Generally Acceptable Accounting Principles (GAAP) form the basis of financial statement preparation for public and private corporations. Yet, unlike law, science, engineering, mathematics or philosophy, the application of accounting principles is not based on fact, case law, statutes, regulations, code (as in French or Spanish law), truths, or empirical scientific evidence. In this period of unprecedented global wealth destruction, estimated at over $30 trillion, this author asks whether we need to contemplate and add a new standard or ethical principle to the inventory of Generally Acceptable Accounting Principles. Is it not time to debate the importance of Socially Responsible Accounting (SRA) as a pillar of our interdependent democracy?
Generally Accepted Accounting Principles are based on rules that have evolved over time, regardless of their relevance or economic substance. They may be subjective (practice guides) or opportunistic (Enron’s mark to market valuation of derivatives). Even when they are followed, they can be highly distortive (as demonstrated by World com’s leased line costs).
In this period of unprecedented global wealth destruction of over $30 trillion (permanent for the boomers), here is my pick of the Big Eight Generally Unacceptable Accounting Principles (GUAP) that may have resulted in or at least contributed to some of the most extensive losses of employment, wealth, living standards, and retirement income (the average American lost five years of savings according to the Employee Benefit Research Institute (EBRI) study, August 9, 2009, as reported by the NY Post). in recent history. This month marks the two year anniversary of the trigger point of this recession. The application of these principles, blessed by accounting firms, in house CPAs, CFOs and corporate accounting departments, may well have contributed to poor investment decision making, bankruptcies of companies too big to fail or too big to ignore, insolvencies, forced mergers, and ultimately tax payer bail outs. Is it time to ask whether there are ways to improve our track record?
What is GAAP, How did it Evolve and Who Applies it?
GAAP is an art form. It is not founded on scientific principle, quantitative economics or fact. In fact, among financial institutions, it may be one of the most creative of contemporary art forms in modern finance. Remarkably, over 70 years after the Securities Acts of 1933-1934, its standards were not even formally codified (until July, 2009).
The evolution of Generally Accepted Accounting Principles by the ARB, APB, FASB and AICPA, is the conspiracy of likeminded thinking. In the legal profession, a significant number of law professors hold advanced degrees in the social sciences such as psychology, sociology, political science and engineering. However, this does not seem to be the case among the leaders of the CPA profession.
The top five board members of FASB, the CEOs of the Big Four Accounting Firms (whose businesses are now among the most concentrated oligopolies of all financial services institutions), and the Chief Accountant of the SEC are all brilliant, successful, highly trusted men and women. These are genuine people of goodwill. But, almost none of them are schooled in nor have advanced degrees in the social sciences. Many have only BS degrees and it is improbable that any had secured a double major or significant minor in sociology, diplomacy, political science, government, international relations or government policy.
The application of GAAP as well, is left to those least schooled to appreciate GAAP’s broad reach and impact on the public and society. This author could find few accounting courses in any business school curriculum devoted to Socially Responsible Accounting Principles. (Socially Responsible Accounting requires that preparers disclose the nature and economic effect that accounting principles and financial reporting practices (including disclosures and non-disclosure) have on society; the impact on the livelihood, economic sustenance, retirement, wealth, and income of communities who depend on the viability of the reporting entity. These are the customers, suppliers/ vendors, employees, investors, raters, and ultimately citizens at large (through their legislative representatives and taxpayers). I define this term as I have not seen its accepted use in accounting literature.) There is, as a result, little literature on a CPAs obligation to society and the general public. Rather, accounting literature identifies the obvious stakeholders - investors, shareholders and users of financial information, the investment community.
CPA firms do not champion Socially Responsible Accounting Principles, although GAAP rules, standards and principles may affect the wealth, living standards and retirement of the public (the socio/economic stakeholders of society) because they are interdependent with the company. They are suppliers, vendors, retirees, customers, employees and government entities (regulators, insurers, tax authorities and bailout entities of last resort - Congress). Look no further than to GM or Chrysler for the voices of these constituencies.
Global social networking sites by pass traditional media and intermediaries (radio, TV networks) to present news and information by reaching directly to the individual. Is it not time for the public accounting industry to consider their responsibility to the individual who is directly or indirectly a stakeholder in the audited entity?
1. Revenue Recognition – “You might presume that revenue accounting standards have naturally evolved over time so as to be straightforward, robust and consistent across transactions, industries, and countries. Sadly, today’s revenue accounting standards exhibit none of those qualities, and stakeholders are forced to make poorer economic decisions as a result (Bruce Ponder, chair of the IMA Financial Reporting Committee and President of Leveraged Logic).”
Before Arthur Andersen’s demise, AA’s internal policy manuals presented AA audit partners with dozens and perhaps hundreds of choices on how to recognize revenue for their clients. In the late nineties and early 2000’s, shopping for the most aggressive ways to recognize revenue (the most aggressive public accounting firms to support it) and the least aggressive ways to recognize cost in order to advance company earnings and inflate shareholder price were the ‘principles du jour’ of the accounting profession. Companies could shop for audit services or favorable revenue recognition policies like any other business to business product or service.
Revenue recognition techniques commonly used by the dot coms was to advance revenue recognition on multiyear agreements (to improve their capitalized value and further demonstrate their skill to increase “cash burn rates”) without having to recognize their long term obligations and liabilities in the event they actually had to perform the service or had their service cancelled. Practice was rampant for the start ups until the bubble burst causing thousands to lose their investments, employment or retirement savings. Similar treatment still exists for retail franchises, where the cost of new construction or leasehold improvements is capitalized but the revenue that relates to it is not.
The sheer variety of revenue recognition principles that make the news makes this the number one GAUP. Creative “employment” opportunities still remain in this open field. Here are some of the more creative ones that have been disclosed, some very recently and many with the blessing of the auditors:
- GE’s legendary ability to deliver consistent earnings growth (GE Settles claims of fraud…agrees to pay $50 million , August 5, 2009, Financial Times)
- Xerox’s advance recognition of lease transactions
- Paragon Construction’s accelerated contracts
- Sunbeam’s channel stuffing revenue upsides
- Rite Aid’s revenue smoothing techniques
- Crazy Eddie’s – he just made up the numbers
- Adelphia, Enron and PNC’s related party sales
- Enron and Dynegy’s double booking
- Waste Management, Knowledge Ware and others who manufactured their own creative revenue recognition techniques
Do we not have an obligation to consider the effect that these ‘events’ have on the other stakeholders who held these securities in their retirement portfolios, were employed by the enterprise or depended on it to sell their products and earn a living?
2. Fair Value Accounting - Most CPAs are aware of the history of Fair Value Accounting, its adoption and abandonment from the Great Depression to the current period. In practice, it is applied inconsistently and unevenly according to asset and asset class. In Europe, many bank assets are treated on a historical basis to avoid fluctuations inherent in mark to market valuation.
Fair value looks at impairment in value at one instantaneous point in time when there is no market value for the asset or it is illiquid. Compared against the principles of the scientific method, (which measure data points over dozens of observations and multiple time periods) fair market accounting has ruined the portfolios of Wachovia, Washington Mutual, Countrywide, and others, has led to liquidations of banks throwing hundreds of thousands of employees out of work, freezing credit, and paralyzing lending in the housing market for a period of time. William Isaac, former Chairman of the FDIC on “How to save the financial System”, September, 2008, said, “If we do not halt the insanity of forcing financial firms to mark assets to a nonexistent market than a realistic economic value, the cancer…will plunge the world into very difficult economic times for years to come.” Eventually, in response to Congress and the public, ‘new’ fair value rules and standards are being issued to ‘clarify’ its meaning.
What is fact about the fair value accounting, however, is that its application (and misuse) has been consistent over the years. Stuebs and Thomas, in the CPA Journal, January, 2009, said, “World com valued its leased line costs consistent with fair value standards….” Enron’s Skilling’s desire to “accelerate revenue and thus earnings by using mark-to market- accounting inevitably led to a treadmill effect….focusing on earnings rather than cash led to some crazy deals being done." (Greed and Corporate Failure by Hamilton and Micklethwait, Palgrave McMillan, 2006) Fair value accounting comes in number two since it has been applied, misapplied, revoked and reinstated and of course, inconsistently applied.
3. Write Downs Due to Impairment - This principle makes heroes of new company CEOs and destroys legacies of ousted ones. More importantly, it insures multi-year bonuses for the management team and leaves the shareholders in the dark. Only the rank and file employees know this sleight of hand. It is an art best practiced in bad times when new management comes in to restructure the business and throw out the old management. As a former senior M&A and business development executive at a global company, I have seen this mastered by many businesses. The international accounting board is looking to curtail these abuses but it remains to be seen whether management’s “creative judgment” also can be curtailed.
Here is how it works (business cycle timing is critical). In recession, post 9/11, after the dot com craze, telecommunication bust, New Management determines that previously acquired or developed products (assets), lines of business, or business segments are not performing according to plan, are not profitable if all of the costs are loaded onto it (as in opportunity to load all costs onto it) and must be written off (usually to retained earnings or as an extraordinary item, now part to P&L).
In essence, New Management determines that the principle activities, core to their business (defined by Old Management) are not earning as expected (due of course to recession or business cycles or their lack of support or investment) and should be written off.
When we emerge from recession, the products/assets start performing (even modestly works), profit is recorded from the first dollar of sales (all acquisition, development and capitalized expenses have been written off. New Management over performs, are the golden children, saviors of the company, get the big bonus and do not worry until they become----‘Old Management.’ Accounting trumps shareholders, employees, and the investment community. Here, IFRS suggests an upward add-back, but do you think, management will champion its reversion? Will auditors abandon conservatism?
4. Reliance (Judgment of management) – Auditors hide well behind this generally accepted auditing principle. “Financial statements are the responsibility of management.” They are based on the judgment of management, not on the judgment of the accounting firms/ auditors (even though accounting firms have over 100 years of history on many of these companies and the profiles of their top executives). The problem here is not new with the darlings of institutional management – the CEO superstar. A dominant CEO emerges, packs the Board and the company “with like-minded executives who owe their position to him and are reluctant to challenge his judgment,” according to Hamilton and Micklethwait. Reliance on management provides the safe haven for the accounting firm at the expense of the public.
But what if the judgment of top management is skewed; its conduct is outrageous and can’t be ignored by the observations of the outside auditor? Why should reliance remain the overriding principle? And is there a point when should it be abandoned? Does the auditor not detect the signs when “…the dominant CEO may begin, perhaps unconsciously, to behave as though it is his own creation and as Kozlowski did at Tyco, Ebbers at WorldCom and Tanzi at Parmalat, use it (company) as his own piggy bank?...this is when shareholders and the board become irrelevant…", according to Hamilton and Micklethwait.
This issue repeats every few years. But it is structurally endemic to our system. About one hundred years ago, the classic Harvard Economist warned “In the US, where the tradition of checks and balances continues to shape political organization, directors in great corporations are often no more than figureheads, while presidents are benevolent despots…” Juries will ultimately decide the culpability of the CEOs involved, from Lehman, Merrill Lynch, Countrywide, feeder operators of Stanford, Madoff, Dreier ($700 million) and Sky Capital ($140 million), the thousands of Suspicious Activity Frauds reported by the Securities and Futures Industry (15,104 in 2008 vs. 4,267 in 2003), but in each case, there is probably an accounting firm or in house CPA or department of CPAs who relied on the “judgment of management for the entries they made and the results they presented to the public.
5. Independence – According to the AICPA Professional Ethics Committee, “Independence is independence of mind as well as independence of appearance…” Can a commercial enterprise be independent when it solicits business from the company it purports to be independent of? Let’s look at Parmalat and Tyco:
- In the case of the multibillion dollar Parmalat scandal, The Wall Street Journal purportedly showed that Deloitte Touche was warned that questions raised by its Brazilian auditor could result in the loss of its multimillion dollar worldwide audit engagement. As a result, a footnote disclosure rather than a qualified audit of the subsidiary was reported ("Auditor Raised Parmalat Red Flag", The Wall Street Journal, 20 March 2004).
- Tyco was a key audit client of Price Waterhouse Coopers. Its fees ranged in the $50 million range and “it was clear that the audit partner on the engagement, Richard Scalzo, knew of the inside and illegal dealings of Tyco’s senior management", according to Hamilton and Micklethwait.
So, in the spirit of independent thinking, let’s assume a conversation takes place between the rain maker of the firm and the CEO or CFO of the Company being solicited. Let’s also assume that the conversation contains the hidden thoughts (off balance sheet thinking) of the independent auditor. Let’s do some role playing:
Company. So, you want to be our auditor?
Q. Why do you want this?
A. So we can bill you millions of dollars in audit fees and I can get a raise
Q. What else?
A. We can provide a full range of services that we will sell you, once we find your internal control weaknesses
Q. What else?
A. We are very flexible (as in standards; as in knowing where the edges are)
Q. What else?
A. We can send your staff to our training sessions for a huge fee
Q. What else?
A. We will supply you with accounting talent so you do not have to train your internal accounting department. They know what we want. It will be cozy.
Q. What else?
A. We offer you accounting literature and databases that you can integrate with your company policy manuals for an additional fee
Q. [After they sign – the Parmalat Factor] Mr. Partner, you have been paid over $2 million for our $50 million account. As you know, you will lose your job if you lose us as a customer. How flexible are you?
A. very flexible
Q. Your manager is paid about $150,000 as audit manager on our account. He does not seem to be as flexible as you?
A. I am sure the next manager will be even more flexible.
6. Off Balance Sheet Activities – The battle continues over disclosure of trillions of dollars of assets that the investment community calls ‘shady,’ ‘shadowy,’ ‘opaque,’ or ‘Enronesque’. The arguments against disclosure are familiar and are not dissimilar to those presented by opponents of the 1933-1934 Securities Acts until Richard Whitney; the head of the New York Stock exchange (NYSE) committed a hundred million dollar Ponzi fraud and served as the catalyst for adoption of security regulation laws in the United States over 70 years ago.
Off balance sheet activities serve very important financial reporting objectives for the entity that needs to manipulate results. It allows a company to report better results than it actually should (taking assets and related debt off the balance sheet) and present financial statements in a much better light. Among the best manipulators was Enron’sFastow, “who employ(ed) his financial engineering skills to manage the reported results…", according to Hamilton and Micklethwait. Off balance sheet activities are misleading but when used successfully provide companies with better returns, significantly better bonuses and keep shareholders, analysts, raters and prospective investors totally in the dark.
One of the most interesting off balance sheet activities were financial instruments called qualified special purpose entities (QSPE). These are the darlings of banks; “the vehicle of choice through which US banks bundled vast pool of loans off their balance sheets and away from the eyes of investors and regulators,” according to Jennifer Hughes, Financial Times, June 27, 2009.
After fighting disclosure for over a decade and much more actively since 2002 (the last time a crisis hit and regulators determined that the Oops Factor [too big to ignore] was now going to hurt them as well), 130 banks responded to the FASB draft and fought against disclosing QSPE’s (including Citibank whose liability now is expected to be over $150 billion. As of next year Citibank will be required to book them). But booking does not mean consolidating them or even putting them on the balance sheet. Booking means disclosing them either in the financials or (burying them creatively) in a footnote disclosure. The expectations by the Federal Reserve is that almost ¾ of a trillion dollars will need to be disclosed among the top 19 US banks.
Credit default SWOPS today are one of the largest asset classes in the world that does not exist…anywhere on a corporate financial statement. They do not appear on the books of financial institutions. At over $60 trillion, about four times the US Gross Domestic Product, a few billion of credit default SWOPS at Lehman brothers almost seized the market. Is there any rationale under any principle not to include them on the balance Sheet?
Just by sheer size, materiality, risk and importance, Off-balance sheet financing rates a number 6.
7. Fraud Prevention – Audits, according to our accounting and audit principles, are not designed to detect fraud. “An audit in accordance with generally accepted auditing standards provides no assurance that illegal acts will be detected or that any contingent liabilities that result will be disclosed.” (Statement of Audit Standards 54, April 1988, and SAS 99, October 2002)
So, one might ask, what does an auditor do, if not to keep the company honest? And as long as auditors rely on the judgment of management, what is the purpose of the audit or the audit committee, now mandated for publically traded companies?
As an aside, the audit committee has fared no better than the auditor in detection or prevention of fraud. At Enron, the audit committee was headed by former Dean of Stanford University’s Business School and other distinguished members who it was reported, met four to five times a year for about 2 hours and discussed at least 7 or 8 critical issues, any one of which could have taken days to resolve. They completely missed the signs and the question therefore needs to be asked – whose signs were they waiving?
8. Fairly Presented - IFRS focuses on Faithful (as in honest, good faith) representation. To date, our financial statements require ‘fair presentation.’ Does this mean that the statements are truthful, accurate, ethical, moral, or presented for the benefit of society to help it understand the business better (Socially Responsible Accounting defines users as customers, vendors, employees, shareholders)? Remarkably, no! Our statements are ‘fairly presented’ when (in) all material aspects the financial position of the entity needs only to be in conformity with generally accepted accounting principles.
The fairness opinion does not require truth, factual correctness or 100% accuracy. It requires adherence to a GAAP which we have seen, is not clearly defined, objectively measured, nor scientifically determined. Among the hedge fund managers who try to determine the reality behind the financials, the mantra is “Profit is opinion, cash is fact.” As with Andersen and Enron, the sum of all these decisions can result in a picture that is far from ‘true and fair’ and has apparently become irrelevant as opposed to produce accounts that present an accurate picture of the corporation as a whole,” according to Hamilton and Micklethwait.
End Note – Today, the IFRS is taking a hard looks at the “Big 8” and another nine. At the end of the late 90s, after the bubble/busts of the early 2000s, in 2002 the International Accounting Standards Board began to assert global leadership to siphon off authority from the independent US regulators, the (FASB), AICPA (professional trade organization in the U.S.), and others. IFRS is even more principled based than GAAP. so it remains to be determined how effective it will be, although in fairness, it goes a lot further in promoting clarity, transparency and economic substance over principle in the underlying enterprise.
About the author
Rick Kravitz, CPA, MBA was former Group Publisher of the Practical Accountant Magazine Group, the largest circulation independent accounting and tax publications in America. He recently left Wolters Kluwer Law and Business as Executive Vice President, Business Development after 19 years. At Wolters Kluwer he also served as Senior Vice President and Group Publisher of Aspen Publishers and President of Panel Publishers, the largest professional pension publisher.