A Thumbnail History of Financial Accounting’s Descent into Madness
An Honest Financial Accounting: Draft of Introduction to Preliminary Edition – Part I
Every report by independent auditors on the financial statements of US public companies must state that, in their opinion, said financial statements are “fairly presented” in accordance with “accounting principles generally accepted in the United States of America” – widely referred to as US GAAP.[1]
Is there even such a thing as generally accepted accounting principles? Not really.
Are the financial statements published by US public companies fairly presented? Not even close.
A Thumbnail History of Financial Accounting’s Descent into Madness
Perhaps there was a brief period of time — almost one hundred years ago — when “generally accepted” had a literal meaning in accounting. But, as politics dominated the development of US GAAP, the phrase lost all plain-language meaning. By 1992, the American Institute of Certified Public Accountants officially owned up to the fact that “US GAAP” as used in an auditor’s report had become a euphemism: nothing more than a “technical accounting term” to refer to thousands of pages of rules to be strictly obeyed by its members under any and all circumstances.[2]
The rules which today comprise US GAAP were initially set by two short-lived adjuncts of the AICPA. As might be expected from a trade association whose mission it is to promote the interests of its members, it conspired with the largest public corporations and their auditors – dubbed the Accounting Establishment by a congressional committee formed to investigate their behavior – to call the shots.[3] A prominent example of the havoc they would wreak still haunts all would-be accountants and business managers practically from the outset of their studies: to permit LIFO accounting for inventories (essentially a contrivance with no basis in reality) at any time, so long as the company had also elected that treatment for tax purposes. As another example, the accounting treatment of “goodwill” — a euphemism for an account balance that means nothing and is widely ignored —changes significantly about once a decade.
The FASB was established in 1973, to take over from the AICPA the responsibility for promulgating US GAAP, and purportedly, to be more independent. But, like the AICPA, it was beholden to the Accounting Establishment for the bulk of its financial support. It was difficult for everyone to keep a straight face for very long about the obvious conflict of interest being created: in return for their largesse, top donors would want to influence what the organization produces. To quote General Motors’ CEO at the time, Roger Smith, “You know, when we did this Wheat study [the Wheat Committee[4] recommended the establishment of the FASB], I ordered chicken salad.”[5]
But it must be said that others who didn’t ‘have a dog in the fight’ attempted to view the creation of the FASB as a significant opportunity for reform. One of the most thoughtful and eloquent proponents for a fundamental change in standard setting philosophy was Stanford professor William Beaver.
In an article published by the AICPA itself, Beaver’s message was essentially that the FASB should ‘keep it simple.’[6] His reasoning was based on one plain fact, and two foundational ideas. The fact, which is widely taken for granted, is that federal law has long required public companies to make their audited financial statements public. Consequently, financial statements were made a ‘free good’ to the investing public.
Of the foundational ideas, one was normative and the other theoretical. The normative principle is that, even though financial statements are free to the public, like any other good or service, production of financial reports should be subject to a cost/benefit test. The theoretical idea, which was relatively new and most critical to Beaver’s reasoning, is “market efficiency” — simply stated that publicly-available information from any and all sources is rapidly reflected in securities prices.
Empirical tests of the “efficient markets hypothesis” (EMH) were already abundant and supportive, including many studies concluding that the relationship between specific components of financial accounting information and stock prices were consistent with EMH. Most especially, a nearly universal finding was that stock prices were unaffected by announcements of accounting information if the same information had been obtained earlier from another source. There would be no marginal benefit to a financial accounting rule if it did nothing but produce information that an investor could have found elsewhere.
Consequently, Beaver recommended that the FASB cease the practice of its predecessors of engaging in protracted debates of alternative financial statement treatments (e.g., LIFO versus FIFO, or when/how to report goodwill) if there would be no effect on the timing and nature of publicly available information. To add another example of historic importance, a controversy over the income statement treatment of an investment tax credit,[7] which shadowed the FASB’s immediate predecessor over practically its entire existence, should have been a non-issue. Each alternative being considered provided equivalent information. It so happened that the failure by the AICPA’s Accounting Principles Board to find a solution to a problem that boiled down to nothing more than presentation of an ITC in a manner that would satisfy all of its stakeholders (principally the Securities and Exchange Commission versus corporate special interests) was the final blow that led to the establishment of the FASB.
We know with the benefit of hindsight that Beaver’s evidence-based recommendations were given very short shrift. The Accounting Establishment has kept the FASB on much the same course as its AICPA predecessors. Yet, it wasn’t for decades, until the 2008 Financial Crisis that FASB rulemaking captured the public’s attention and ire in any significant way: when dysfunctional accounting rules were exposed as the instruments of massive financial frauds. The Nobel laureate and long-time economics columnist of the New York Times Paul Krugman characterized the rude awakening thusly:
“So here’s what Mr. Summers [Secretary of the Treasury] — and, to be fair, just about everyone in a policy-making position at the time — believed in 1999: America has honest [emphasis supplied] corporate accounting; this lets investors make good decisions, and also forces management to behave responsibly; and the result is a stable, well-functioning financial system.
What percentage of all this turned out to be true? Zero.”[8]
This book will show that Krugman’s brutal assessment was, and 15 years later remains, accurate; and that there is nothing save the Accounting Establishment to thwart an honest financial accounting from public companies.
The public has a right to expect “honest” financial accounting from public companies. And, as Beaver clearly suggests, it shouldn’t be hard. Clearly, the FASB has been operating with a different agenda in mind, as may be best illustrated by two high-profile anecdotes: one being a cautionary tale of a prominent CEO with questionable accounting scruples; and the other of a courageous auditor in an international accounting firm just trying his best to be honest.
Jack Welch, CEO of General Electric Co.
Warren Buffet has referred to Jack Welch as “the Tiger Woods of management.” But in Welch’s best-selling memoir of his time as CEO of GE, he blithely blew the whistle on himself:
“The response of our business leaders to the [earnings] crisis was typical of the GE culture. [emphasis added] Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder [a recent acquisition] gap. Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise. Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people.”[9]
Essentially and with evident impunity, Welch oversaw a “culture” of earnings management at GE. His subordinates would fill their own accounting “cookie jars,” and as team players they were expected to share them around the organization. Though few have so frankly acknowledged the practice, the fact of the matter is that it is not uncommon for CEOs to consider financial statement manipulation an honorable management activity. Why is that?
Financial accounting has the potential to be part of an incentive structure for aligning the personal interests of C-suite executives with value creation for shareholders. But in the practice of corporate governance during a period of ever ballooning executive compensation — which has been as thoroughly documented as capital markets efficiency — there can be large gaps between “neutral” financial accounting and actual financial accounting. Supposedly, a manager’s temptations to manipulate published financial statements would be mediated by competent and independent board members, who take their fiduciary duties to shareholders more seriously than amicable relations with the CEO. Such a BOD would put in place measures to prevent executives from “gaming” accounting numbers solely to their personal benefit.
But boards of directors are frequently not nearly as effective as they could be. Just as frank as Welch was about his lack of respect for financial accounting, there is often little to no attempt by CEOs to hide the fact that board members serve at their pleasure. The notion of board members being “independent” of management is largely a myth.
Auditors are a potential backstop to weakness in corporate governance, but they also serve at the forbearance of the CEO. For example, at the time Jack Welch was the CEO of GE it had engaged the same “independent” auditing firm for more than 100 consecutive years. One could speculate as to how forcefully a partner-in-charge of the GE account would push back against the CEO’s accounting “estimates” and risk losing GE as a client for the firm.
Walter Schuetze, KPMG auditor and SEC Chief Accountant
As Walter Schuetze has described it, the major accounting firms have been part of the problem that financial accounting is not as good as it could be (not even close) on at least two fronts: aiding the likes of GM and GE in pressuring the FASB (and its predecessors) to promulgate manageable accounting standards; and performing lousy audits.
By way of background, the Securities and Exchange Commission has the legal authority to set and enforce accounting standards for public companies in the U.S. But as a matter of formal policy, it looks to the private sector (e.g., the FASB) to actually create the rules. The Chief Accountant is the principal adviser to the SEC on accounting matters. Schuetze left KPMG to become Chief Accountant in January 1992. Coincidentally, I also joined the SEC for a one-year appointment as Academic Accounting Fellow in August 1992. Two days before I was to show up for my first day at work, Schuetze gave a bombshell of a speech at an annual meeting of professors of accounting:
“The profession will not go to its clients and tell its clients that their balance sheets have to have realism in order to elicit unqualified opinions. Why not? Well, that could involve being tough with a client. …
The profession, again with an exception or two, will not go to the FASB and support realism in financial accounting and reporting. … Why is that? Is it because the profession has become so beholden to its clients that it will not speak to them about realism and relevance and credibility in financial accounting and reporting? …
I think that instead of thinking simply of its clients and itself, the profession needs to give some thought to the public that it serves, to the investors and creditors and employees who put up their money and their labor to make investments in the profession’s clients.
I suggest that the profession go to the FASB and ask it to issue accounting standards that produce more relevant, more understandable, more useful, and more credible financial statements than what we now have.”[10] [emphasis added]
For added context, it is helpful to know that Schuetze’s criticisms were leveled at the accounting profession in the wake of an earlier financial crisis fueled by lax accounting standards and compliant auditors: the costly government bailouts of savings and loan institutions:
“I’ve got scars on my back from when I … told my clients that they could not manage their earnings. My clients went to the Board of Directors of the firm and said ‘get Walter off my account—just get him off.’
Earnings management was rampant … it was like dirt; it was everywhere and I think it’s still everywhere because the accounting standards that we have today still allow management to have control of the numbers.”[11]
While at the SEC, I learned from my colleagues that some of those “scars” Schuetze referred to were courtesy of his fellow partners at KPMG. They might have respected him for his technical expertise, but not all wanted to hear what he had to say. KPMG was a market leader in auditing the S&L industry. It lost a lot of business because Schuetze insisted that they could not bless inflated revenues and loan balances. He became a pariah to many disgruntled partners, but he ended up being their prophet and savior. His hard line against dishonest accounting spared KPMG from the litigation losses that cost dearly every other major accounting firm.
Schuetze’s stance was also prophetic of accounting’s responsibility for later crises. There is no doubt that dishonest accounting was at the root of the wave of gigantic financial frauds around the turn of the century (e.g., Enron, Worldcom). There is no doubt that dishonest accounting pervaded the financial statements of regulated financial institutions, leading up to the Financial Crisis of 2008. Yet, the FASB’s response has been tepid at best.
Former FASB chair Robert Herz, like many past and present board members, became ‘qualified’ for FASB membership by working in the national office of an international auditing firms. While there, he was actively involved in engineering ‘creative accounting’ solutions for his firm’s clients. Even though Herz, while at the FASB, was among the most proactive of board members for the public interest, he remains reluctant to find much fault with the institution. In his memoir of his time as chair of the FASB he recounts how he repeatedly claimed that financial reporting did not “cause” the financial crisis — yet he grudgingly admitted that “… it did reveal a number of areas requiring improvements in standards and overall transparency.”[12]
But, as to those needed “improvements,” as might have been expected, nothing much has changed since 2008. Projects to improve the accounting for loans, leases, revenues and the general incomprehensibility of disclosures were each debated ad nauseum for more than 10 years, (fun fact: tenure on the FASB is limited 10 years) and very little was accomplished. In the words of David Mosso, a former FASB member:
“Eighty years of tinkering [with US GAAP] has not done the job. … In the case of business failures, the company’s auditors are usually the scapegoats, but I suspect that accounting standards are often more, or at least equally, at fault.”[13]
It is no coincidence that accounting rules have become bloated and skewed toward the interests of the Accounting Establishment while at the same time the role of financial accounting in corporate governance has, for better or worse, also become more prominent. The fact of the matter is that corporate management wants to be able to control its own scorecard. Imagine a college professor permitting the students to grade responses on their own exams. If the FASB has accomplished anything in the past 50 years, it has been to continue to allow management to do much the same thing.
In summary, fifty years after Beaver’s recommendations to the FASB, we should now have a keener awareness of how much business managers care about the financial statements of their companies; and how little regard they have for the “independent” auditors who might question their judgment. On multiple occasions, their collective efforts at accounting manipulation have done great damage to the US economy. Investors in an efficient market may be indifferent about the manner in which they receive information, but managers are not indifferent about accounting rules versus other forms of disclosure. Krugman was right: “honest” is the furthest things from their minds.
An Economic Basis for Honest Financial Accounting
It so happens that around the time Beaver published his recommendations for the FASB, Harvard philosophy professor John Rawls took on the larger question – in which financial accounting surely plays a part – of fairness in politics and economics. His first major book, A Theory of Justice,[14] is regarded by many as the most influential work of political philosophy of the 20th century.[15] He was awarded the National Humanities Medal in 1999 for “his argument that a society in which the most fortunate help the least fortunate is not only a moral society but a logical one.”[16]
Rawls’ philosophy is derived from a novel thought experiment: How would “social justice” be formulated by a convention of economically “rational” individuals who otherwise knew nothing about themselves? From behind this “veil of ignorance,” these individuals wouldn’t, among every other thing, know the color of their own skin, their innate capabilities, or to whom and where they were born.
Very broadly speaking, Rawls derives from his thought experiment standards of moral behavior that should be presumed to be just, given that they were derived by society’s members before they knew how the standards would affect them individually. Of particular relevance, he reasoned that since the convention members cannot know whether they are on the giving or receiving end of any particular action, they should agree that anything less than honesty is a prerequisite to just outcomes.
To illustrate from the tale of Jack Welch, let’s consider whether individuals from behind a veil of ignorance would agree that Welch should be allowed to manipulate the earnings of General Electric. Even though they can be proponents of their own personal interests with impunity, they will rationally expect that earnings management is highly unlikely to add to their own well-being. For a very few would attain the enviable position of CEO of a public company. Thus, presuming that earnings management does not otherwise contribute to social good, the convention must conclude that permitting earnings management puts practically everyone – except for the Jack Welch’s of the world – on the short end of the stick.
This book will show, among other things, that a simple honesty constraint imposed on financial accounting rules would produce a vast improvement over extant US GAAP. For there are a great many examples of US GAAP that fall short of an honesty standard in a great many ways. Notwithstanding, not all of US GAAP violates an honesty constraint. There are also many examples where a choice could be made between two or more honest accounting treatments. For those, this book is intended to be an example of a good-faith attempt to weight those relative costs and benefits from behind a veil of ignorance.
Accordingly, this preliminary first edition is the product of an iterative process to develop An Honest Financial Accounting (AHFA). Initial chapter drafts were exposed for comment in my blog The Accounting Onion. Subject to constraints on civility and relevance, all readers’ comments made through the blog have been considered and published. A ‘final’ first edition will follow that adds extensive examples of the application of AHFA, and a tabular presentation of the differences and similarities between AHFA and US GAAP.
Next section begins here.
[1] At present, the majority of U.S. public companies domiciled outside of the U.S. (so-called “foreign private issuers) furnish financial statements prepared in accordance with International Financial Report Standards. This book primarily refers to requirements of US GAAP, which will be regarded as substantially the same as IFRS, except where noted.
[2] Insert reference to SAS 69
[3] The Accounting Establishment: A Staff Study, Subcommittee on Reports, Accounting and Management of the Committee on Government Operations, United States Senate (“Metcalf Committee”), 1976.
[4] Insert reference to Wheat Committee report.
[5] [As told by Donald Kirk, one of the original members of the FASB.]
[6] William H. Beaver, “What Should be the Objectives of the FASB?”, Journal of Accountancy, August 1973, pp. 49 – 56.
[7] [xxxinsert explanation of investment tax credit controversy here.xxxx The saga of the investment tax credit is somewhat of an obscure anecdote for today’s accountants and users. But the story needs to be told as it was an inflection point in the history of accounting standards setting.]
[8] Xxx”The Big Zero” Reference here.
[9] [Welch, 2003, p. 225]
[10] Insert reference to speech at AAA conference.
[11] Insert reference to SEC Historical Society interview.
[12] Insert Herz book, p. 145.
[13] Mosso, David, Early Warning and Quick Response: Accounting in the Twenty-First Century, 78.
[14] John Rawles, A Theory of Justice, Harvard University Press, 1971 (revised 1999).
[16] Insert footnote. Weinstein, Michael M. (December 1, 2002). “The Nation; Bringing Logic To Bear on Liberal Dogma”. The New York Times. ISSN 0362-4331. Retrieved September 7, 2021 [emphasis supplied]