Peeling away financial reporting issues one layer at a time

Beyond the “Inactive Markets” Problem: The Crisis in Accounting

“It’s painful now to read a lecture that Mr. [Lawrence] Summers [who is currently President Obama’s principle economic adviser as chair of the NEC] gave in early 2000, as the economic crisis of the 1990s was winding down. Discussing the causes of that crisis, Mr. Summers pointed to things that the crisis countries lacked — and that, by implication, the United States had. These things included “well-capitalized and supervised banks” and reliable, transparent corporate accounting. Oh well.”

Paul Krugman, New York Times, March 29, 2009 [emphasis supplied}

“Oh well,” indeed. It seems that NYU economist Nouriel Roubini has been given the lion’s share of the credit for prognosticating the economic calamity we now find ourselves in. But many independent-minded accountants have warned, decades before Roubini, that our financial reporting standards – not just those rules having to do with mark-to-market – are as thin and flimsy as the paper they are printed on. That nobody would heed the warnings can only be due to the collective weight of the business and banking lobbies pressing on standard setters, with the paid support of the Big 8, 7, 6, 5, 4.

Contrary to those with whom I usually stand on financial reporting issues, I am not going to excoriate the FASB for its latest kluges to GAAP, which they made at the behest of Congress.  Methinks that a few little tweaks to make banks look sounder was better than at least one other alternative: doing nothing. Who can argue that a 20% run-up in bank stocks isn’t something that the economy needed RIGHT NOW?

My own frustration and sense of gloom is from two sources.  First, next-to-know-nothing-about-accounting congressmen may be further emboldened to hunt for messengers to shoot instead of focusing on real problems.  Second, as Krugman points out, financial reporting has been exposed as totally kaput, and it ain’t getting fixed any time soon.  The question policy makers should be addressing is not whether we should keep GAAP or adopt IFRS, but rather how long it will take for both the FASB and IASB to become completely discredited as agents of investor protection.

Accounting Needs to Start with a Clean Sheet of Paper

Everyone agrees that there is no silver bullet that can fix the economy. Whatever the capitalist or socialist ideologues will preach, we can’t simply scrap the current system and make a new one; every policy decision has to be made at the margin.

But, when it comes to financial accounting and regulation of financial institutions, I believe that 76 years after the enactment of the first federal securities laws, establishing the accounting and auditing disciplines as we know them today, it’s high time to start over.

First, we have to start by completing de-linking those banking regulations from the rules of financial accounting. Second, we need to recognize that neither historic cost accounting nor fair value accounting are providing the answers we need. The second point is where I am going for the rest of this post.

The Choices: Fiction-, Fantasy- or Fact-Based Accounting?

The three candidates competing to be the foundation of accounting standards are historic cost, fair value, or replacement cost.  Stated differently, the choices are fiction, fantasy, or fact. From that characterization, I suppose you have already figured out which of the three I would choose.

Historic Cost Accounting as Fiction

The conventional wisdom is that historic cost accounting is fact-based, objective and verifiable. The sad truth is that it is a fiction, however it has been practiced.

To account for historic costs, we subjectively choose which portion of a particular cost should be capitalized; and consequently, which portion should be expensed immediately.  Of the capitalized costs, we have to decide on a plan for transferring them to the income statement.  There can be no right answers, and there is hardly a pretense of impartiality in the numbers that management presents for the auditors to bless as “reasonable.

But even setting aside concerns of bias, so-called “historic cost accounting” only pretends to measure the historic cost of, say PP&E. Instead, fragments of historic costs are dumped in a parking place, bearing the fictitious name PP&E on a financial statement, misleadingly and pompously entitled the “statement of financial position.”  So, cutting through the pretense, historic cost accounting is simply a rules-based protocol for describing past cash flows and selected ‘expected’ future cash flows. Big deal.

Proponents of historic cost, defend it as “verifiable,” but as the example of PP&E illustrates, net book values are not verifiable; neither is the allowance for doubtful accounts verifiable, or any other estimate management makes.  The term “verify” stems from “truth”, and there is nothing true about these numbers other than the grim fact that management made them up.

And the auditors?  We derive little value, if any, from an audit report that opines on “reasonableness” of the estimates that make up those fictitious book values.   Walter Schuetze, former FASB board member and SEC Chief Accountant (where he was my boss) gave a zinger of a speech in 2003 on this topic a few years ago to the New York State Society of CPAs. Among other things, he proposed a much more limited role for auditors (and an expanded role for other independent appraisers).  To my mind, the speech is Roubini-esque – so disquieting that the accounting profession and its regulators could respond only by acting as if one of the most visible and prominent accountants in the world did not make it.  If I were teaching an accounting theory class or auditing today, I would spend at least two sessions discussing its implications.  You can access it here.

Fair Value as Fantasy

Fair value, sometimes referred to as mark-to-market or exit value accounting, consists of a series of predictions of the outcomes of liquidating transactions that probably won’t occur.  Some people like exit values, especially for gauging the health of financial institutions, because the values assigned to assets provide some indication of margin of safety in the reporting entity’s financial structure, should liquidations be required to pay off creditors.

But the sturm und drang of the past few years in implemting SFAS 157 should be some indication that fair value has some real problems — if not as a principle, then at least in its implementation.  I think it’s both.

The fundamental problem with an exit value approach is the need to imagine the market conditions that would exist at the time of the hypothetical liquidation. Therein lies the fantasy; the Pollyanna FASB wants preparers to assume that liquidation won’t happen under duress, but the reality is that unplanned liquidations happen under duress more often than not.  Not only that, whatever the market conditions that are to be imagined do nothing more or less than to replace the market conditions that actually did exist around the time of the balance sheet date.

To clarify the implications of fair value, let’s momentarily step away from financial assets, and consider a very simple scenario (inspired by an unnamed source, who claims that it is based on fact):

A Ford dealership in rural Vermont has an inventory of 300 model F150 pickup trucks. The dealer sold about 50 – 60 trucks a month in 2006 and 2007.  In 2008, the dealer sold 30 trucks all year, with only 10 from July through December.  In January 2009, the dealer had one sale.  In February 2009, the dealer had no sales.  In March 2009, the dealer has had no sales.  What is the fair value of the 300 trucks in the dealer’s inventory? 

Zero, or something close, would be a simple answer that everyone can understand, but most would consider useless as information relevant to assessing the present financial position and future prospects of the dealership. But, under these circumstances, no higher amount could be legitimately described as an ‘exit value,’  simply because anything other than a recent price is a made-up number.

Seeking fair value is just as problematic for subprime mortgages as it is for those pickup trucks. That’s because, as I just stated, the question of ‘fair value’ or ‘exit value’ is nonsensical when there are no currently active markets for either trucks or subprime mortgages. Valuing a subprime mortgage by the discounted cash flows to be derived from holding it does not magically change a ‘value in use’ to an ‘exit value,’ even if the parameters to the DCF model are based on so-called ‘marketplace assumptions.’  When we rely on management to estimate the sales price that would clear out the inventory of pickup trucks, or to estimate default rates and discount rates for subprime mortgages, that’s fantasy and not fair value. Even worse, we are back to where we started with historic costs: biased estimates buttressed by audits of, to be kind, questionable value.


Replacement Cost as Fact

Every western economist, from Paul Krugman to Gary Becker, accepts as axiomatic the notion that wealth is manifested by the command over goods and services. For a non-cash asset, the appropriate measure of its wealth effect is the amount it would cost to replace it (let’s leave aside the question of obsolete assets for the moment).

In a nutshell, if you think accounting is about reporting financial margin of safety, then fair value is for you. And by “you,” I mean primarily the bank regulators. But if financial accounting is supposed to be about reporting wealth and changes in wealth to investors, then you gotta go with replacement costs.

Replacement cost accounting is fact-based. It accounts for the wealth you now have. It’s not about what you hypothetically could have if, in some imagined scenario, you suddenly  sold an asset for its ‘fair’ price, whatever that means. Replacement cost accounting is most certainly not about fantasizing that you can command a nice price for an asset from selling it in a market that may not, and in many cases does not, actually exist. Replacement cost accounting is much simpler and, dare I say, saner: it measures actual wealth and actual changes in wealth – isn’t that what we were taught accounting is supposed to be about?

Of course, measuring the replacement cost of what you have is subject to error, just as is any other measurement. Getting back to trucks, how does replacement cost accounting handle the absence of a market in which to sell an asset? Perhaps not easily, but a heckuva lot easier than FAS 157, or any other implementation of exit value accounting could. The Ford dealer still knows almost exactly how much he would have to pay to buy 300 trucks, even if every single Ford dealer in New England were feeling the heavy breathing of lenders on the backs of their necks. Nevertheless, the price would be a lot higher than zero; and, that’s because the trucks are still worth a substantial amount of money. As for the subprime mortgages, even though there haven’t been a lot of recent transactions, dealers and other holders should have a pretty good idea (independent of management) of how much it would take others to part with their holdings.

I prefer fact-based reporting of wealth to fantasies of exit value. In both of the new proposed FSPs, the FASB has invoked the SEC’s recent study on fair value accounting. That study has also recommended that replacement cost should be given a closer look.

When the FASB takes time from responding to the congressional command to chase its own tail, perhaps we can take out that clean sheet of paper and write accounting rules that are based on fact, instead of fiction or fantasy. I’ll be honest, I don’t know if it can be done, but I think it can. But we won’t know until someone tries.


  1. Reply RandomDude April 1, 2009

    Replacement cost moves with the market too. If the market loses confidence in some class of instruments (say sub-prime), then the market nose-dives and with it the replacement cost. Then everyone has to write down their assets and you’re back to square one.
    >>The Ford dealer still knows almost exactly how much he would have to pay to buy 300 trucks
    Valueing an asset for which there is little to no demand at anything above market value a recipe for disaster. Just because Ford think the truck is worth $XX and lists it at that on it wholesaler sheet, doesn’t mean anyone else agrees.
    If I sell you empty coke cans at $1 million each, then that does not make the coke can worth $1mil and it would be foolish to let you list it at $1mil on your balance sheet.
    No. If the perceived value of an asset crashes (aka Market Value) then the Balances sheets *must* crash too. Anything else is wishful thinking/fantasy.

  2. Reply Bob Hinkel April 4, 2009

    I think your comments are spot on, and I also feel that there are good accounting guidelines and rules that exist already for companies to follow…if (and this is the big “if”) they are serious about transparency and managing for long-term value; not making the next quarterly targets. Having managed companies in highly cyclical industries; I believe that you have to set “ruthless” inventory aging rules and then follow them; if the product doesn’t sell in the given time frame, then it must be written down to liquidation value. Likewise, each long-lived asset on the books needs to be subjected to regular impairment tests.
    However, both of these require internal standards that most Boards just don’t and won’t demand (I could comment on the ability of many Board members to even understand these issues…but that’s a story for another posting). By the way, the SEC just gave another “gift” to the oil and gas industry by actually loosening the reserves reporting and recognition standards on the last trading day of 2008. But this little ticking time bomb won’t go into effect until the end of this year; and then you will see all the company valuations rise again; only to crash several years down the road when it becomes apparent that the valuations cannot be sustained.

  3. Reply Shawn Fahrer January 19, 2011

    As long as balance sheets are full of ESTIMATES (which ‘fair value accounting’ and ‘replacement cost accounting’ ENCOURAGE rather than discourage), you can NOT have the ‘reliable, transparent, corporate accounting’ you allegedly desire.
    And as for historical cost being a ‘fiction’, it is at least a ‘fiction’ BASED ON FACT. Both replacement cost accounting (especially in a time when prices are rising or falling QUICKLY), and fair value accounting (ditto) are based on far less ‘fact’ than the actual bill of sale for a purchased asset dated at the time that asset was purchased (because the ‘cost’ to be recorded under the other methods is recorded at an ARBITRARY moment in time — the date of the balance sheet– as opposed to a defined moment in time (the time of purchase, which need not have been that date).
    Another problem here: The IFRS folks don’t even allow LIFO for inventory valuation– only FIFO and average cost method. Since ‘replacement cost’ is more like a LIFO valuation, IFRS must make your head spin altogether.
    In any case, I’m not buying what you’re trying to sell. Your ‘fiction’ is the best fact we have on the cost of an asset; your ‘fantasy’ is the real fiction and your ‘fact’ is the real fantasy….

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