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Saturday, May 28, 2022

I never thought I would say: ‘Let the SEC set accounting standards’

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If you remember “The Spirit of Accounting,” perhaps you’re as surprised as I am to see it published again. If you don’t recall, this column appeared in almost every Accounting Today issue from 1996 to 2016, consistently challenging leaders and practitioners to improve our collective contributions to our society and economy. 

Even more stunning to me is the topic I have written about. 

After all, for more than 50 years, I’ve fervently defended the private standard-setting system that’s been around since the 1930s. Ironically, I don’t think it has survived because it works. Rather, it’s still in place because the Securities and Exchange Commission has let accountants do the heavy lifting while it has held the nominal authority to override the system’s output. 

I first gained a key insight 35 years ago when I heard then-SEC Chief Accountant Clarence Sampson forthrightly explain his limits to a visiting counterpart from another country by saying: “Yes, I do have the authority to overturn a FASB standard, but I don’t have the power to do it.” (Disclosure: I was on his staff at that time.)

The way it has been

Over the last several years, I have pursued many other interests, but recent events and non-events have encouraged me to share these thoughts about almost all accountants (including auditors and professors):

  • They only know how to gather data about events and conditions.
  • They generally do not care (or even know) what constitutes useful information for the capital markets.
  • They have maintained control over standards through self-regulation with little, if any, effective accountability to the public.
  • Therefore, they continue to gather the same kinds of data they’ve gathered, in some cases, for a century or two.

The problem is that these data are just not fully useful for rational decisions. 
What hasn’t changed

In contrast to other professionals (doctors, lawyers, managers, scientists, plumbers, etc.), today’s accountants are still doing basically what I first learned to do in 1965 as a brand-new accounting major. Here are seven samples of evidence for my proposition:

  • Financial statements are filled with cost-based numbers derived from assumptions and predictions, instead of current observations of real conditions. 
  • Systematic depreciation and amortization continue in use, even when the assets are appreciating. (Note: This practice became acceptable in the 1830s.)
  • Changes in assets’ market values are recognized only when they decline.
  • Managers choose among multiple contradictory inventory flow methods to help them report what they want to report.
  • Managers still present baffling indirect cash flow statements instead of straightforward descriptions of cash receipts and disbursements.
  • All accountants disregard the irrationality of dollar-based measures that aren’t adjusted for inflation. (Yes, this issue is coming back … .)
  • Despite modern technology, accountants claim they can do no better than the laughably obsolete quarterly reporting frequency that became mandatory for many companies 90 years ago and for all public companies 60 years ago.

Other deficiencies include deliberately biased and incomplete reporting about defined-benefit pension assets and liabilities, intangible assets, stock-based compensation, long-term leases, and earnings per share.
Surely, this evidence is sufficient to prove that GAAP-based statements fail to supply useful information because they are, and always have been, full of data that accountants know how to gather. 

Although users who are oblivious to GAAP’s inadequacies might seem to be the victims, the real losers are all who live and work in our economy, which is rendered less efficient by its poorly informed capital markets.

Is now the time? 

The Financial Accounting Standards Board was purportedly created 49 years ago to fix these shortcomings. It started toward real progress with its conceptual framework that was supposed to identify what information is useful. (More disclosure: I was on FASB’s team for that project.)

Despite the massive effort invested in the framework, FASB has essentially ignored its own guidance, not because it isn’t sound but because board members don’t want to upset accountants and managers by creating substantive change.

The board’s failure to achieve the desired results compels me to now ask whether it would be better to take the standard-setting process out of accountants’ hands and put it where progress would be more likely.

Thinking the unthinkable?

I never thought I would say, “Perhaps it’s time to let the SEC take full control over the standard-setting process.” 

Like most of you, I’ve resisted that approach because the SEC has no jurisdiction over private companies, and because the government generally cannot do this sort of thing very well. However, my unfulfilled hope that accountants will succeed on their own now leads me to consider the possibility that I may need to start thinking about thinking the unthinkable. 

Two recent developments have pushed me in that direction.

The arcane and the mundane

The first is that FASB has acted like an especially slow-moving version of the Emerging Issues Task Force for the last five years or more. The bulk of its pronouncements have simplified fine points of existing standards and otherwise tried to make compliance easier for accountants. 

Whether the board’s members and staff are unaware of GAAP’s many weaknesses or are afraid of controversy, they’re just not getting the bigger job done. Their hyper-focus on the arcane and the mundane makes no sense when they should be resolving so many other more significant issues.

The list below illustrates FASB’s approach by listing as sample of its recent arcane and mundane output:

  • Troubled Debt Restructurings and Vintage Disclosures;
  • Fair Value Hedging — Portfolio Layer Method;
  • Disclosures by Business Entities about Government Assistance;
  • Discount Rate for Lessees that Are Not Public Business Entities;
  • Determining the Current Price of an Underlying Share for Equity-Classified Share-Based Awards;
  • Certain Leases with Variable Lease Payments;
  • Accounting Alternative for Evaluating Triggering Events; and,
  • Revenue from Contracts with Customers (Subtopic 952-606): Practical Expedient.

Is the SEC chair watching?

The second development is SEC Chair Gary Gensler’s decision to blow up and rebuild the Public Company Accounting Oversight Board. 

His actions in that arena signal that he also may be inclined to get actively involved in setting financial reporting standards. 

If he were to similarly conclude that FASB wasn’t protecting the public interest, perhaps he would find ways to encourage the board to improve its process and results. 

What needs fixing?

A good place for Gensler to start would involve enhancing the regulatory horsepower the SEC applies to the standard-setting process. 

Despite being responsible for a long list of oversight and advisory roles, the Office of the Chief Accountant has only 40 staff members, or less than 1% of the commission’s 4,200 employees. Without more people, resources, authority and, yes, power, I am sure this team is not sufficiently equipped to overcome the accounting establishment’s political control that has surely kept FASB from achieving more reform. 

But I have an idea.

A new division?

I believe the commission could achieve a great deal more if it replaced the OCA with a much larger Division of Financial Reporting Policy and Implementation that would be empowered to get more genuinely useful information into financial statements. 

I’m confident this division would be more effective if, unlike the OCA and FASB, it were to be staffed with only a relatively few accountants among many more experts in economics, finance, and decision science who would see through accountants’ traditional flimsy excuses and apply their own analytical paradigms to propose innovative practices. 

Further, I’m convinced this division should have an Office of Financial Reporting Research to do what FASB tried but couldn’t finish with its conceptual framework. Specifically, this office could conduct top-down normative research to determine what useful information ought to be reported, instead of merely documenting what is being reported. 

There could also be an Office of Financial Reporting Practice that would apply that research to develop pathways for improving the contents of financial reports and increasing their frequency. Whether this office could displace FASB would depend on the board’s willingness to create new standards consistent with the research findings.

Another crucial addition would be an Office of Financial Reporting Education that could help investors, managers, accountants and auditors understand how new and different information would be more useful to both the capital markets and themselves. For example, managers could learn that their capital costs will fall and their share values will soar when they reduce the markets’ uncertainty and risk by providing more timely and otherwise enriched financial reports. In the same vein, auditors could learn that their opinions would be much more valuable if they audited truly useful statements instead of today’s highly compromised versions. (As things stand now, an audit’s main benefit for users is warning them that the auditors have carefully verified that the GAAP-compliant reports contain irrelevant, incomplete, out-of-date and otherwise not useful data.) 

Food for thought?

I’ll close by asking and answering four questions:

  • Should these changes happen? Perhaps. 
  • Could they happen? I’ll simply say it’s uncertain, but anyone would be unwise to deny the possibility. 
  • Would financial reporting be improved? I can’t imagine an outcome other than vast progress compared with what FASB is likely to accomplish at its current pace.
  • Would the SEC produce more efficient capital markets and a stronger economy? Of course, that depends on what actually changes. (For the record, I’m convinced the fastest route to more market efficiency would see managers voluntarily reporting all kinds of useful non-GAAP information more often than quarterly.)

As unthinkable as this SEC-based solution might seem, I don’t see how anybody could legitimately object to trying a radically different approach after they objectively assess how little progress accountants have achieved over the last 90 years, especially during FASB’s 49 years. 
On the other hand

Perhaps these reforms wouldn’t be needed if FASB would just step up to its mission and transform financial reporting to make it more useful instead of merely trying to make life easier for accountants. 

I know which strategy I prefer. Do you?

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