My inspirations for this post are the maiden speech of the SEC’s new chief accountant James Schnurr, and the joy of paying only $2.02/gallon at the pump.
As for Mr. Schnurr, I plan to dissect his remarks more fully in a blog post to come, but for now I’ll confine my review to his mentioning comparability of financial statements no less than seven times, e.g., “Comparability is a hallmark of U.S. financial reporting…”
As to the relevance of my satisfying gas station experience, the financial reporting implications of the 50% decline in oil prices over the past six months make for a timely illustration for why Mr. Schnurr’s statements about comparability are nothing more than hot air.
Why Comparability of Financial Statements is an Illusion
There are many, many reasons why financial reports are not comparable. Tops on my list, though somewhat off topic, is the absence of adjustments for inflation. No respectable economist would ever dream of comparing trends in costs or revenues without adjusting for inflation; so it really irks me that in accounting, we never adjust for inflation.
Truly, by ignoring the necessity for inflation adjustments, it makes the accounting profession (including our august chief accountant) look like a bunch of simpletons. Some will argue over implementation details, but accounting for inflation is no harder or easier than dealing with multiple currencies (yet, see here and here for how the FASB managed to screw that up, too).
Adjustments for inflation are merely a pre-condition for making comparisons. Let’s get back to the drop in O&G prices that have made many of us joyous, but must surely frustrate the managers of companies whose recent investment decisions were predicated on higher and steadier prices. These managers have many hard operational and strategic choices to make; and to make matters worse for them — e.g., the threat to their earnings-based bonus checks — they also have to deal with the accounting question of asset “impairment.”
To keep this explanation as simple as I can, let’s assume that we are testing one asset, an oil field, for impairment. The wise men of the FASB, with ample assistance of special interests, pronounced in 1995 (FAS 121) that everyone would sing their own variation on the following tune:
Step 1: If recent events indicate that the economic benefits to be derived from an asset group (i.e., oil field) could be less than its carrying amount, continue to Step 2.
In this example, the recent drop in O&G prices would be a pretty solid indicator that an impairment might exist. So, for a great many companies, on to Step 2 they go. But as one more aside, it’s sort of fun to point out that “impairment” is actually one of those niggling accounting misnomers. For example, every aspect of the oil field could be in perfect working condition, yet for some reason the FASB chooses to treat the asset as if it might be “impaired.” Cynical me thinks they wanted to create the appearance of substance where none exists. But the reality is very often that when write downs are made, they accomplish little more than to catch up the accounting to economic events that occurred in the distant past.
Step 2: Sum the expected net cash flows to be generated by the asset being tested without adjusting for the time value of money. If that sum is less than the carrying amount of the asset, continue to Step 3.
This the the dog’s breakfast aspect of impairment accounting. The FASB blithely instructs issuers to violate the most fundamental commandment of finance: ‘thou shalt adjust future cash flows for the time value of money before adding or subtracting.’ (Actually, I don’t know which is the greater sin: not adjusting for inflation, or not adjusting for the time value of money.)
Step 3. If the fair value of the asset is less than the aggregate carrying amount, write the asset down to its fair value, and report an “impairment” loss.
The first point of this post is that, even if the impairment protocol were auditable — which it is not, it will fail to provide investors with comparable information when oil and gas companies file their next 10-K. For example, consider two oil fields, A and B, which are owned by two different companies:
- Field A has a carrying amount of $10,000,000; expected net operating cash flows are $2,000,000 per year for five years; its fair value is $6,000,000.
- Field B is identical to Field A, except that the expected cash flows from operating the oil field sum to $9,999,999.
Field A is not treated as “impaired,” even though its fair value is $4,000,000 less than its carrying amount; because it barely “passed” Step 2. In contrast, Field B is written down by $4,000,000; because it failed the Step 2 test by a mere $1. A change in the Step 2 cash flows of $1 will in this case trigger an “impairment” charge of $4,000,000; or $40,000,000, or $400,000,000 for larger oil fields. To quote my favorite tennis player of all time, “YOU CAN’T BE SERIOUS!”
But seriously, the above example plainly illustrates that even the most assiduous application of GAAP will not produce comparable information. Impairment is just one of many examples that we can all think of.
Why Financial Statement Audits are an Illusion*
Which brings me to the second, and main point that I want to make: the impairment test is not auditable.
This will be short and sweet, in part because I have made the same general points only a few weeks ago, here.
Imagine that you are the auditor assigned to examine the Step 2 process for your O&G client. Management predicts that O&G prices will recover at a rate of 20% per year until it reaches $100 per barrel. Because of this estimate, management concludes that it has passed Step 2 by a slim margin; and, consequently, no impairment will be recognized.
What will you do as the auditor to assess whether management’s predictions are reasonable?
I suppose, you could pull out your own crystal ball and compare it with your client’s. But, that’s not realistic. If you really could predict future oil prices and be correct just a little more often than you’re wrong, you would definitely need to turn in your shingle and set forth on a much more lucrative career of trading oil and gas contracts.
Or, admitting that you wouldn’t be good at forecasting oil prices yourself, you could simply review what your client states it sees in its own crystal ball. If their “analysis” looks “appropriate” than that’s what you will go with. But what, pray tell, is an “appropriate” method of forecasting future oil prices?
Next, imagine that your firm has another client that claims it has a very different crystal ball to predict oil prices. Like you, your fellow audit partner has managed to convince herself that management’s estimates are “reasonable.” But, if the they were swapped from one client to the other, both sets of financial statements would be materially changed.
Is this comparability? Is this auditing? Nope, it’s a crapshoot.
* * * * * *
Financial accounting standards like the one for the impairment of long-lived financial assets defeats, instead of promotes, comparability. And, especially when facts and circumstances indicate to any extent that the past is not indicative of the future, not even the most independent and technically competent auditor on the planet could reliably assess the “reasonableness” of management’s estimates of variables like future oil prices.
There is only one reasonable solution. Oil fields should be valued by independent appraisers, i.e., not (biased) management. And auditing should be solely a verification function. The auditor would verify that: the factual information provided by management to the independent appraiser is accurate and complete; that the appraiser performed its work in accordance with their engagement letter with the issuer; and that the appraiser’s calculations were performed accurately.
Nothing I have written here concerning the lack of comparability of financial statements is something that Mr. Schnurr doesn’t already know. Instead of disingenuously blowing smoke about comparability being a hallmark of U.S. GAAP he should at least be raising real issues and getting the PCAOB and FASB to actually do something about them.
*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 its staff.