Two posts ago, I provided two reasons for the PCAOB* to take the opportunity of its auditor’s report project to look closely at the meaning of, “fairly presented … in accordance with Generally Accepted Accounting Principles”:
- Truth in labeling — As I described in that earlier post, few readers of financial statements fully understand the technical meaning, in part because it no longer bears any relationship to common English usage.
- The Wild West of nonauthoritative GAAP — The vaguely specified methods set forth by the FASB for utilizing “non-authoritative” GAAP should be of great concern to the PCAOB.
In this post, I’m going to provide my views on #2, above. To begin, I’ll first provide some background on the role of nonauthoritative GAAP in financial reporting under US GAAP. Then, I’ll describe two cases in which the application of nonauthoritative GAAP should cause concern. My presumption is that if I can stumble on these two cases, then there must be lots of others lurking in audited financial statements.
The latest pronouncement on the matter of nonauthoritative GAAP is Statement of Financial Accounting Standards No. 168 (2009). As the last SFAS issued by the FASB, it pronounced that the Accounting Standards Codification would become the sole “authoritative” source of U.S. GAAP. As to the enduring question of what to do when authoritative sources do not directly (or by suitable analogy) address a particular transaction, ASC 105-10-05-3 enumerates the following potentially permissible nonauthoritative sources that could be referred to as GAAP:
- Practices that are widely recognized and prevalent either generally or in the industry;
- FASB Concepts Statements;
- AICPA Issues Papers;
- Pronouncements of professional associations or regulatory agencies;
- Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids;
- Accounting textbooks, handbooks, and articles.
ASC Topic 105 makes clear that an issuer has broad discretion to choose amongst analogy to authoritative GAAP or from the above smorgasbord of nonauthoritative sources. Although auditors would have some say on the matter, the PCAOB’s guidance to them is clear as mud. Per AU 411 as amended by the PCAOB:
“The auditor’s opinion that financial statements present fairly … in conformity with [GAAP] should be based on his or her judgment as to whether (a) the accounting principles [whatever that means] selected and applied have general acceptance [whatever that means]; (b) the accounting principles are [merely] appropriate in the circumstances; (c) the financial statements, including the related notes, are [merely] informative … and (e) the financial statements reflect the underlying transactions and events … within a range of acceptable limits, that is, limits that are reasonable and practicable….”
I encourage you to think about how the auditors have applied AU 411 when reading the following two cases.
Case #1: Revenue Recognition by For-Profit Universities
About five years ago, I had occasion to review the revenue recognition policies of a for-profit university (FPU). Below is what I found for what evidently constitutes “practices that are … prevalent … in the industry.”
Students are billed on a course-by-course basis. They are billed on the first day of attendance, and a journal entry is made to debit A/R and credit deferred revenue for the amount of the billing. The A/R is ultimately adjusted by an allowance for uncollectible accounts of around 30%, and the deferred revenue is recognized pro rata over the duration of the course.
Does prevalent industry practice justify recognition of executory contracts? FPUs, like other enterprises engage in all manner of executory contracts; but, with the exception of some lease contracts, none are given accounting recognition before any performance has occurred. Evidently, if FPUs act together to violate a broad-based convention, that’s okay, because it makes ‘industry practice.’
But, recognition of executory contracts is not even the most glaring inconsistency with authoritative GAAP by FPUs. Long-established and generally accepted (literally, for once) principles of revenue recognition run counter to what FPUs are doing. Specifically, SFAC No. 5 enshrines the long-held view that revenue should not be recognized until it is earned and realizable (or realized), and practically all of the specifics in the ASC, not to mention SEC interpretive guidance, is consistent with this aspect of SFAC No. 5.
Is anything “earned” by an FPU until grades are recorded in transcripts? I think it’s safe to stipulate two things: (1) from a student’s perspective, nothing is owed if the FPU doesn’t fulfill the obligation of recording a grade in a transcript that a student can use to document performance; yet (2) there is no “authoritative” GAAP that specifically speaks to this question. Ergo:
“If the guidance for a transaction or event is not specified within a source of authoritative GAAP for that entity, an entity shall first consider accounting principles for similar transactions … and then consider nonauthoritative guidance.” [ASC 105-10-05-2, emphasis supplied]
Call me cynical, but that language is squishy enough for an FPU to do pretty much anything it wants regarding the timing of revenue recognition. So it does.
But, determining the revenue recognition trigger is still a mere quibble compared to the “realizable” question. A typical company estimates its allowance for doubtful accounts to be around 2% of gross accounts receivable; but an FPU’s allowance could be 30%. If, after an allowance is initially accrued, it is discovered that the actual uncollectible amount was one-third higher than the accrual, the premature recognition of earnings by the typical company may or may not be material; but for an FPU, it will be a cataclysmic income statement event.
Industry practice is industry practice, but that doesn’t make it good practice to come to a conclusion that collectibility is reasonably assured when a small change in the estimate of uncollectible billings can have such a material effect on the financial statements. Yet, over a sizable number of FPUs and their auditors, they see nothing in the ASC to stop them.
Case #2: Accounting for Tax-Advantaged Projects
Investments for which tax credits are available (e.g., solar, wind, affordable housing) are often set up as IRS-approved “partnership flip structures.” Without getting into a lot of detail, “tax equity” investors receive nearly all of the cash distributions (mainly from tax benefits) in the earlier years of the project. A “sponsor” is responsible for operating the project and receives the bulk of the cash distributions occurring near the end of the project’s planned life.
Tax equity partners must account for their investment using the equity method. The sponsor must consolidate the partnership — since it meets the definition of a “variable interest entity” and the sponsor is deemed to be the primary beneficiary. The sponsor measures the non-controlling interests (i.e., the tax equity) using the mirror image of the equity method.
Nonauthoritative GAAP comes into play because authoritative GAAP presumes that an “ownership percentage” can be calculated by investors for measuring their share of the partnership’s earnings under the equity method. This is not possible for investors due to the complexities of the contractual provisions for allocating taxable income/loss and cash flows.
In response to the problem, the AICPA’s Accounting Standards Executive Committee issued an exposure draft in 2000 that proposed the “hypothetical liquidation based on book value” (HLBV) method for determining a varying ownership percentage each period. Again, I don’t think it is necessary to get into the details, but basically what happens under HLBV is that: the business is unrealistically assumed to have been liquidated at each balance sheet date (probability is essentially zero of that actually happening in most years) at its book value (usually a huge understatement of economic value); and the hypothetical net proceeds from liquidation are distributed to investors according to the cash flow “waterfall” set forth in the partnership agreement. Each equity investor’s “percentage of ownership” for the period is calculated as its relative share of the waterfall.
We could debate the merits of HLBV, and perhaps I could even explain it a little better (for what it’s worth I think it’s a whacky approach to a problem that boils down to changes in the present value of expected contractual cash flows); but for the purposes of this post it is sufficient to know that the ED was never finalized. In other words, HLBV was explicitly rejected by an authoritative accounting standard setter, but is still permissible to be used as nonauthoritative GAAP because … lots of issuers do it.
* * * * * * *
As the forgoing examples illustrate, nonauthoritative GAAP can be a crapshoot. Surely there is a better way to determine an appropriate accounting treatment than from an unordered list of ingredients for coleslaw?
Of course, there is. Standard setters have always had the ability to produce a set of recognition and measurement principles that no issuer should be permitted to violate when filling a gap in GAAP. I’m pretty sure that most of my readers have a pretty good idea why they haven’t done that.
At minimum, and the reason I am writing this post, is that the application of nonauthoritative GAAP should trigger special disclosures:
- The notes to the financial statements and MD&A should prominently identify the sources of nonauthoritative GAAP, and explain why it was necessary to find and apply a nonauthoritative source.
- The notes and MD&A should also identify and quantify the revenues, expenses, assets and liabilities that were subject to nonauthoritative GAAP treatments.
- The audit report should also include a paragraph that alerts the reader to the use of nonauthoritative GAAP and the note wherein the details are disclosed.
- The auditor should specifically state that the use of the specific nonauthoritative GAAP is a reasonable choice under the circumstances, and preferable to the application of authoritative GAAP by analogy.
If the dubious concept of nonauthoritative GAAP must be allowed to persist, then, as in other areas where issuers have discretion, financial statement readers are entitled to know the gory details.
*I am a member of the Standing Advisory Group of the PCAOB. The views expressed herein are my own and do not necessarily reflect the views of the Board or other Board members or staff.