GRUMPY ENOUGH TO RETIRE

Ed has become really grumpy lately!  Is it the classes, the research, or just that the thrill of accounting is too much for someone who has crossed the threshold of geezerdom?  The answer is “all of the above,” plus the fact that weekly blogging is a lot of work for someone entering his “golden years.” So, Ed has decided to retire from the Grumpy Old Accountants blog.  Yes, the Statler and Waldorf of the accounting blogosphere are parting ways (at least temporarily).  And, oh by the way, Ed is Waldorf, since he looks older and actually started the blog!  The Grumpies want to share some final thoughts about this phase of our efforts to improve the accounting profession.

In writing our essays over the past 18 months, we have been guided by one foundational principle — financial reporting requires corporate fairness to investors and creditors.  We think that this ethic was first articulated by Arthur Andersen in its 1960 publication, The Postulate of Accounting: What It Is; How It Is Determined; How It Should Be Used.  In this book, Arthur Andersen held that there is only one requirement for accounting, and that is fairness.

• “Each party to the accounting is entitled to a fair statement of his economic rights and interests.  Any misstatement of the rights of one group will necessarily misstate those of another group.” (p.3)
• “Financial reporting is concerned with ascertaining the rights of all parties and impartially applying the accounting principles thereto.”  (p.5)
• “To ascertain those conditions that are prerequisite, we must look to the purpose of the financial statements.  It would seem that this purpose, as universally recognized by the standard short-form accountant’s certificate, is to give a fair presentation of financial position and results of operations.  Accordingly, essential prerequisite conditions are those which result in fairness—which ‘present fairly.’” (p.25)
• “Thus, financial statements cannot be so prepared as to favor the interests of any one segment without doing injustice to others; and such statements could not meet the test of fairness which the public demands always be present in public financial reporting” (p.29).

Of course, some of you will argue that times have changed and that we need to adapt with them.  Surely, you can’t expect that a 50 year-old postulate by a now defunct firm has any merit today in our dynamic, global, technologically driven world!  Well we do, and are sorely disappointed by the many (and increasing) examples of published financial statements that ignore the fairness postulate, instead favoring the interests of managers, without regard to the rights of external investors and creditors.  MF Global, for example, is a classic case in which repo accounting was distorted for the benefit of management and management alone.  If we had only one word to describe MF Global’s accounting and its disclosures, it would be “unfair.”

One main purpose of financial accounting and reporting is to tell current and potential investors and creditors what has happened to the company’s economic resources and obligations during the past year (or quarter).  The goal is NOT to help corporations hide facts in the name of competitive advantage.  It is NOT to help managers keep their jobs or earn higher salaries and bonuses.  It is NOT to assist auditors in obtaining and retaining clients or avoiding litigation.  The primary goal is to assist investors and creditors in making rational investment decisions, which in turn helps the economy direct resources to the most efficient firms.

Managers should issue financial reports that are transparent.  To make the best decisions possible, investors and potential investors need the truth, the whole truth, and nothing but the truth.  Financial reports must accurately report what happened to a company; they must tell the full story, and they must not embellish the tale with exaggerated claims.  In other words, there needs to be a link between reality and what is actually reported in financial filings.

And to no one’s surprise, ethics plays a role in all of this as well.  Part of the problem with transparency is the assault on truth found in our society.  Students in school — and this includes universities —often are told that there is no such thing as truth, just different views held by different persons, and that they ought to respect the opinions of different parties.  Balderdash!  If a corporation’s balance sheet reports land with a value of $100 million, then it better have contracts that validate the ownership or the leasing of lands.  In addition, the enterprise needs creditable documentation that supports its claim that the value of the land is indeed what it is stated to be.  Since valuation is becoming increasingly judgmental (i.e., one sees what one wants to see), investors are entitled to know exactly how a firm determined the value of the land.  Further, valuation experts should be independent from the firm, and the analysis should be as objective as possible.

Make no mistake about it.  Reporting land as an asset without ownership or property rights to the land is a lie.  Not divulging accurately how that value is measured is a deceit.  Overvaluing and undervaluing resources and liabilities is a canard.  And nondisclosure of pertinent facts is a falsehood.  Similarly, underreporting liabilities makes the financial reports as opaque as possible.  Just ask the investors of MF Global.

Unfortunately, to make our financial system work, we need an objective and independent auditing of management assertions.  It does not take a rocket scientist to figure out that managers have incentives to lie in financial statements.  Over 75 years ago (yes, even back then), Congress and the SEC thought it valuable enough to require that independent accountants audit manager financial statement assertions to make sure that they are telling the truth.  Otherwise, potential investors might decide to protect themselves by simply not participating in Wall Street at all, thus depriving corporate America of the funds needed to meet capital requirements. Just to be clear, auditors are not required to and do not assess the worthiness of investing in the firm.  Instead, they assure the investing community that evidence exists to back up the claims made by management in the financial statements.  In other words, the Certified Public Accountant verifies that management is telling the truth in the financial reports.  Interestingly, the PCAOB has been presenting this message recently:  read “The PCAOB’s Role in Investor Protection” by Hanson and “Capital and Adventure: The Auditor’s Role in the Modern Corporation” by Doty.

It is within this context that we have often decried the movement seemingly away from the auditor as professional skeptic to the complicit accomplice.  Auditors are responsible for the flotsam and jetsam produced by the banking fiasco as seen in the reports by Lehman Brothers, Citigroup, and others.  And audit quality seems to be in a continued decline as evidenced by Michael Rapoport’s recent article citing the PCAOB’s discovery of insufficient audit work by major accounting firms. Without good audits by truly independent and competent persons, investors will protect themselves by the only two choices they have: either they will leave the market altogether, or they will raise the cost of capital by what one might term the “accounting risk” component.

With respect to MF Global, one wonders where was the going concern exception.  Given the corporation’s losses and its negative cash flows, one would have thought the auditor might have done more than just issue the usual boiler plate opinion.

We believe accounting to be a glorious profession, and we hope that it retains its high standing.  But it must be vigilant in maintaining its high ethical standards (something more than just taking ethics courses for CPE).  The profession must renew its commitment to the moral imperative of truth telling in accounting as seen in the goals of decision usefulness, transparency, and attesting to the truth.  Then and only then will financial statements be fair to all interested parties.

This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.