GAAP and the Federal Budget Deficit
The accounting topic of the season is income taxes. But, as the nation contemplates what Congress could end up passing, I want to talk about how one under-the-radar amendment to financial accounting standards has been quietly adding to the federal budget deficit for two decades and counting.
The amendment I speak of came into existence as EITF 96-15, Accounting for the Effects of Changes in Foreign Currency Exchange Rates on Foreign-Currency-Denominated Available-for-Sale Debt Securities. One of the touchstone issues of the current tax debates (such as they are) is that U.S. companies with foreign subsidiaries are reluctant to repatriate earnings from their foreign operations if there is a U.S. tax to be paid. The raison d’être of this EITF is nothing more or less than to give those companies one less reason to repatriate those infamous foreign earnings; to just let the cash pile up overseas and deprive the U.S. government of taxes owed.
EITF 96-5 helps companies figure out how best to park their money outside of the U.S. A tempting alternative is to invest it in marketable securities issued by other companies based in the U.S. That way, at least, the money is invested in dollars, which limits the economic — as opposed to accounting — exposure to currency fluctuations. However, as I’m about to explain, without the provisions of EITF 96-5, managers obsessed with their reported earnings might shy away from that choice, even if it is the best thing to do from an economic standpoint.
How the Accounting Loophole Works
FAS 52 (codified as ASC 830) is overall very generous to issuers, but it is relatively demanding in the area of “foreign currency transactions,” which, simply stated, are monetary assets and liabilities — i.e., cash, receivables and payables — denominated in a currency other than the foreign entity’s “functional currency.” Normally, the effect of translating assets and liabilities from the subsidiary’s functional currency to dollars gets thrown into other compressive income (OCI) without affecting net income. An exception is that the translation of “foreign currency transactions” must be reflected in net income. I have written about this in a previous post, here. Note also that, even though the monetary versus non-monetary distinction can significantly affect the accounting for foreign operations, the FASB has provided no official definitions. That turns out to be very helpful to the EITF as it works its magic for issuers.
The formal question addressed in EITF 96-15 is whether a marketable debt security designated as “available-for-sale” is a foreign currency transaction. Notice that the EITF is not questioning whether marketable debt securities designated as “trading,” or as “held-to-maturity” are foreign currency transactions – but only those debt securities that are arbitrarily and capriciously designated by management to be AFS. Knowing only that should tell you that the fix was in before the first word of “debate” among the cheerleaders for issuer interests had been uttered.
What sounds like a serious question is but an absurdity. An AFS marketable debt security is still at bottom a receivable. Perhaps, marketability may be a consideration in determining the appropriate accounting treatment, but some arbitrary AFS designation doesn’t change its basic nature as a receivable. FAS 52 is crystal clear as to the treatment of a receivable: it’s a foreign currency transaction.
Yet, the EITF found a way to arrive at the opposite conclusion. By an alchemy that can only be fully appreciated by those ordained as accounting policy makers, the EITF stated that in their view, a marketable debt security arbitrarily designated as AFS, could not be a “monetary item.” (It’s like the old accounting joke: two plus two can be anything you want it to be.) By that twisted logic, an AFS marketable debt security, unlike every other kind of receivable, is not a foreign currency transaction.
Eureka! The formula for turning copper into gold! Waive the AFS magic wand over any marketable receivable, and presto change-o, you no longer have to worry about income statement exposure.
Back to the proposed income tax legislation of the present, much of the debate concerns its effect on the federal budget deficit. I want Congress and the public to know that if EITF 96-15 were rescinded, it would unambiguously work to lower it: managers would be more inclined to repatriate the cash if they couldn’t reduce the accounting exposure to foreign exchange movements while it is overseas. This will sound like heresy to supporters of the FASB and EITF, but I would be happy to see Congress enact a law that does just that.