Peeling away financial reporting issues one layer at a time

Accounting Complexity: What if “Truth in Labeling” were an Accounting Principle?

“I do not deny that what happened to us is a thing worth laughing at. But it is not worth telling, for not everyone is sufficiently intelligent to be able to see things from the right point of view.”  — Don Quixote

Battered and bruised from tilting at the windmill of accounting convergence, the FASB sets forth on another quixotic adventure against an immovable object: accounting complexity.

I’m sure that we can all recite the standard explanations for why accounting standards have become so complex, and why that complexity will prove impossible to undo: the growing complexity itself of commercial arrangements, special interests desirous of emasculating the plaintiffs’ bar or having sufficient tools to manage earnings, etcetera, etcetera, etcetera.

But, another explanation has recently occurred to me, which if not an original thought, is one that I wasn’t heretofore aware of: the absence of a “Truth in Labeling” principle.

To explain what I mean, let’s start with one of the most ubiquitous mis-labelings on the balance sheet: property, plant and equipment.  To an innocent reader of financial statements, “PP&E” should indicate that a number is a measure of some attribute of an asset, when in fact, it’s not.  It’s not any of the financial attributes we usually think of, like historic cost, current cost to replace, value received if sold, or the the expected present value of future benefits to be derived from the asset by the entity.

So, what is that number labeled “PP&E”?  In the best of circumstances, it is the “undepreciated cost of PP&E in (very) old units of purchasing power.”

If this hash of a number is the best information that we accountants are capable of producing for investors, who can blame us for not coming clean with a truthful label?  Right.

Next, let’s consider the issue of asset impairment.  Whoops, another mislabeling.

If a company owns a fleet of vehicles for which the carrying amount is supposed to be written down in accordance with the complex GAAP that is the “asset impairment” rules, is it because there is something wrong with the vehicles that impairs their usefulness?  Nope; it’s only that there is something wrong with the way the vehicles were accounted for in prior periods.

Truth in Labeling Will Set us Free

There are two points I want to make from this example.  The first, and smaller point is that without truth in labeling, accounting is not being as forthright as it could easily, and should, be.  We can argue about why mislabeling occurs, but that doesn’t change the fact that those who would address accounting complexity could do worse than by at least acknowledging the ubiquity of our truth in labeling problem.  PP&E is one of tens of examples we could come up with.

The larger point is that calling things what they actually are is the only way to understand whether complexity is necessary or unwelcome.  Of impairment, for example, if PP&E were labeled correctly we would have to ask of what use are such complex impairment recognition and measurement rules when applied to a number can never considered to be “correct” in any sense to begin with — i.e.,  merely an undepreciated cost stated in ancient units of purchasing power.

So, now, back to the future, the FASB’s latest convulsions for “improving” lease accounting.  If a “Truth in Labeling” policy had been operating at the FASB, the new rules we are about to get that few want, and even fewer see as making any sense, could not have been birthed.  At least with PP&E, I can imagine contriving a label that reasonably describes the process that led to arbitrary carrying amounts.

But with leases, the proposed standard is so convoluted that no label — most certainly not “lease obligation” or “right of use asset” — could come close to describing the dog food inside the can.

10 Comments

  1. Reply James Ulvog March 4, 2014

    Here’s a simple question: How do I explain to my clients that “right of use asset” sitting as a separate line item on the balance sheet which was generated from a 5 year office lease?

    • Reply Tom Selling March 4, 2014

      James,
      I think the easy part is to explain that it is an asset similar to other rights — the right to receive cash in the future (A/R), or the right to make an insurance claim (prepaid insurance). The hard part is to explain why the ROU asset is not offset by the lease obligation in the b/s presentation — consistent with other executory contracts, or receivables/payables with the same party. Capital lease accounting is an exception to these general rules, I think because leasing is widespread and some companies (e.g., airlines) obtain virtually all of their resources through leasing.
      Best,
      Tom

  2. Reply Karen March 5, 2014

    I’ve never thought of it this way, but you’re right. ‘Truth in labeling’ could demystify some concepts for clients, and even give accountants some more common vocabulary.

  3. Reply Jerry March 5, 2014

    Tom, I read your website regularly, with great interest.

    This is a little bit off topic, but I wonder if I could make a request: One of my favorite comments from you is that, “[t]hanks to double-entry accounting, financial statement fraud is like squeezing a balloon filled with water: fraud that would squeeze the balloon to make the trend in one account look normal has to pop up somewhere else; one only needs to look close enough for the bulge.”

    Would you consider, in some future post, walking through some examples of how this works? I suspect others might enjoy this as well.

    Thanks for the thoughtful blogging!

    • Reply Tom Selling March 6, 2014

      Hi, Jerry:

      Here’s two quick examples. Add fraudulent revenues and A/R is too high — turnover decreases. Don’t write off obsolete inventory, and inventory is too high — turnover decreases.

      Basically, Beneish’s financial fraud model is based on this premise. When fraud occurs, financial statement relationships get out of whack.

      I hope this helps.

      Tom

      • Reply Jerry March 24, 2014

        Thanks, Tom!

  4. Reply Steve Chai March 12, 2014

    I don’t want to sound cynical, but I kept wondering where FASB or IASB are going with their talk of “reducing accounting complexity”. They seem to just talk the talk. The new FASB chairman Mr. Gloden has talked about it in numerous occasions. The recent effort made by PCC to simplify goodwill impairment is a good example. The proposal (i.e., option to amortize the goodwill) was fully supported by the board (except for one borad member). However, when recently considering whether to allow public companies to use similar approach, the board simply brushed aside the PPC approachm for which they have whole-heartedly supported a few months ago. How could they think it is such a good idea but not even consider it two months later?
    IASB is not doing any better either. When it came up with the convoluted new hedge accounting/financial instrument models, why didn’t they talk about simplifying accounting then?

  5. Reply John Nest April 9, 2014

    I was also thinking that “labeling” would be misconstrued as fraudulent in the books. Thanks for giving me a better grasp at explaining this to my clients.

  6. Reply Christin Thomas October 12, 2014

    I am a Bcomm Accounting Sciences student in South Africa. Currently, I am learning about IFRS and all the ‘wrongs’ and ‘rights’ of accounting, the policies and how to best show financial statements to clients.

    Whilst reading this blog, I started to wonder how much of the information that we give to the clients is shown and what it truly is. However, it is an extremely long and difficult task to give the perfect description and cost to our clients. Due to many of the clients not being as knowledgeable about accounting as others, the task that will be done may deem to be worthless.

    The question then lies; do we rather keep things straight and simple as everyone else does it. or do we take time to show things perfectly?

  7. Reply Nthabiseng Molelekoa October 12, 2014

    Accounting makes things more complex unnecessarily at times. Some things need to be treated as simple as they appear to be and this has helped me to realize that this career path is not as difficult as others perceive it to be. Thank you for enlightening me regarding this.

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