Will Global Accounting Rules Help or Hinder Accuracy?Published: November 15, 2007 in Knowledge@Emory
In July 2007, the Financial Accounting Standards Board (FASB) issued a statement clarifying its commitment “to the convergence of high-quality accounting standards worldwide, as demonstrated by its partnership with the [International Financial Accounting Standards Board (IASB)] to improve financial statement presentation.”
The move to unify U.S. and international accounting standards—spurred by an increasingly global economy and by Enron and other accounting scandals—has been hailed by many observers. But some experts, including faculty at Emory University’s Goizueta Business School, say the move toward worldwide accounting standards won’t necessarily be a panacea for accounting shenanigans and may even carry threats of its own.
In July 2006, as part of a goal of integrating U.S. and European Accounting Standards, the FASB proposed the Conceptual Framework for Financial Reporting. The FASB expects the result to be a single document that is accepted by both the FASB and the IASB; one that will replace the FASB’s series of Conceptual Statements and the IASB’s own Framework for the Preparation and Presentation of Financial Statements, which describes the basic concepts by which financial statements are prepared.
Based on the current proposals, it appears as though the final document will shift emphasis to the balance sheet from the traditional accounting emphasis on the income statement, according to George Benston, a professor of accounting, economics, and finance at Emory University and its Goizueta Business School. He is the lead author of the response of the American Accounting Association’s Financial Accounting Standards Committee to the FASB’s proposal. The response was published in the June issue of Accounting Horizons.
“We [Benston and coauthors Douglas R. Carmichael; Joel S. Demski; Bala G. Dharan; Karim Jamal; Robert Laux; Shiva Rajgopal; and George Vrana] believe this approach as currently proposed is fundamentally flawed and should not be adopted in its present form,” he says. “Our concern about the Preliminary Conceptual Framework begins with the fact that there is too much focus on an investment role of accounting, while neglecting the more important stewardship role. Further, the new framework relies on fair values [such as ‘‘mark-to-model’’ and present value-determined numbers] that are rarely trustworthy because they are not grounded on actual relevant market transactions.”
Benston also notes that while he “concurs with FASB’s desire for neutral accounting numbers,” he and his coauthors believe that management “has a bias to increase reported results, requiring conservative standards to produce neutral accounting numbers.”
He suggests that FASB’s standards should not be based only on a “conceptual framework,” calling it “too broad for determining a specific standard. Instead, a more rigorous field-performance-testing model is needed. We recommend giving market forces a greater role in setting accounting standards by offering companies more flexibility in their reporting choices.”
For example, some companies might want to report their regularly traded and readily verified securities at their market values, whether held to maturity or not, Benston explains. “Others might want to report hedges more broadly and, as a result, not have changes in the value of derivatives reported in net income until the hedged gain or loss is reported. As long as there is disclosure, acceptance or rejection by market participants can sort out which procedure is more useful.”
Peter Demerjian, an assistant accounting professor at Goizueta, also has some concerns over the proposed changes.
“Historically, the ‘income statement’ approach of Generally Accepted Accounting Principles, or GAAP, has focused on measuring the changes in operations of a firm, while the ‘balance sheet’ approach focuses on accumulated values over time,” says Demerjian. “Generally speaking, investors are more interested in the periodic income of the firm, while other stakeholders (for example, banks lending money to the firm) are more interested in the accumulated balance. On average, I think the balance sheet approach will reduce the usefulness of financial reporting for investors, because most investors are interested in the ongoing operations of the firms in which they invest.”
He adds that some academic research, such as Hayn (1995) and Burgstahler and Dichev (1997), show that the income statement is useful for investors when the firm is financially strong, and the balance sheet is useful when the firm is financially weak and at high risk for bankruptcy or default.
Addressing the issue of the FASB’s fair value accounting approach, which at present allows for the upward revaluation of financial assets based on estimates of the prices that independent buyers might pay for those assets, Benston notes that these amounts are easier for managers to manipulate than prices actually paid for assets and may be very difficult for auditors to verify.
“To begin with, managers are and should be presumed to know more than auditors when it comes to identifying potential buyers of assets and/or estimating future cash flows and determining appropriate discount rates,” he says. “So unless they are clearly out of line, how can auditors question these and other fair-value assumptions and estimates? Further, how is an auditor going to determine that a manager’s estimates of fair values were deliberately over- or under-stated?”
Demerjian adds that “the long-standing argument in favor of historic cost accounting is that it is reliable, and not generally subject to manipulation.”
“A move towards fair value certainly provides additional means for impropriety,” he says. “Consider, for example, a firm with a machine that was purchased for $5 million. Under current GAAP rules, it would be reported on the balance sheet at $5 million (less depreciation), while under fair value accounting, increases in the value of the asset could be recognized on the income statement. The concern is that management would hijack this process for its own gain.”
Motivation could come from a variety of issues, including concerns that the company’s results in a particular period were going to miss consensus analyst's forecast by a certain amount, say $100,000.
“Management could try to re-estimate the value of the machine from its $5 million historic, and readily ascertainable, purchase price, to a newly computed $5.2 million market value,” Demerjian postulates. “The gain, which would be recognized on the income statement, would mean the company went from missing analysts’ expectations to beating them on the strength of the upward valuation.”
According to William Tayler, an assistant accounting professor at Goizueta, the convergence of GAAP and IFRS [International Financial Reporting Standards] “is about making capital markets more efficient by eliminating the need to reconcile between reporting standards.”
He notes that convergence is also about improving standards, “since neither the FASB nor the IASB want to compromise the quality of the standards they currently have in place in the name of convergence.”
But he cautions that improved standards provide no guarantee against accounting scandals.
“Managers will continue to respond to their incentives,” Tayler says. “If markets focus on short-term achievements like beating quarterly earnings forecasts, managers will focus on those targets, sometimes attaining their goals via ambiguities or subjectivity in accounting standards. While improving standards via convergence will very likely change the way unscrupulous managers achieve their goals, it is by no means a cure-all for accounting debacles.”
In fact, the way that FASB appears to be ready to adopt the IASB’s focus on cash flow, instead of income or loss, as a measurement of a company’s performance, could pave the way for even more malfeasance, contend Benston and Demerjian.
“The whole point of accrual accounting is to remove the effects of volatile cash flows,” says Demerjian. “The key point is that accrual account recognizes revenue and expenses in the period they occur, regardless of whether cash changes hands. In this sense, accrual accounting better captures the economic substance of transactions, which results in financial reporting reflecting the actual financial condition of the firm.”
Benston also notes that cash flows are not “largely free from measurement and related issues.” Instead, he says, they can be affected by random fluctuations in receipts and payments, while accrual accounting is designed to reduce these fluctuations.
“If managers wish to distort results, they can boost cash inflows by simply delaying the purchase of supplies, or of interest-bearing, short-term securities,” he warns. “They can also delay paying their liabilities. The value of information from financial statements arises from a combination of cash basis and accrual basis measures. The Conceptual Framework [CF] does not explore this issue.”
Of course, accrual accounting can lend itself to intentional management misstatements.
“Accruals are subject to measurement issues, since every accrual requires certain assumptions and estimates,” explains Demerjian. “For example, when a firm completes a sale on credit, it must estimate the likelihood that the cash will be received, when the receipt will take place, and if full payment is uncertain, how much should be reflected on the income statement. None of these issues arise when the sale is for cash.”
Instead, he says, if a cash flow analysis is conducted in conjunction with accrual accounting; the analysis may serve as an ex post measure of how accurately the accrual estimates are being made.
“Dechow and Dichev (1997) examine the impact of errors in estimating accruals,” says Demerjian. “So there is definitely a place for analysis of cash flows in understanding the economic position of an entity, but this is complementary to accrual accounting.”
Despite his criticisms, Demerjian recognizes that some sort of convergence between the FASB and the IASB is virtually inevitable. The concern now is whether that process will be done in a thoughtful manner.
“The convergence process is one of the clearest signs of how globalized the economy has become,” says Demerjian. “Convergence is an effort to provide, if you will, a common language across countries.”
He considers convergence in the context of standard setting in the past.
“Since roughly the era of exploration, when trading companies were formed to pool resources, earn profits, and share risks, accounting has emerged organically in response to the needs of users,” explains Demerjian. “The standards that emerged in each country were largely a product of several things, including the information needs of firms, investors, and regulators; and the legal environment of the country. The result was different standards that reflected idiosyncratic features of economies.”
With convergence, he says, the differences must be dropped, “as has happened in Europe, where most countries have adopted the International Financial Reporting Standards and interpretations promulgated by the International Accounting Standards Board (though with some wrangling). It will be interesting to see how the U.S. and Europe will settle their differences to manage converge of standards.”
Benston’s concern is with the FASB’s conceptual framework.
“Although a regulatory agency or board is likely to find it useful to have a
conceptual framework that reflects its core values, the Conceptual Framework presently in place is not an adequate foundation on which to base professional understanding, standards, or professional aspirations,” he says. “Indeed, the FASB’s preliminary Conceptual Framework is so highly abstract that it is unlikely to be directly useful in setting accounting standards.”
Benston calls for more detail, perhaps through an intermediate-level conceptual structure that can guide the process of setting accounting standards.
“Accounting standard-setting should be more than a conceptual exercise; it should also consider the incentives of both producers and users of accounting,” he explains. “Otherwise, the actual implementation of accounting standards is likely to be quite different from what the standard-setters expected to occur. Then the standard-setters will be locked into a cycle of revision and disappointment with the actual implementation of accounting standards.”
Nevertheless, Benston “applauds the FASB’s desire to seek views on its preliminary effort” and he hopes to continue to participate “as this important activity progresses.”