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Financial Accounting versus Financial Reporting – Part 1

An Honest Financial Accounting: Draft of Chapter 1 – Part I

Chapter Title: Financial Accounting versus Financial Reporting

Draft Table of Contents

In this chapter we consider where – within the broader activity of “financial reporting” –“financial accounting” should begin and end.


A popular way to begin discussing the basic ideas of “accounting” is with a fictionalized case – actually, more of a fable than a business case – one variety of which was published in 1974.[1] A feudal lord engaged two of his serfs to grow wheat on separate plots of his land for a season.  A key excerpt:

“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 — for which necessary steps are as follows:

Step 1:  State what the entity started with;

Step 2: State what the entity ended up with;  

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

Unfortunately – for two no-good reasons – US GAAP doesn’t match such a straightforward characterization of accounting: it often puts Step 3 before Step 2; and,often while doing so, it ends up presenting fiction as fact.  To illustrate, let’s consider this brief addendum to the fable:

“I also hired Iliya, our village’s master plowperson, to teach my daughter Ida how to plow. For that I paid him with two bushels of your 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.   My CPA’s opinion is that US GAAP calls for presenting the two bushels I paid Iliya should be reported in compliance with U.S. GAAP as an asset on my balance sheet – to be captioned ‘deferred training costs.’ I do realize that my Lord won’t ever be able to make his own bread from the bushels I paid Iliya, or to sell them. But my CPA explained to me that it also wouldn’t be fair to count the cost of training Ida for next season against this year’s income.”

The FASB actually did, in its early days, let the world know that Step 3 should follow 1 and 2.   It wrote that assets and liabilities should be viewed as primary elements in accounting; and accordingly that presenting deferred costs per se as assets would be a fiction.  As even such a simple fable can show, “net income” for a business enterprise is impossible to cleanly define — despite many attempts to do so —except by its derivation from changes in assets and liabilities.[2]

But the FASB’s concept statements have never been official rules – like one requiring capitalizaiton of certain training costs. [citation omitted]  When it came to writing actual “standards,” the principle that honest reporting of assets and liabilities should be given primacy over measuring net income was disregarded whenever it was inconvenient.  Which was very often.

Here are just a few of the significant examples from US GAAP that demonstrate how pervasive the problem of putting Step 3 before 1 and 2 has become:

  • “Goodwill” is rarely goodwill (see Chapter xx);
  • “Translation” of the assets in foreign operations is random number generation (see Chapter xx);
  • “Asset impairment” has little or nothing to do with current changes to the value of an asset (see Chapter xx);
  • Revenue is recognized when a “performance obligation” is satisfied, which may not necessarily correspond to the receipt of an asset or satisfaction of a liability (see Chapter xx);
  • A loan or receivable is measured by how future defaults are expected to affect income, as opposed to measuring the loan at its economic value. (see Chapter xx)

If US GAAP were an honest accounting, none of the above would be permitted.  National and global financial crises could have been averted, and CEO pay could be more commensurate with performance.

Draft Table of Contents

Next post is here.


[1] Insert footnote to Accounting Review version.

[2] Insert CON reference to asset/liability view.

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