Peeling away financial reporting issues one layer at a time

To Catch a Chief Accountant

I received an email from the source I previously dubbed Debit Throat, providing some interesting reactions to my previous post on handicapping the chief accountant 'contest.'

"I agree [with your odds] – I don't think that Neimeier is [no longer] a possibility (although my choice also) for CA.  Frankly – I don't think that Charly even wants to do it anymore although I understand that there has been savage fighting between the Big 4 and the SEC about this.

One thing is for sure – the CA appointment will tell the tale on what happens with IFRS, and I believe that the tide has turned there AGAINST IFRS.  For this reason I don't think that Wayne Carnall will be the pick since he is a big IFRS advocate. 

So my guess: 1) Adams and 2) a long shot in Ciesielski.  I don't see Kroeker getting the nod."

For some reason, DT's email triggered my memory of a 1991 Accounting Horizons article, "The Selective Financial Misrepresentation Hypothesis." It was written by the late Lawrence Revsine of Northwestern University, apparently to lend much-needed perspective on the contributory role that politically-driven financial reporting rules played in the trillion-dollar savings and loan debacle.

Sad to say, very little about financial reporting has changed for the better since 1991, while much has changed for the worse, making Revsine's observations even more relevant to the current conversation.  I would also say that it is directly applicable to the chief accountant selection SEC Chair Mary Schapiro has been putting off, but eventually must confront before the debate on IFRS can continue.  If she can summon the gumption to heed Revsine's message in the face of tremdous pressure to act otherwise, then that would be progress enough for me.

The Seeds of Selective Misrepresentations

According to Revsine, financial reporting originally became necessary as business arrangements increased in complexity; its intended role was to "…summarize events and to provide information for more complex analyses." No surprises there, but Revsine continued, "…managers gradually learned that while events that affect performance often cannot be controlled, the way that people perceive these events can be controlled" by "distorting economic reality." Misrepresentations cannot be too comprehensive lest a complete loss in the credibility of financial reporting should occur; hence, the importance of being "selective."

Many of the selective misrepresentations that have been enshrined in GAAP take the form of "loose" accounting standards. Management exploits them to shift income with the objective of maximizing its total compensation when, as is very often the case, that compensation is tied to reported earnings. To cite but a few examples, management can 'cherry pick' gains, manipulate the timing of revenue recognition, fudge loan loss reserves, etc. In general, managers desire choices among mutually "acceptable" alternatives, "…rather than methods that tightly specify statement numbers under given economic conditions."

But managers are not the only group that can benefit from selective misrepresentation of financial information. Auditors prefer accounting standards that foster client harmony, so as to maximize client retention. The same loose standards that managers prefer generally fit that bill, but standards that are loose and complex at the same time sweeten the deal for auditors. Management should have their flexibility, but detail and complexity should also be present so that auditors can stretch the envelope on billable hours.

Even current shareholders benefit from "loose" accounting standards. That's because, by placing upper and lower bounds on earnings-based bonus payouts, shareholders provide managers with built-in incentives to smooth earnings over time. The resulting appearance of lower earnings volatility induces higher bid prices for shares. Moreover, loose accounting standards also allow shareholders to transfer wealth from creditors and the public by evading debt covenants and regulatory capital requirements.

With respect to those regulatory capital requirements, Revsine asserted that the role of misrepresentation in accounting standards had not been adequately recognized in accounts of the near trillion-dollar S&L debacle; and I fear that the story will not be fully told this time around, either. The moral hazards associated with our subprime mortgage mess – for example, taking on excess risk because bank losses were protected by deposit insurance – were clearly exacerbated by outdated GAAP-based measures of capital adequacy; yet, I feel like a voice crying in the wilderness when I call for a de-linking of capital adequacy measures from GAAP.

Chairperson Schapiro: If You're Out There, Please Read this Part Very Carefully!

After explaining why selective financial misrepresentation happens, Revsine provided a compelling explanation of the how, and it's not a pretty picture: the "regulatees" (managers, auditors and shareholders) banded together out of common interests to "capture" the regulators. This has largely occurred through movement of personnel between the regulatory agencies (e.g., SEC and FASB) and the regulatees:

"… regulatory 'capture' describes a process where the ostensible purpose of regulation—protection of consumers—is eventually reversed and regulatees become the beneficiaries [citation omitted]. …

While it regrettably conjures a pejorative image, the phrase "regulatory capture" is not intended to impugn the integrity of standard setters. Instead, the point is that everyone is influenced by their background and becomes comfortable with familiar perspectives and experiences. This is inevitable and natural. Unfortunately, in the regulatory sphere, it is also antithetical to the intended purpose of regulation."

From today's perspective, I think Revsine was being too kind to the regulators. But in his defense, he did write his article before Chistopher Cox was appointed SEC chair by George W. Bush. Anyway, that's beside the point.

Revsine's main point was that knowledge of the mechanism by which selective financial misrepresentation occurs is the first step towards reversing a process that has given short shrift to investors and taxpayers. Just starting with the savings and loan debacle of twenty years ago, the abject failure of the SEC to insulate itself from the influence of regulatees on accounting standards makes the financial consequences of the Bernie Madoff affair look like a convenience store heist. I'm not just talking about the subprime mortgage crisis, although that would be more than enough. I'm also talking about mergers and acquisitions motivated by accounting results, rust belt pension plans gone bust, executives paid with mountains of stock options they didn't deserve, Enron, Worldcom, and much, much more.

Accounting will never be fully free of misrepresentations, but without significant change, the next financial crisis could send financial reporting, and the SEC along with it, back to the Stone Age. As the SEC Chair faces pressure from the Big Four et. al. over naming a chief accountant, I would urge her to review the current list of candidates for the obvious signs that they have been captured by the regulatees. By the standard of independence that her own appointment by President Obama exemplifies, Charles Niemeier should be the odds-on favorite; Jack Ciesielski should be given serious consideration. And the others, bless their acculturated hearts, should be politely told 'thanks, but no thanks.'

3 Comments

  1. Reply Edith Orenstein June 12, 2009

    Tom,
    Speaking personally, and without taking a position on whether I agree or disagree with your personal views on any of the rumored candidates, I think you have a very thought provoking post on conceptual grounds.
    However, I believe you are being a little unfair in referring to SEC Chairman Mary L. Schapiro’s process of selecting a new Chief Accountant as an ‘overly protracted process’ (in your June 3 post), and your reference to “the chief accountant selection SEC Chair Mary Schapiro has been putting off, but eventually must confront” (in your post today).
    In this regard, I thought it may be worthwhile to provide some context as to the length of time of the appointment process for recent Chief Accountants (CA’s). Based on data from SEC press releases showing dates CA’s were appointed and resigned, (and dates new Chairmen began their terms from historical list of commissioners on SEC website), here is what I found:
    – Seven months (approximate, as of today, 6.12.09) since Conrad Hewitt resigned 11.25.08
    – Ten months between Hewitt appointment (7.24.06) and Don Nicolaisen resignation (9.7.05)
    – Nine months between Nicolaisen appointment (8.14.03) and Bob Herdman resignation (11.12.02 Jackson Day was named Acting Chief Accountant following Herdman’s resignation; Day resigned 3.27.03; Wm. Donaldson became Chairman of SEC 2.18.03; thus the total 9 month period between Herdman and Nicolaisen consisted of 3 mo’s under outgoing Chairman Pitt, and 6 mo’s under incoming Chairman Donaldson)
    – Two months between Lynn Turner resignation (7.26.01) and Bob Herdman appointment (9.19.01). However, the two month period may be viewed as understating the amount of time the new administration under Pres. Bush (as of 1.20.01) had to consider potential new appointments if the need were to arise under SEC Acting Chair Laura Unger and new Chairman Harvey Pitt; Pitt became Chair on 8.3.01.)
    – Five months between Michael Sutton’s resignation (12.9.97) and appointment of Lynn Turner (5.7.08) under Chairman Arthur Levitt)
    I believe the above data indicates that the current period of time it has taken so far in considering a potential new CA (approx. 7 months) is about in the middle of the pack for appointments of CA’s over the past dozen years or so.
    The SEC staff is generally viewed as keeping the ship sailing pretty well during the ebb and flow of new appointments (full disclosure: I used to work at the SEC), and while the length of time for appointments to take place can be a concern, I believe the quality of the appointment process and the quality of the appointment is as important as the quantity of time it takes to make the selection. From reading your blog, I believe you would take that position as well.

  2. Reply Independent Accountant June 13, 2009

    I oppose ’em all for chief accountant. They are all hopelessly compromised. Or worse. I oppose IFRS as giving the SEC, yes the SEC, too much ability to creatively ignore economic substance. I agree with Revsine. We learned nothing from the S&L debacle.

  3. Reply Raza June 13, 2009

    Hi Tom, you left out the reverse mortgage industry from your list 🙂 Just joking. An EXCELLENT post, as usual. Loved it.

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