that the statements are now reliable when they previously were not.  This latter point also comforts the market about the future:  if the management went to the trouble to fix the effects of this error, then perhaps they will take steps in the future to prevent any additional errors.

I also noticed the word “wrought,” which appears to be the past tense of “wring,” which implies that the threat of sanctions was the only thing that forced management to restate.  If this is so, I think the market would really like to know that fact.  A management that freely and openly admits and fixes its mistakes will experience a market premium over those managers that resist telling the truth in their statements.  There really is more to restating than new numbers.

As for the summary comment that the impact of restatement has diminished, I am not at all sure that (a) this summary of the research is valid or (b) the questioner really understands what the research shows, or doesn’t show.  Or what it implies or doesn’t imply.

What the research apparently shows is that the markets are showing less of a reaction to restatements.  That’s only to be expected because more of them are occurring.  To illustrate, I live in a neighborhood that is presently populated by a great many deer, to the point that they are well accepted and tolerated.  It wasn’t always this way, and we used to stop what we were doing and take pictures of this rare phenomenon.

Under the old pre-Sarbanes regime, restatements were tantamount to confessions of serious misdeeds.  They were unexpected and often shocking.  The markets reacted by hammering the stock because something must have been seriously wrong.

Under the new regime, restatements are more frequent because, well, managers now know that they had better restate before they’re found to have not restated.  Their voluntary actions, though somewhat compelled, are much more welcome than the forced confessions that restatements used to represent.

Here is the bottom line:  restatements are absolutely important to the capital markets.  As a result, it will always be in management’s interests to go to the trouble to accomplish them in order to remain credible and to escape the heavy discount that falls on the untrustworthy.  Managers who look at the cost of restating without considering that discount are penny wise and very pound foolish.

In the CFO article, Hal Scott is quoted as saying that the lack of reaction may indicate that restatements are not important.  I encourage him, and others who think like him, to reconsider.  It seems to me that the lack of reaction is proof that they ARE important.  They are now an accepted part of the environment and seen as essential.  You have to ask what would happen if they stopped occurring.  Surely stock prices would decline as a result of the growing uncertainty that errors are not being corrected.

In closing, those managers who would hope to find relief from being held to a high standard by a diminished reaction to restatements are hoping in vain.  Their shareholders will pay either the small cost of restating or the very high cost of a discounted market cap.  The answer is obvious when the issue is put in those terms.

Implications: The silver lining in the so-called Subprime Crisis is that it is yet another event that illustrates the need for greater quantities of more useful information in financial statements and financial reports.  As long as management chooses to comply only with the most minimum of standards, they are surrounding their stock with uncertainty, which, in turn, creates risk and drives the stock value down, not up. With regard to pension funds, they are nothing more than proprietary mutual funds in which the employer’s stockholders are obliged to hold an interest, whether they want to or not.  Their fortunes are linked to the management’s ability to manage this pension/mutual fund, and it only makes sense for them to be fully informed as to its portfolio and their risk exposure. In other words, that’s no shadow being cast on pensions – it’s the bright disinfecting sunlight that’s been needed for a long time.

Analysis: Ever since SFAS 87 was issued in 1985, accounting for defined benefit pension plans has been in need of significant reform.  In that standard, FASB members said that they had a great deal more they wanted to accomplish but that they had gone just about as far as they could against the irrational opposition from managers who were worried that telling the truth about their plans would be fatal.  It took 20 years, but SFAS 158 accomplished a modest reform by forcing a net liability on the balance sheet for underfunded pension and other post-retirement benefit plans (or a net asset if they’re overfunded).  This was nothing more than a baby step compared to what’s needed and what’s surely coming.

With regard to the so-called Subprime Crisis, it is yet another event that illustrates the need for greater quantities of more useful information in financial statements and financial reports.  As long as management chooses to comply only with the most minimum of standards, they are surrounding their stock with uncertainty, which, in turn, creates risk and drives the stock value down, not up.

With regard to pension funds, they are nothing more than proprietary mutual funds in which the employer’s stockholders are obliged to hold an interest, whether they want to or not.  Their fortunes are linked to the management’s ability to manage this pension/mutual fund, and it only makes sense for them to be fully informed as to its portfolio and their risk exposure.

What I think has happened is that managements have been advised by their money managers to put together extra-risky portfolios in order to earn a higher return and eventually close the funding gap while driving the net annual pension cost lower.  But, the absence of any but the most modest requirements for describing the portfolio has permitted them to take these risks without revealing what they’ve done.  The Subprime Crisis is calling attention to the risk associated with junky bonds, and that is surely going to impact a great many pension fund portfolios and returns.

The most useful information about pension funds is their contents and their risks and returns.  And the best way to do that is open and above board reporting, primarily by flowing the investment results right into the income statement where they can be seen by all.  Managers objected in the 1980s, and will do it again in the 21st century, that this flowthrough reporting will cause their earnings to be volatile.  This view is, of course, nothing but nonsense.  The income statement cannot cause income to be volatile, but it can reveal whether it is volatile or not.  If it’s volatile, then greater risk is associated with future cash flows; if it’s not, then less risk is associated with those flows.  

All that happens under existing GAAP is that the volatility is CONCEALED from scrutiny because it defers unexpected investment gains and losses in hopes that they’ll be offset in the future.  This hiding does nothing but encourage unwise managers to take even greater risks because they’re sheltered from accountability for their actual results.

If managers want to show nonvolatile results, they need to implement investment strategies that produce nonvolatile returns, not rig the scorecard to make the returns look nonvolatile.

To get to that point, the best path for FASB to take is to get more truth into the markets by requiring managers to describe their portfolios in more detail and their returns with more candor and without artificial smoothing of real volatility.

While they’re at it, as Mr. Katz suggests in his column, FASB is going to reconsider the most flawed part of defined benefit pension (and OPEB) accounting.  Under SFAS 87, the annual cost gets run through a giant blender, sort of like the famous “Bass-O-Matic” from Saturday Night Live where a whole fish is placed in a blender and ground up into a uniform revolting liquid.

What happens in SFAS 87 is that the annual pension cost consists of these disparate components:  (a) a labor cost (ongoing service cost), (b) a financing cost for borrowing (interest on the liability), (c) an investment return (on the plan assets), (c) amortization of a goofy off-balance sheet intangible asset (prior service costs arising from increasing benefits) or an even goofier off-balance sheet liability (prior service savings from cutting benefits), and (d) corridor amortization of excessive accumulated deferred gains and losses from unexpected asset returns and actuarial adjustments to the estimated value of the pension liability.  Just as no one would really drink the output of the Bass-O-Matic, no one should believe that the annual pension cost under SFAS 87 actually means anything worth knowing.  It simply conveys no useful information whatsoever.

What FASB should do, and what I think it will do, is decompose that aggregate cost into its components, each of which will end up in its own useful segment of the income statement.  (a) Service cost will be expensed as incurred as an operating cost or added to inventory cost and eventually cost of goods sold.  (b) The interest cost on the liability will be included with other financing charges.  (c) The investment return, unsmoothed, will flow through to the other income section of the income statement.  (d) If the liability gets bigger through a grant of higher benefits, a loss should appear on the income statement as the consequence of the agreement.  If the liability gets smaller through a concession from the labor union, there should be a gain on the income statement for the savings.  And, (e) if actual conditions change concerning the pension liability, such as new market discount rates, different longevity, and different life spans for the beneficiaries, this gain or loss should also appear on the income statement when it happens.

Look at it this way – a defined benefit pension plan (or a medical plan) creates an irrational liability to pay (a) an unknown amount (b) to an unknown set of persons (c) for an unknown period of time.  In some respects, it is the consequence of an irrational transaction.  As such, the only rational way to report about it is to tell the truth, the whole truth, and nothing but the truth.  

If management doesn’t like the results, then it needs to reshape its policies for granting benefits and for managing its portfolio.

NO ONE will benefit in the long run if FASB simply leaves pension and OPEB accounting unchanged.  

The Subprime Crisis did not create this mess, but it has served to shine some sunlight on a huge problem that has stayed below the surface.  The only good answer is more information of a different character.  And I think the board will do it and do it well.  And, wise managers would be extra wise if they started now without waiting for FASB.  The consequence of the additional information will be less risk, a lower cost of capital, and higher stock prices.  It’s as simple as that.

Implications: Perhaps it’s the educational system that is at fault, but discounted (DCF) has to be among the most misunderstood analytical tool ever created.  Regrettably, this paper fails to acknowledge the flaws, and the flaws of the other authors’ papers that it describes.  Especially lacking is any criticism of FASB’s approach to DCF for financial reporting.  On the whole, this paper accomplishes only the perpetuation of the myth that the outcome of a DCF calculation offers any worthwhile guidance for any activity.

Analysis: The author of the paper, Salty Schumann, starts off on the wrong foot by misspelling “Uncertainty” in the heading on the first page.  Unfortunately, it went downhill from there, at least as far as I am concerned.

DCF is nothing more than a hypothetical economic model that attempts to explain the observed phenomenon that cash flows received sooner are more highly valued in the market than those that are received later.  Its results are well correlated with unusually constrained situations in which the amount and timing of the future cash flows are reasonably certain, as in contractual cash flows where the payer can be counted on to make the cash payments.  Even in those cases, the best use of the model is to estimate the apparent discount rate, using a KNOWN market value for the contract.  Even in these cases, the interpretation of that discount rate remains speculative, as it includes such things as time value of money, inflation expectations, risk assessment, risk preference, the supply of alternative similar cash flows, and the demand for similar cash flows.  About all that can be done with the implied rate is to apply it to another set of similar cash flows to estimate its value, which can then be compared with its real value to see whether there is an arbitrage opportunity.

The two flaws in DCF as a value estimation model are (a) its dependence on predictions of future cash flows and (b) knowledge of a discount rate that reflects all the factors described above.  Apart from contractual situations, any predictions of future cash flows are inherently inaccurate and subjective.  Even in contractual situations, it is often the case that they don’t occur as expected.  As a result, the output cannot be very reliable for any purpose whatsoever because it cannot be any better than the highly questionable inputs.  The discount rate is the economic consequence of many factors, many of which are elusive and immeasurable.  Even when it can be known, no one can determine which factors caused it to take on that level, which means that it should not be blindly applied to situations in which those factors may very well take on different values.

Here is an example from accounting history, back to the 1980s.  FASB was attempting to deal with how to establish values for assets in discontinued segments when those assets were not expected to be sold for several years.  One method under consideration involved estimating the current market value by first predicting the assets’ future market value and then discounting it back at some unspecified rate.  Note that the goal was knowledge of the current market value yet the methodology involved predicting the unknowable future and then processing it with a flawed model to get a current estimate.  Why not just estimate the current value directly without going through this nonsense?  Based on what I read, the author would not understand what’s wrong with this method because he is enamored with DCF and oblivious to its shortcomings…

I about gagged on page 3 when he proceeded to capitalize and then discount future net income numbers.  He should know that GAAP income is not cash flow; in fact, it isn’t much of anything because of all the political compromises that have gone into developing the GAAP it’s calculated with.  What about accruals?  What about allowances?  What about depreciation?  What about nonreported income from appreciation of assets?  There is a huge breach between future cash flows and earnings.  And, besides that, we’re talking about the unknowable future.

Right there in the middle is another huge mistake that accountants and other business types frequently make, and that’s ignoring significant digits.  Revenue is predicted to be $6,000, which means that it is anticipated to be somewhere between $5,500 and $6,499.  As a result, there is only one significant digit in that number.  That means that there can be only one significant digit in the result as well.  What do we find?  Four significant digits in the capitalized result and four significant digits in the estimated market value.

All that is apart from the confusion of the model as it’s applied.  Capitalization assumes an infinite stream of future cash flows.  Dividing by the cap rate gives an estimate of the amount to be invested at that rate to yield that stream of cash flows.  The cap value is a DCF present value where n is infinitely large.  Thus, I’m puzzled by the discount factor and what the result means.  

If it was Mr. Schumann’s goal to illuminate, he fell short.

One more point to demonstrate why I am not impressed favorably by this paper.

Specifically, the author fails to subject the FASB expected cash flow method to any sort of evaluation.  It has a huge flaw to which the board was itself blind, but not its critics.  Specifically, it applies a Bayesian expected value adjustment that reduces each alternative outcome (a future cash flow amount) by its probability (an inherently unknowable factor) and then takes the sum of those products to get an expected value.  First of all, the output can be no better than the input, and who can accurately assess the probability of unobserved (unobservable) future events such that the product would have any validity?

More than that point, which is devastating, is the failure of the expected value calculation to reflect the invalidity of the outcome as an economic quantity.  To explain by example, each of the following scenarios has the same expected value of $10, yet no rational investor would consider them to be equivalent:

Scenario A:  $10 cash inflow, 100% probability
Scenario B:  $5 cash inflow, 50% probability and $15 cash inflow, 50% probability
Scenario C: $50 cash outflow, 50% probability and $70 cash inflow, 50% probability
Scenario D: $1 cash inflow, 99.9% probability and $9,000 cash inflow, 0.1% probability

The implication of the expected cash flow model is that each of these scenarios has the same economic value.  That is, the assumption is that the market would value each of them at $10.  This result flies in the face of the fact that they are not equivalent at all.  Scenario A is a sure thing.  Scenario B is not a sure thing, and the likelihood of a higher cash flow is offset by the likelihood of a lower one.  Scenario C is like B, but has the possibility that the investor would have to cough up additional cash half the time.  And, Scenario D poses the virtually sure thing that the investment will pay off only $1 but the model posits that investors would risk the $10 for the 0.1% possibility of bringing in $9,000.  Perhaps, but perhaps not.

I could go on and on, but enough is enough.  

To summarize, DCF is a highly limited model designed for one purpose (explaining how market values of debt securities are determined) that has been abused by being applied in other situations.  It does offer an advantage in capital budgeting over simpler payback period analysis by reflecting the reality that earlier cash flows are more valuable than later ones, but it still lacks precision and its results are inevitably limited by the unknowability of future cash flows and the appropriate discount rate.  The author and his colleagues abuse DCF even more by using it to estimate what the market value would be under a highly restricted set of assumptions and predictions.  They make it even worse by never seeing the fallacy of insignificant digits.

What’s even worse than this misapplication is the efforts by some to bring DCF into measurements for financial reporting and financial accounting.  The consequence can only be misleading and otherwise useless financial statements.  If the market value is to be reported, then the accountants should estimate the market value by looking at comparable recent transactions.  Making up future numbers and then discounting them with a fabricated discount rate can only produce garbage.  The consequence has to be low-quality financial statements.  Perhaps better than cost-based statements that flatly ignore market values, but not as good as those that use more useful estimates of those values.

Implications: The shortage of value–based accounting expertise is real, but only in the sense that financial reporting practice is poised on the brink of a new era in which the volume of useful information is about to increase dramatically.  The issue is how to get more people into the pipeline who understand that value-based reporting is not a hazard to be avoided but an opportunity to be seized.  The ultimate outcome will be financial reports that are actually useful and, as such, more valuable for those who consume them.  And that means more income for auditors and accountants alike.  What, then, is the basis for the fear that more value-based reporting seems to create for them?

Analysis: In reading Sarah Johnson’s article, it was clear to me that she missed the main point about the transition to more value-based reporting.  Then, because it is probably true that most of what she knows about value-based reporting came from the PCAOB, then perhaps they, too, have missed the main point.  And, if the PCAOB is missing the point, then a great many practitioners (managers, accountants, and auditors) are also going to miss it.

For example, I think many will latch onto the news of a shortage of expertise in auditing values as a justification for not using these numbers in financial statements.  If so, that would be a poor decision.  By analogy, when computers were being introduced into accounting, there were shortages of programmers and auditors who knew what to do.  Where would we be if everyone had dug their heels in and said there was no good reason for making the transition?

This particular expertise is an economic commodity, and it should be no surprise that the demand for it exceeds the supply.  The solution to the shortage is in letting the market work:  those who want experts will have to pay higher compensation to get them, and that incentive will create a great many new experts, and equilibrium will be reached, sooner or later.  What is painful to watch is that the accounting profession, including its education branch, has not seen this demand coming.  It’s as if they’ve been in denial that anything is wrong with the status quo.  

For example, I was bemused to see that the authors of the standard text book I use in my Intermediate Accounting class simply deleted the section on value-based reporting in their recent new edition.  Because textbook content is driven by the instructors who teach from them, it appears that my colleagues don’t see the main point, just like the PCAOB.

Uncertainty: more or less?

Further, it would appear that the PCAOB staff doesn’t understand an important concept about the nature and purpose of financial reporting.  As paraphrased by Sarah Johnson in her column, they believe “that the increased use of estimates based on market value — rather than historical cost — adds uncertainty and subjectivity to financial reporting and an added risk of material misstatements.”  

I contend that this assertion is DIAMETRICALLY opposed to reality.  The error arises from their adopting the perspective of those who supply financial statements, not the point of view of those who use them to support decisions.

If it’s true that fair values contain information that reflects the present cash flow potential inherent in assets and liabilities, and if it’s true that historical costs contain information that reflects their past (even long past) cash flow potential, then any increase in the quantity of value-based information will greatly INCREASE the usefulness of financial statements by actually eliminating a great deal of the uncertainty created when obsolete cost-based information is presented.

If you were to be making a rational decision on whether to keep an asset in production in your company, would you want to know what you could get if you sold it or its original cost minus systematically (and subjectively) compiled depreciation charges?  Or, if you were presenting financial statements to potential lenders, would you want them to base their proposals on what your assets are worth today or what they were worth years ago, minus accumulated depreciation?  In the same way, would you want the capital markets to be valuing your stock on the basis of precisely calculated but totally uninformative book values or on their approximate fair values?  

What does it say about our cost-based reporting system if the worst thing that could happen is that those who use our reports actually believed the numbers reported on them?

Auditors don’t know fair values?

And, as for the assertion that auditors don’t know how to deal with fair values, it, too, is patently false.  Auditors have dealt with values for decades and done right nicely with them.

Consider that purchase accounting for business combinations has always been based on the fair values of the acquired company’s assets and liabilities.  Auditors have performed their testing and reached conclusions quite comfortably in these situations.  Why couldn’t they apply the same tests and procedures to the values of assets and liabilities of the acquirer?  And, for that matter, why couldn’t they apply them to the assets and liabilities of a company that is neither an acquirer nor an acquiree?

Furthermore, auditors have had absolutely no problem dealing with asset values when they have fallen below their book values.  Back a long time ago when I worked at FASB on the original Conceptual Framework, we were bemused even then at those who thought value is perfectly reliable for impaired assets but totally unreliable when it is higher than book value.  The board itself has clung to that lower-of-cost-or-market thinking into the modern era with its standard (SFAS 144) on writing down impaired assets but not writing them up.  

In any case, where were the auditors’ objections to the subjectivity and uncertainty of these lower market values?

Here’s the answer

My bottom line: The shortage of value–based accounting expertise is real, but only in the sense that financial reporting practice is poised on the brink of a new era in which the volume of useful information is about to increase dramatically.  The issue is how to get more people into the pipeline who understand that value-based reporting is not a hazard to be avoided but an opportunity to be seized.  The ultimate outcome will be financial reports that are actually useful and, as such, more valuable for those who consume them.  And that means more income for auditors and accountants alike.  What, then, is the basis for the fear that more value-based reporting seems to create for them?

Implications: When all the dust settles, there will be no doubt that backdating was wrong, even if it wasn’t illegal.  Furthermore, it will be shown that there were two reasons for its existence:  poor ethical reasoning and bad accounting standards.  The judge has seen through the smoke and mirrors and rightly characterized backdating to be like betting on a horse race that’s already been run; the only difference is that “The Sting” was a fictional story and backdating is as real as can be.  Alas, GAAP created another fiction that should never have been published instead of the authentic truth that options are liabilities.

Analysis: It appears the current management at UnitedHealth continues to hold on to two primary personal values that were displayed by Dr. William McGuire:  “When you’re in charge, don’t let anybody tell you what you can or can’t do” and “When you’re in charge, you’re entitled to everything you can get your hands on.”

Instead, they should have applied, and still should be applying, the wisest ethics rule of thumb yet known to mankind:  “Would you want the results of this decision to appear on the front page of tomorrow’s newspaper?”  On the face of it, backdating is clearly inappropriate for stewards of other people’s money.  It is nothing short of deception.  The irony is that these managers were so well entrenched that they could write themselves essentially any kind of compensation plan they wanted.  They could have paid themselves plenty, and there was nothing magic about getting that loot through backdated options or just straightforward salary, bonuses, or special pension benefits.  

So, why did they use backdated options?  After all, wouldn’t they know there would be an outcry when they were discovered?  And, shouldn’t they have expected that they would be exposed, sooner or later?  

(I just have to wonder how this scheme ever got started; it seems to me that whoever brought it up would have been laughed out of the room.  Nonetheless, the idea not only lived, it survived the “scrutiny” of lawyers and auditors, not to mention compensation committees.  I also have to wonder how the idea spread from one place to another:  was it directors of one company taking it to another, was it a law or audit firm bringing the idea to its clients, or was it CEOs talking in one venue or another?)

I am convinced the allure was created mostly by the original version of FASB’s Statement 123 that did not require management to report its compensation if the option strike price equaled or exceeded the stock’s market value.  In the case of backdating, all that mattered was the fictitious grant date.  Once that was pulled off, the accounting followed:  NO COMPENSATION EXPENSE.  Thus, the managers were able to pull down all that money and never report it on the income statement; of course, the footnote was so vague and incomplete that it didn’t tell the story either.

Would a different standard have produced a different result?  Yes, but, alas, there would have been only a little difference if the newly revised SFAS 123 had been in effect when backdating occurred, simply because the option valuation model would have been applied on the fictitious grant date and would not have revealed how much was really plundered from the shareholders.

Instead, what is needed is a new standard that would treat options for what they are:  derivative liabilities with volatile market values.  And, if these liabilities were to be marked to market, the initial backdated discount would have flowed right into compensation expense in the grant year.

For example, suppose the board of directors approved (on December 31, 1999) a grant of 100,000 options as of January 1, 1999, at a strike price of $20, which equaled the stock’s market value on the bogus grant date.  Under the intrinsic value method allowed under the old SFAS 123, the company’s income statement would report no compensation expense, even though the stock’s market value at December 31, 1999, was $60.

Under SFAS 123 (revised), the options would be valued as of January 1, 1999, based on the facts as they existed at that date, such that they might come out with a value of, say, $3 each, for a total cost of $300,000.  This amount would then be spread over the vesting period of, say, 3 years, for a hit to earnings of about $100,000 for 1999 and next two reporting years.

Under realistic and complete accounting, the options would be valued as of the balance sheet date, and then reported as a liability.  The offsetting debit would be to compensation expense.  If the stock was worth $60 at the end of 1999, the options would have been worth at least their intrinsic value of $40 each, plus maybe another $5 for the option feature.  The liability accounting method would report a liability of $4,500,000 and compensation expense of the same amount, a far cry from the piddling $100,000 under SFAS 123 (revised).  Then, as the liability changed in value over its life, compensation expense for each reporting would be increased if it appreciated and decreased if it depreciated.  

This method doesn’t make any smoothing amortizations based on assumptions about when the compensation is earned, and it doesn’t put outdated numbers on future income statements.  Instead, all it does is observe and report economic facts when they happen:  what the options are presently worth and how much that value changed during the reporting period.

Note that there are no new reliability issues with this method either.  It would apply the same valuation model that is presently applied at the grant date.  The difference is that it would apply that model to ALL options at EVERY reporting date until the options are exercised or lapse.

The only objection to reporting options as liabilities is that the truth would be known and fully disclosed for everyone to see.

So, if this method had been required in the past, perhaps no backdating would have ever occurred.  

There are two more points to observe.  

First, if and when it’s determined that the options were indeed backdated and improperly so, they would have an intrinsic value on the real grant date (the market value of the stock exceeded the strike price), which means the income statements will have to be restated to reflect the compensation expense that should have been reported.  However, so much time has passed that those statements will never be republished.  To the shock of those who took those backdated options, though, the IRS is licking its chops to get at them because that positive intrinsic value would have created taxable income to the grantees as of the grant date, with the unpleasant result (for them) that they owe a slew of back taxes plus interest and possibly penalties if it’s determined they filed fraudulent returns.  That will hurt, and they won’t get much sympathy outside their closest circle.

Second, did you notice the pathetic gesture on the part of McGuire in his offer to keep his options with a new higher price?  He just doesn’t get it – he was caught pilfering large amounts from the shareholders and now he’s asking them to let him pilfer a bit less just because he confessed.  Remember his two true values:  “don’t let anybody tell you what you can and can’t do,” and “get yours while you can.”  Just because he isn’t in jail now doesn’t mean he won’t be when everything is fully known.

Implications: Hasty analysis leads to hasty judgments which, in turn, produce bad decisions.  Any consideration of the costs of Sarbanes should include identifying who bears the costs, what benefits are achieved, and who enjoys those benefits.  Taking these points into the analysis shows that perhaps the law has produced a great deal of benefit well in excess of the compliance costs.  We may never know for sure, but the political discussion must include more than the absolute cost of compliance if it is to lead to a wise decision to keep, modify, or repeal the law.

Analysis: These two discussions (the original and Mr. Pugh’s) of SOX are typical and unfortunately may be too hasty and superficial.  

The issue at hand should not be merely how much it costs to comply.  Obviously, compliance with any new law creates new costs.  To some extent, these costs are like those incurred with repairing a roof after it leaks and damages the interior of a building.  Many of the costs of assessing and strengthening internal control should have been incurred a long time ago.  By not directing attention to the quality of their financial statements, managers left their financial reporting roofs in leaky condition.  A penny saved in the short run often brings much greater costs when the damage must be undone.

It seems to me is that a more complete analysis must include addressing the questions of (1) who incurs the cost, (2) what are the benefits of compliance, and (3) who enjoys those benefits?  A conclusion that compliance costs too much may be fatuous without considering these additional factors.

The costs, of course, are borne by the shareholders.  No manager has paid a dime of the extra fees and salaries associated with compliance.  In fact, some managers are better off because they now have more staff to supervise and higher salaries reflecting their additional responsibilities.  The decision of whether the costs are too great, then, will be made by those who own the stock or who might wish to own the stock.  The ultimate expression of that assessment would be a depressed stock price if the costs are too high and a higher stock price if the costs are in line with the benefits of compliance.

As to those benefits, I noted that Mr. Pugh did not incorporate the cost of capital in his analysis.  The purpose of any information is to reduce the uncertainty of those who receive it.  The result of high uncertainty in the capital market is investors’ demand for higher rates of return, which are, in turn higher capital costs for the corporation.  The rate of return is also the discount rate applied to future cash flows by the market, such that an increase in uncertainty will produce a decrease in the market value of a security while a decrease in uncertainty will increase that value.  The benefit for the shareholders of compliance with SOX is thus a higher stock price because risk has been reduced.  Although this benefit may be difficult to discern because many factors affect a stock’s value, it should not be simply ignored as if it doesn’t exist.

In addition to this micro level analysis, there is also a macro effect in that the combined efforts of all public companies to improve internal control (and management of internal control) should produce a lower level of systemic risk that affects all securities.  In other words, a massive effort to comply with higher standards could very well have increased the aggregate level of confidence in the capital markets such that stock prices on the whole have gone up.  A quick glance at a chart of the DJI since the passage of SOX shows that it has moved steadily upward to and above 13,000 since it was at around 8,000 when the law was passed.  Not proof, but certainly food for thought when assessing the benefits of SOX.

As to the third question of who enjoys the benefits of compliance, the answer has to be that everyone does.  If the cost of capital can be reduced by driving down the perceived risk that management might be purposely or accidentally producing misleading financial statements, the result is more efficient capital markets that, in turn, make the economy more efficient because capital is being priced more appropriately for risks and returns.  Again, one could see some suggestion that SOX has worked because interest rates have declined and stayed low since it took effect.  Is SOX the only factor behind this phenomenon?  Of course not, but an analysis of the costs and benefits of compliance is incomplete without considering it.

As with any law, the ultimate decision of whether SOX should be repealed or amended will be resolved through a political process.  To the extent that economic analysis can enlighten the politicians, so much the better.  To the extent that the debate is engulfed in incomplete or otherwise inadequate analysis, then we could all be worse off.

An additional point also deserves our attention.  Some suggest that American companies are going offshore to raise capital to avoid the high costs of compliance.  What is often completely unaddressed is the question of whether that strategy actually produces benefits in the form of higher stock prices.  Unless compliance does absolutely nothing to reduce the perceived uncertainty and risk, we should expect these companies to incur a higher cost of capital when they go overseas.  It makes little sense to save a few million in compliance costs if doing so produces many more millions in capital costs and lower market cap.  In a sense, this flight to overseas markets actually strengthens the U.S. markets by getting rid of those managers who do not like disclosing more about what they’ve been up to.  Rather than reflecting a competitive disadvantage, it seems to me that the flight to lower quality reporting is actually producing a competitive advantage for participants in U.S. markets.

Implications: It’s tempting to conclude something is amiss when pension and OPEB liability estimates are revised downward.  Perhaps something is wrong, but imprecision is inevitable.  Without more details, financial statement users are at management’s mercy.

Analysis: When you realize where the estimated values of pension and OPEB liabilities come from, you know you have to take the results with a large dose of salt.

The process involves a number of predictions applied to unknowable future outcomes.  Start with the current population of retirees and project how long they’ll live, and how long their dependents with live for  the portion of the population that chose spousal benefits.  Associate those life spans with the amounts being paid out based on their final pay (for pensions) and amounts to be paid out for future medical costs.  Then, throw in the costs that might be incurred in the future to pay for that portion of the active working population that may be around at retirement, and then project not only their final salary but also how many years of credit they will have accumulated, not to mention how long they and their dependents will live and what sort of arrangement they’ll choose for collecting their benefits.  Repeat the projection of future medical costs for the active workers and their dependents.  Put it all in the hopper and produce a probabilistic distribution of future payouts.  Then, apply an estimated current market discount rate for similar liabilities.  The result is an estimate of the market value of these debts.

There are a great many opportunities for manipulation, up or down, simply because of the unknowability of the key factors and the fact that no one can verify any prediction until the future unfolds. Simply put, there is no way that the output of this process has more than one significant digit, and even that one is suspect.  GM reports, for example, an $85 billion pension liability.  It wouldn’t be wise to stake much on the precision of that estimate/prediction.  It may be somewhere between $80 billion and $90 billion, or say, $70 billion and $100 billion.  

Of course, accounting standards ignore that variability and imprecision, and require management to subtract the seemingly precise pension asset value from the seemingly precise pension liability to get a, well, seemingly precise net liability.

Don’t be fooled by all the spurious precision.  And don’t think the number is beyond manipulation through careful guidance to the actuaries.  It’s wise to remember that these are bell-shaped curves and develop your best case/worst case analyses accordingly.  If only the disclosures would actually help you pull that analysis off.

Implications: There is only one point in this comment:  it is not wise to focus on the so-called pension shortfall, and it certainly isn’t wise for management to strive to close the gap between assets and liability before its time.

Analysis: This short comment is addressed to any who might be concerned about the presence of an underfunded pension liability, especially those who see it as a bad thing in every case.  

Certainly, there are situations in which plans are grossly underfunded and in need of massive infusion of new collateral to provide the security required by common sense and the law.  However, the nature of the situation is such that it always makes sense to have an underfunded pension liability.

To explain, the current balance of the liability is the present value of the expected future cash outflows discounted at an appropriate market BORROWING rate.  The target balance of the fund assets is the desired present value of the future cash outflows discounted at an appropriate market EARNINGS rate.  If the earnings rate is greater than the borrowing rate, then it is a mathematical certainty that the target balance of the fund assets will be less than the current balance of the liability.

To illustrate with a very simple example, suppose that there is a single cash outflow of $1 million that is expected to occur after ten years.  If the borrowing rate appropriate to this liability is 5.7%, then the present value of the cash outflow at that rate is $574 thousand.  The target funding amount is the present value of the cash outflow discounted at an expected earnings rate of 8%, which is $463 thousand, or just over 80% of the liability balance.  As maturity approaches, the two present values will converge, but the target fund balance will always be less than the current value of the liability.  (If the time horizon is extended to 20 years, the two amounts are $330 thousand and $215 thousand, with the target being only 65% of the liability balance.  If the horizon is only 1 year, the comparable numbers are $946 thousand for the liability, $925 thousand for the asset, and a coverage ratio of 98%.)

Page 6 of this article documents the distribution of actuarial assumptions for 9,000 companies.  The median expected rate of return appears to be around 8% and the median discount rate is around 5.7%, just as in the above examples.

This outcome is just another example of the amazing benefit of leverage:  borrowing at one rate so that you can invest to earn at a higher rate.  The pension liability represents an amount borrowed from the employees by agreeing to paying them much later after they exerted their efforts.  The saved compensation cash flows are then invested in the pension fund assets to earn at a higher rate, with the consequence that profits are boosted.  

The amazing thing about all the pension deficits is that so few otherwise astute people seem to have figured out that they are potentially good for the shareholders, depending on how deep they are.  On the other hand, fully funded pension plans are never good for the shareholders unless the pension fund is more profitable than the employer’s underlying rate of return in its own industry and markets.  But, of course, if that’s true, then the employer should get out of that business and start managing pension funds for other companies.

So, when you’re looking at a deficit for your own company, or for a company that your analyzing, don’t forget the power of the exponent.  It is your friend and it will help you understand that an employer’s only pension deficit disorder might be not having one.  Once you realize that, all you need to do is sit back and let the exponent take you for a pleasant ride up the curve.

Implications: I believe the main issue that is or ought to be under discussion is what FASB will do in the future with regard to lease accounting.  To answer that question, it is appropriate to look at the forces that are at work now and the kind of thinking that has been going on more recently.  While there’s nothing wrong with looking to the past to get some insight into what happened then, it doesn’t do much good to look there if the goal is to predict the future.  As I see it, forces are in place that will bring significant reform in lease accounting, especially for operating leases.

Analysis: With appropriate respect for Mr. Pugh and with due appreciation for his thorough historical scholarship into the origins of today’s 30-year old generally accepted accounting principles for leases, it appears to me that he is addressing the wrong issue in the wrong way.

The question at hand is not what the long-disbanded Accounting Principles Board thought in the 1960s or what the Financial Accounting Standards Board wrote in the 1970s.  While the ideas expressed in those writings were sufficient for their day, their analyses and conclusions have been made obsolete by several developments.

One change was the creation of FASB’s Conceptual Framework over 25 years ago.  A key definition in Statement of Financial Accounting Concepts number 3 (now number 6) states that assets include future benefits that are controlled even when they are not owned outright.  This provision was added specifically to ensure that a company’s assets include those that it controls through leases, without regard to whether they are traditional capital or operating leases.  Importantly, the definition makes it clear that a real asset can exist for the lessee even if the tangible property is owned by someone else.  Indeed, this point was in alignment with practice in SFAS 13.  Specifically, a lessee that will not acquire title at the end of a capital lease still recognizes an asset and amortizes its cost over the lease period.  This lease is not an in-substance purchase of a tangible asset but a purchase of an intangible asset in the form of the right to use the property.  The old distinction between rental contracts and purchase leases was artificially clean and no longer describes today’s situations with any clarity.

A second change was a shift in thought at the standard setting level away from reporting on the basis of form to reporting on the basis of substance.  Standard setters grew tired of seeing manipulations and “loopholing” by managers (aided by experts, including their auditors) that were designed to avoid reporting requirements in their standards.  Leases are the poster children for this kind of behavior, as illustrated by the numerous amendments and addenda to SFAS 13 over the years.  Consider these words from a 2005 SEC report on off-balance sheet financing:

“Problems with the all-or-nothing character of the accounting have been magnified because many issuers involved in leases, taking advantage of the bright-line nature of the lease classification guidance, structure their lease arrangements to achieve whatever accounting (sales-type/capital or operating) is desired. These issuers have been aided in these endeavors by a large number of attorneys, lenders, investment banks, accountants, insurers, industry advocates, and other advisers. Indeed, lease structuring to meet various accounting, tax, and other goals, has become an industry unto itself in the last 30 years.”

(The irony of this activity that escapes most managers and their experts is that manipulating financial statement numbers tends to achieve an effect opposite the one that is sought.  By engaging in these manipulations, they show the capital markets that they cannot be trusted, which leads to the certain consequence that their stock values are driven down instead of up.  A window-dressed positive representation that’s known to be false will kill a stock price quickly.)  The impact of this second change is that future standards are going to be principles-based, not rules-based.  Leases are a perfect example of the latter, such that an agreement that covers 75.0% of a property’s expected future life is capitalized while one that covers 74.9% of that life is not capitalized.  This classic approach to standard setting is not likely to be carried forward into the future.

A third development is the burgeoning acknowledgement among all standard setters over the last fifteen years that the established accounting methods for leases fail to provide statement users with information they need to have.  For example, a report prepared several years ago jointly by five standard setting bodies proposed putting an asset and liability on the balance sheet for all leases.  In addition, a recent monograph from the CFA Institute pleads for capitalization of all material leases.  Mr. Pugh’s focus on the original language simply misses the tide that has turned over the last 40 years.

Still another development that is only now beginning to come clear is the great boost in FASB’s independence from its constituents, especially those who used political and economic pressure on the board, primarily by threatening to withhold their charitable contributions to the Financial Accounting Foundation.  Sarbanes-Oxley created the Public Company Accounting Oversight Board, of course.  What some have missed is that the PCAOB now collects a fee from public companies for its own costs as well as the cost of operating FASB.  As a result, the FAF stopped accepting contributions from corporations, auditors, and others in 2003.  Has this made the board more independent?  It certainly hasn’t hurt.  For evidence, one needs to look no further than SFAS 158, issued on September 29.  This standard is essentially identical to its exposure draft even though about 250 opposing comment letters were sent to the board.  It is also pertinent to note that FASB put the project on its agenda less than 11 months before issuing the standard.  In short, the current board members are feeling strong and empowered, and they’re showing their inclination to advance reform over the complaints of those who are satisfied with the status quo.

To return to my first point, then, the issue at hand is not what the APB said, not what the old FASB said, not what practice has been for 30 years, not what Mr. Pugh prefers, and certainly not what I prefer.  The past pronouncements, while accurately quoted and interpreted by Mr. Pugh, simply no longer matter in the current debate.  What does matter is what today’s FASB is inclined to accomplish in the future.  By putting leases on the agenda, this board declared its willingness to “comprehensively reconsider the existing accounting for leases,” to use the language from FASB’s website.  The goal is ensure that “investors and other users of financial statements are provided useful, transparent, and complete information about leasing transactions in the financial statements.”

This determination of what is useful will be accomplished by a newly empowered and independent FASB that does not feel encumbered by past rationalizations of its predecessors.  Rather, it is focused on the needs of financial statement users around the world and will not be held back by anachronistic thinking.  

So, will the board leave lease accounting intact, as Mr. Pugh seems to believe it surely will, or will it move to current value accounting as I would have it go?  Probably neither of those things will be accomplished.  However, we can be sure that the board will require managers to capitalize all material leases, whether short- or long-term, and perhaps implement other new practices as well.  Keeping today’s 30-year old GAAP intact is simply not one of the alternatives for the future.