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Financial Accounting versus Financial Reporting – Part 2

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

Chapter Title: Financial Accounting versus Financial Reporting

Draft Table of Contents

“Financial” Accounting

In the Securities Exchange Act of 1934, Congress gave the new Securities and Exchange Commission broad powers to regulate the disclosures of public companies, including the rules of accounting. But sensing very soon that accounting rules would become a time-consuming political football, the SEC punted accounting standards setting to the private sector.  Today, the financial reporting rules issued by the SEC amount to a few hundred pages.  For historical reasons that are not particularly germane to this discussion, a few of the SEC’s rules are financial accounting rules.[3]  That said, no one at time could have anticipated that the private sector would produce 8,000 pages of “authoritative guidance” – many more pages than even the Internal Revenue Code.

Beyond authoritative guidance, the FASB has published numerous attempts at articulating a comprehensive conceptual framework to underpin its rulemaking.  It has produced eight extensive “statements of financial accounting concepts.”[4] Yet, despite having been establish to be a financial accounting standards board, what “financial accounting” is regarded to be by the FASB has never been addressed.

The FASB’s concepts statements don’t refer to “financial accounting.” Not even once.  Instead, the FASB refers to itself as the promulgator of “general purpose financial reporting” standards.  It first used the term in 19xx, but it doesn’t seem to have gained much traction outside of the Accounting Establishment: since then, scores of textbooks on the application of US GAAP have been published with “financial accounting” in their title; tellingly, not a single one with “general purpose financial reporting.”

The difference between financial accounting and general purpose financial reporting is more than semantics.  In one respect, there is a cost of redundancy that should be considered. How, for example, does it serve the public interest to disclose information about a potential liability for ongoing litigation in the financial statements, and to repeat much the same disclosures in another portion of the same SEC filing (e.g., risk factors, legal proceedings, MD&A)? [5]

In an even more cynical respect, the failure to directly address the meaning of “financial accounting” is part of the Accounting Establishment’s conspiracy to serve up “chicken salad”[citation omitted) instead of honest financial accounting.  Referring again to our fable, its particular facts and circumstances are intended to produce several different accounting treatments from the students; hence, it will provoke a discussion in class of which of the several possible accounting treatments is most appropriate. Although several different treatments might be reasonable, even a newcomer to the discipline of accounting would see that the more specific one can be about users, the more straightforward it becomes to determine the most appropriate accounting treatment.

By definition, “general purpose financial statements” address the needs of no one user in particular.  To be fair, the FASB has stated that it should choose among accounting treatments by anticipating the predominant usage: through (1) identifying the “primary users” of said general purpose financial statements; and (2) determining which treatment will “… meet the needs of the maximum number [emphasis supplied]  of primary users.”[6]  Notwithstanding, the FASB has given no indication as to how it would – or even could – do what it says it should do.  Does one individual trader for one’s own small account, who may have only a high-level knowledge of the 8,000 pages of U.S. GAAP, count the same as a team of sophisticated analysts working for a large investment bank?  If the actual process that the FASB employed for weighing the pros and cons of accounting alternatives were that straightforward, then every major project listed above could have been resolved quickly, instead of each taking more than a decade.

In short, the stratagem of replacing “financial accounting” with the made-up concept of “general purpose financial reporting” has helped the FASB to broaden its job description.  Practically anything on which a number can be pinned, and which might provide some small clue about a company’s future, is according to the FASB, fair game for making a new rule.   It permits, as suggested by the fable addendum, recognition of deferred costs as assets so long as they might in some roundabout fashion be informative to someone for something.

It is also important to note that in order for the FASB to broadly defines its objectives through “general purpose financial reporting,” it fails to recognize one principal reason for why Congress chose to regulate finance statements in the Exchange Act: for their value as a tool of effective corporate governance, e.g., to contract with directors and executives, and to hold them accountable for their past actions.  Accordingly, the Exchange Act doesn’t simply require companies to file their financial statements with the Commission.  It also requires – in a section known as the proxy requirements – that current financial statements are delivered directly to shareholders prior to their meeting to elect directors, and for other corporate governance matters.[7]

The proxy requirements were far from an afterthought by Congress.   It is broadly understood that financial accounting gained in importance over time as ownership/management of larger enterprises evolved to become separate activities. When shareholders are not directly involved in running a company, they take steps to bind management contractually to act as stewards of their investment.  The FASB’s concept statements make no mention of the fact that financial statements can also be the principal source of information to ownership for assessing how well management is acting as stewards of their investment.

The implications of stewardship on the formulation of a basis of accounting is much more straightforward than the vague notion of “general purpose financial reporting.” Stewardship motivates a much clearer picture of assets and liabilities — and changes thereto — than U.S. GAAP.  That said, however, the question whether the accounting rules applicable to public companies should be constructed to be more usefulf for “valuation/prediction” or “stewardship” is a valid one.

The position taken in this book for developing AHFA is that accounting is appropriately limited to reporting information about a clearly-defined subset of economic assets and obligations.  It can provide valuable information for a broad spectrum of uses, but it is most directly related to the vital task of performance evaluation: of the economic entity itself and by extension, its managers.

AHFA will be stewardship focused, yet that focus should not result in lower valuation/prediction value.  In addition to simply providing a more honest financial accounting by a public company, there are a host of SEC regulations that, taken in combination with AHFA financial statements, can provide even better information to current and potential investors.  AHFA will be a significant improvement over US GAAP in every major respect: fewer detailed requirements, more detailed quantitative financial information,  less costly to produce, and more auditable.

AHFA will also curtail, if not practically eliminate, a CEOs ability to manage reported earnings. But even setting that benefit aside, it should be said that the evidence that financial statements are reliable sources of information for valuing a public company has never been strong.  And it is even weakening.  Baruch Lev and Feng Gu of New York University find that the correlation between reporting earnings and changes in stock market prices has been deminishing over time; i.e., not increasing as the FASB keeps adding to those 8,000 pages of “authoritative guidance.”[8]

The collective effect of US GAAP on all stakeholders in US capital markets is profound, even in good times.  But more bad times are inevitable.  It remains to be seen whether financial accounting will help or make matters worse.  MacArthur Fellow and economic historian Jacob Soll argues that the power and economoic welfare of nations throughout history has depended on a culture of using accounting to produce a realistic view of what resources an enterprise controls, and what it owes.[9]

If so, and if critical financial institutions can continue to hide risk and overstate profitability by mere technical compliance with the FASB’s version of “general purpose financial accounting,” what will be the outcome of the next financial crisis?

A Statement of AHFA

“Financial accounting” is an information service primarily for assisting shareholders of public companies in evaluating the performance of an entity, and by extension its managers, for a given period of time. Accordingly, it is concerned with the production of financial statements and accompanying notes that, at an appropriate level of detail, report the following: (1) a subset of the economic assets and obligations of an entity as of the beginning of the period; (2) comparable information as of the end of the period; and (3) fully-reconciled information about the flows of those assets and liabilities that occurred during the period.

Draft Table of Contents

[3] Principally, SEC Regulation S-X. (insert brief description of the accounting rules.)

[4] Refer to the current status of the CONs.

[5] Insert references to S-K items and briefly describe what they do.

[6] Insert reference to para. OB8 of CON 8.

[7] Insert reference to SEC regulations:  Rule 14a-3?

[8] Insert reference to The End of Accounting and the Path Forward for Investors.

[9] Insert reference to The Reckoning

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