Peeling away financial reporting issues one layer at a time

Is “Accounting” Really Accounting?

I wonder why so little is made of the fact that key technical terms in U.S. financial reporting are misleading perversions of plain English?  As a sampling, consider these, which I have written about in postings over the years:

Each one of these weasel terms contributes to a state of affairs in which “accounting” — as in Generally Accepted “Accounting” Principles or Financial “Accounting” Standards Board — is not actually accounting in the ordinary sense.  “Accounting” in compliance with GAAP has become more complex with each passing year, that much is for darn sure.  But just how very much the gap widens between “accounting” and accounting is not adequately appreciated by the general public, or even many seasoned accountants.

Is GAAP Really Accounting?

My favorite way to introduce accounting to new students is through discussion of a teaching case entitled “Another Improbable Occurrence.”  Actually, it’s more like a fairy tale than a business case, but provocative nonetheless.  In the narrative, a feudal lord engages two of his serfs to grow wheat on separate plots of land for a season.  Here is a key scene, from soon after the first harvest:

“Igor, who had been given 10 acres of land, 10 bushels of wheat and 10 pounds of fertilizer, spoke next. ‘Here, my Lord, is a partially used-up ox, the plow for which I gave Feyador, the Plowmaker, three bushels of wheat from my harvest and 105 bushels of wheat. I, too, used all my seed and fertilizer last spring. Also, my Lord, you took 30 bushels of wheat several days ago for your own table. I believe the plow is good for two more seasons.’ ”

Now, that’s accounting! It isn’t a very detailed accounting, but an accounting nonetheless consisting of three essential steps:

Step 1:  Reporting what the entity started the period with.

Step 2:  Reporting what the entity ended the period with.

Step 3: Summarizing in reasonable detail the flows that took place during the period — i.e., why the amounts reported in Steps 1 and 2 are different.

It would be tidier for my argument in this post to have decided on a common unit of measure for the land, wheat, seed and plow.  That is done in the case in order to produce financial statements.  But none of that is necessary to make my point — which is that the fundamental flaw in GAAP is that it has a strong tendency to put Step 3 before Steps 1 and 2. To illustrate the consequences of putting the plow before the ox as it were, here are a few more sentences I should like to add to Igor’s soliloquy:

“And finally, my Lord here (waving his arms in the air) is a deferred cost.  I hired Iliya, the Plowman to train my oldest daughter Ida how to plow; and for that I paid him two bushels of wheat.  I did all the plowing myself this year, but Ida will be taking over next year as I am retiring to Miami, in the New World.

You won’t be able to make bread from this deferred cost, nor sell it.  But since my CPA tells me that it wouldn’t be fair to count this expenditure against my performance this growing season, you have yourself this deferred cost (waving his hands in the air again) as an asset!”

Back to now.  Referred to as the asset/liability view, the FASB recognized in its original concepts statements that Step 3, as above, logically follows from Steps 1 and 2.  Assets and liabilities should be viewed as the primary elements of a accounting; hence, income is properly measured in terms of the changes in assets and liabilities.

But, just like Igor the serf, managers of the modern public companies look at net income as just one more thing to manage.  To the modern manager who has a personal stake in reported income, the asset/liability view just gets in the way of reporting the ‘right’ amount of income, whatever ‘right’ is.

To be fair, the FASB doesn’t always “account” by starting with Step 3, but it does it often enough to keep the plutocrats (or “constituents,” to use the FASB’s technical term) from storming the castle.  Here are three recent and very significant examples:

ASU 2014-09 — the FASB created new deferred costs related to customer acquisitions;

ASU 2016-02 — the amount of lease expense could determine the measurement of the right-of-use asset — instead of the other way around.

AS 2016-13 — The carrying amount of a loan is adjusted for the ‘appropriate’ amount of expense representing expected future defaults.

What’s the Big Deal?

It matters a lot that GAAP “accounting” is not accounting.   In The Reckoning, Jacob Soll’s perspective on accounting and the rise and fall of nations, he argues that throughout the centuries the power of nations depended on the discipline of producing a realistic view of what resources the government controls, and what it owes.  In our own recent history, if the FASB had hewed to its asset/liability view, banks would have been required to produce a real accounting instead of a distorted view that was technically in compliance with GAAP.  Much, if not all of the fallout of the S&L crisis of the late 1990’s or the Financial Crisis of 2008 could have been avoided.

But instead of accounting, we now have “accounting”— a hodgepodge of “generally accepted” (another weasel term) rules that have been cobbled together over the past 80 years.  They treat income as if it were a concept that might be intelligibly defined independent of changes in net assets.   Yet somehow the rules makers have avoided providing a definition of “income” that is independent from changes in assets and liabilities.

Because they can’t.

1 Comment

  1. Reply Rose Laudiato October 10, 2016

    Very enlightening post! Accounting terms can be quite confusing at times. Thanks for sharing this very interesting article with us.

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