Peeling away financial reporting issues one layer at a time

How Accounting Standards Went Insane: It Didn’t Start with IFRS Convergence

If you subscribe to The Atlantic magazine, the title of this post may ring a bell — a riff on  “How American Politics Went Insane: It Didn’t Start with Donald Trump…”  from the July/August edition.  Now that I have made that acknowledgement, I will describe for you the accounting pronouncement that sent GAAP off its rocker.

The pronouncement was SFAS 52, Foreign Currency Translation.  By a rare 4-3 vote in 1981, it replaced SFAS 8 from just a few years earlier.  SFAS 8 remains the most principled statement ever promulgated by the FASB, which probably goes a long way toward explaining why issuers hated it so much.

The core principle of FAS 8 could be straight from an undergraduate accounting course: consolidated financial statements best portray a parent and all of the operations it controls as a single economic entity. SFAS 8 merely affirmed that foreign operations are no different in this regard than domestic operations.   Here are two examples of the accounting implications of that principle:

  • Foreign currency-denominated monetary items should be remeasured into dollars using the current exchange rate, with the resulting gains and losses from changes in exchange rates reported in earnings.  It should not matter whether, for example, accounts receivable are posted to the books of a domestic operation or a foreign operation.  Similarly, the measurement of accounts receivable in the reporting currency (e.g., US dollars) are unaffected by changes in exchange rates, even if they are posted to the books of a foreign operation.
  • If the accounting policy for a non-monetary asset (e.g., land, buildings, equipment, inventory) is to measure the asset on the basis of its cost, that non-monetary asset on the books of the foreign subsidiary would be translated at the “historic” exchange rate — i.e., the exchange rate in effect on the date the cost was incurred.  Since the asset is not being remeasured for movements in exchange rates, there would be no exchange gain/loss to report.

As sane as these conclusions were, they were driving issuers insane.  They didn’t, and still don’t, really care a fig about reasoned accounting principles.   They care only about making their earnings numbers; and for that SFAS 8 gave them nothing but grief.  This is a simple example to illustrate why:

The left-hand side of the balance sheet of a foreign operation, say a hotel located in France, could consist almost 100% of real estate and equipment, which are translated at historic exchange rates.  But the right-hand side might be 70 percent foreign-currency denominated debt, which would be remeasured at current exchange rates.  Consequently, the income statement would be exposed to large foreign exchange gains/losses from changes in the dollar value of the debt, even if exchange rates between the dollar and the euro moved only just a teeny bit.

There is, of course, an obvious principles-based solution: to change the accounting for nonmonetary assets from historic cost to current cost (or value).  In that way, the gains/losses on the liabilities would be largely balanced out by the losses/gains on assets.  But, it is all too obvious why issuers would want none of that either.

In the end, there was  only so much crap the FASB could take, so by that narrowest of margins it issued SFAS 52.

To begin to appreciate the insanity of SFAS 52, let ‘s begin with an example from the physical world.  This is something you would never think of doing, but bear with me for a moment:

Two attributes of any person are height and weight.  Let’s measure height in inches and weight in kilos (it really doesn’t matter which scales we choose to use).  If we took the product of a stranger’s height and weight, it might be “7,000”.  (I put the answer in quotes, because there is no meaningful indicator of units that we could attach to this number.)   Now, multiply your own height in inches by your weight in kilos.

Question: what can you learn about the stranger from the difference between his/her number and yours?    Answer:  Zilch.  Bupkis.  Nada.

The product of height and weight is  a number that can only be described by regurgitating the arbitrary manner by which it was produced — the product of height, arbitrarily expressed in inches, and weight, arbitrarily expressed in kilos.

Now, back to the crazy world of SFAS 52 for a disturbingly similar example:

  • Company A has no subsidiaries and Company B has a wholly-owned subsidiary in the UK that operates independently of the parent.
  • Both companies issue their financial statements in U.S. dollars.
  • Both companies hold land in the UK, purchased for GBP1,000.  At the date of the purchases, the exchange rate was GBP1.00:USD2.00.  Therefore, the historic cost of the land in the reporting currency (dollars) is USD2,000 for both companies.
  • The exchange rate moves to GBP1.00:USD1.60 on the balance sheet date.

Every Accounting 101 student knows that (barring an impairment charge) Company A will report the land on its consolidated balance sheet at its historic cost of $2,000 for all time, until the day that it sells the land.

But, only a FAS 52 nerd will know how Company B “translates” the land from its historic cost in GBP to USD:  it will be reported on the consolidated balance sheet of Co. B at the historic cost in UK pounds multiplied by the new exchange rate, or $1,600 (notice the meaningless dollar sign).  The purely arbitrary $400 debit difference will be reported in other comprehensive income as a “translation adjustment.” This is not technically a loss, mind you, but an “adjustment” to owners’ equity that doesn’t affect earnings until some indefinite future period when the parent no longer controls the foreign operation.

Thus, one company reports their land at historic cost (an attribute of the land), and the other company reports the land at an amount that is not only different, but also at a purely fictional dollar amount.  In fact, the only way to describe “1,600” is by the entirely arbitrary manner in which it was calculated.

If you want to learn about just some of the additional horrible implications of this provision in GAAP, you can read these past blog posts:

All of this would be bad enough if SFAS 52 were an anomaly.  But, in point of fact, it let the camel’s nose under the tent.  It was the first standard to sanction white noise on the balance sheet for the sake of income smoothing.  (And, incidentally, with this standard the FASB also opened the Pandora’s box of other comprehensive income.)  The FASB came to care less and less about the quality of balance sheet numbers.  It paid lip service to the asset/liability view for a while, but only that.

Perhaps the closest relative to SFAS 52 is SFAS 133  on derivates and hedge accounting.  Solely to reduce income statement volatility, fair value hedging under SFAS 133 permits changes to the carrying amount of hedged items that simply balance out the changes to the fair value of hedging instruments.  Before he came on the Board, Tom Linsmeier referred to fair value hedging as “mutt accounting.”  That’s what I’m talking about.

Following SFAS 52, the unthinkable — adding white noise to the carrying amounts of assets and liabilities — became the norm.  Who cares anymore that numbers on financial statements don’t actually measure anything?  Nowadays, all that matters is that we can come up with a number that might be in the vicinity of real attributes of assets and liabilities.  Post-employment benefit costs can be smoothed, deferred tax liabilities don’t have to be discounted, and hedged items can be measured wily-nilly, to name just a few of the affronts to any principles-based accounting that are now considered normal.

And It’s Going to Get Worse

If you have been following the ups and downs of the last-gasp convergence projects with the IASB, you might notice that white noise keeps getting added to financial statements with ever greater impunity. The measurement of lease obligations and loans are direct descendants of SFAS 52.  They cannot be described in any way except for how the numbers were calculated.  But in the process, issuers got what they wanted:  smoother earnings.  And much the same can be said about the forthcoming revenue recognition standard, plus it makes no qualms about creating new “contract assets” out of thin air.

Is There a Cure?

Some would suggest that the only cure for the raging GAAP insanity is to measure all assets and liabilities at their current values.  I am all for that, but the cure could also be as simple as to require truth in labeling.

Let’s start with SFAS 52.  If the FASB (or the SEC for that matter) were to require detailed roll forwards of all balance sheet accounts, a user would be able to see exactly how much of a period’s translation adjustment came from each balance sheet account.  Translation adjustment in accounts receivable?  No problem!  The astute analyst will move it into earnings.  Translation adjustment in operating assets like PP&E?  No problem!  Reverse the entry.

In other words, roll forwards of balance sheet accounts should permit users to separate the wheat from the chaff. Leave it to the user to decided which is which.

Ironically, the FASB and SEC have been working on ways to “simplify” disclosures and to reduce disclosure redundancy.  What could be simpler, and more useful, than balance sheet roll forwards?   When it comes to disclosures, numbers are almost always better than narrative, especially when that narrative is controlled by CEOs who have their own self-serving stories to tell.

The FASB has been sitting on a proposal to require roll forwards for about 7 years (actually, not so terribly long by current standards).  When I asked a high ranking FASB staff member about its status, I was informed that the FASB had received too many objections.

Oh yeah?  By whom?  Issuers, I’ll bet.

* * * * * * *

Ponder this.  Imagine yourself an auditor (unless you actually happen to be one!).  You sign your name to a report stating that, in your opinion, the financial statements are “fairly presented in accordance with U.S. GAAP.”

If you can’t even describe, except by regurgitating the calculations, what the numbers on the balance sheet represent, what does your signature actually mean?

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