Long live Grumpy Old Accountants!

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

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.

Public Company Accounting Oversight Board (PCAOB) board member Jay Hansen seems to agree that auditors face some significant hurdles.  In a recent speech (“The PCAOB’s Role in Investor Protection”) at University of Nebraska, Mr. Hansen stated,

Recent inspection findings tell us that auditors have struggled with auditing fair value measurements, impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets, allowance for loan losses, off-balance-sheet structures, revenue recognition, inventory and income taxes. Our inspection results in 2010 and 2011 showed an increase in inspection findings, particularly in the area of fair value, but also in the auditors’ testing of internal controls.

Basic business strategy demands attention to the customer value proposition, as well as product and/or service differentiation.  The fact that the Big Four continue to ignore the real customer (the investing public), and make no attempt to distinguish their audit product on any dimension (quality would be nice), dooms whatever “strategy” that they think they may have to complete to utter failure.

So what’s prompted our recent rant?  Well, several weeks ago one of our Executive MBA students (i.e., a mature, experienced, and motivated individual) shared with us an interaction that he and his audit committee recently experienced with their Big Four auditor.  This particular student serves as both the corporate secretary and as a member of the board of directors and audit committee for a medium-size financial institution.  At a recent meeting with its independent auditor, the audit committee asked the external auditor what the firm was doing to address concerns expressed by the PCAOB about the quality of audits conducted by their firm.  Here is where it gets interesting.

Instead of addressing the question posed by the audit committee or acknowledging that their firm needed to improve audit quality, the engagement partner chose to blame the CLIENT for the firm’s poor audit quality.  Moreover, the partner suggested that if the client would pay higher fees, then their firm could do more work and improve their audits!

 Does this Big Four audit partner’s argument have any merit?  Yes, but only a little…we have known for quite a while that declining audit fees were becoming a problem.  And of course, companies must also share in the blame to the extent that they play the “auditor shopping” game. But a bigger and more troubling question is “why is the audit firm accepting engagements if the fees are not sufficient to guarantee a quality audit?”  The answer of course is that the Big Four just “can’t say no!” What…walk away from a client over fees?

Well, these two Grumpy Old Accountants remember a day (yes, it was almost 30 years ago), when the big accounting firms would actually do this.  Of course, back then, reputations mattered, firms recognized their public service responsibilities, and audit quality was a firm differentiator.  Some will remember the days when if you needed an aggressive accounting treatment blessed, at a cheap price, you hired a certain Big Eight firm.  On the other hand, if you wanted good advice and a high quality audit, and were willing to pay for it, you sought out Price Waterhouse.  Those were the “polar” extremes of audit firm quality, with the rest of the firms falling somewhere in between.  My how times have changed…increasingly audits have become a homogeneous, undifferentiated commodity, and the Big Four offerings are virtually indistinguishable.

So, we ask again…does this audit partner’s statement reflect arrogance or ignorance?  We think BOTH, and that is very sad indeed.  The arrogance is in ignoring the audit committee’s question about improving audit quality, and blaming the client.  The ignorance is in the partner’s lack of understanding of his responsibilities to the investing public, as well as strategy and business model fundamentals.  And we forgot one more descriptor…the partner’s statement reflects stupidity for actually going on the record to admit that the audit firm is a “revenue junky,” so addicted to revenue, that it will do lower quality work instead of actually dropping a client.

What can be done about all of this?  A lot frankly—and Jon Weil’s question “When Will the SEC Finally Go After the Auditors?” points us in the right direction.  The ultimate solution can be found in regulatory enforcement as we discussed in “Big 4 Audits: A Thing of the Past?”  Let’s refresh our memory.  Until the Enron debacle (when Arthur Andersen was effectively closed by the regulators), regulatory agencies had no problem going after the auditors.  For example, during the savings and loan crisis of the 1980’s, banking agencies had no problem routinely suing big auditing firms for shoddy work.

Regulators have created the public audit market by requiring an audit for all publicly traded companies.  But regulators have decided to overlook obvious declines in audit quality (e.g., auditor malpractice in the financial crisis of 2008).  As long as regulators continue to accept substandard audits to meet their requirements, the Big Four have no incentive to change the status quo.

The SEC previously examined the accounting and reporting issues at Nortel, and we re-examine the relevant Litigation Releases and Complaint to review the case against these managers.  We also note the slow justice in this case.  The fraud occurred over 10 years ago, and only now have these executives faced a criminal trial for their deeds.

Nortel’s shenanigans fall into two groups.  The first set of activities dealt with revenue recognition issues beginning in 2000.  Specifically, the firm employed bill and hold transactions to increase revenues and earnings.  For the most part, generally accepted accounting principles require inventory to be delivered to the customer before the corporation can recognize the revenues.  There are some exceptions, and bill and hold transactions may be an exception.

Bill and hold transactions are governed by Staff Accounting Bulletin No. 101, and they must meet several guidelines in order for the revenues to be considered realized.  They are:

• The risks of ownership must have passed to the buyer;
• The customer must have made a fixed commitment to purchase the goods, preferably in written documentation;
• The buyer, not the seller, must request that the transaction be on a bill and hold basis. The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis;
• There must be a fixed schedule for delivery of the goods. The date for delivery must be reasonable and must be consistent with the buyer’s business purpose (e.g., storage periods are customary in the industry);
• The seller must not have retained any specific performance obligations such that the earning process is not complete;
• The ordered goods must have been segregated from the seller’s inventory and not be subject to being used to fill other orders; and
• The equipment [product] must be complete and ready for shipment.

The SEC (Litigation Release No. 20036 and Litigation Release No. 20275 and the related complaint SEC v. Dunn, Beatty, Gullogly, and Pahapill) pointed out two major deficiencies in Nortel’s accounting for these transactions, both violations of the third criterion.  The bill and hold transactions under questions were requested by Nortel, and not by its customers.  Additionally, the customers of Nortel did not have any particular reason for having bill and hold transactions; there was no business purpose for these activities.

The second accounting scheme involved manipulation of reserves (liabilities).  When more reported income was not necessary to achieve manager bonuses, no later than 2002, Nortel started accruing a number of items, thereby recognizing the expenses, and the related current liabilities.  Later, when they desired greater income, the managers released the reserves by reducing current debts when incurring various costs, instead of recognizing them as expenses.  These transactions make a mockery out of expense and liability recognition criteria.

The SEC linked these accounting shenanigans with the compensation schemes of Nortel Networks.  In particular, not only did Nortel managers manipulate revenues and expenses to obtain the bonuses, but they were careful not to exceed the thresholds by very much.  In this way, managers were able to save revenues and incomes for the proverbial rainy day, and collect bonuses whether the business climate rained or shined.

In October 2007 Nortel Networks paid $35 million in fines for these behaviors (Litigation Release No. 20333).  We still find this amazing inasmuch as the shareholders are paying these fines.  Thus, shareholders get whacked twice: first by the scoundrels masquerading as managers, and then by the SEC who is supposed to be giving them justice!  We just don’t understand fines against a company.

Three top managers of Nortel settled with the SEC (Litigation Release No. 20546).  These three individuals were vice presidents of the business units involved in the accounting schemes.  They paid fines, disgorgement, and interest to the tune of $143,481 to $163,031 each.  Given their salaries and given how much they earned via unwarranted bonuses, we wonder whether these fines were sufficiently high to serve as a disincentive to other managers.

Recently we discussed “Restoring Criminal Liability for Financial Fraud.”  The Nortel case is an attempt to restore such legal exposure, but it is only one case.  We still do not understand why so little has been done to hold bank managers responsible for what they did in the financial crisis of 2008 that continues to reverberate through our society.

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

An interesting paper came our way recently that addresses these topics.  “Restoring Criminal Liability for Financial Fraud in the United States: A Moral and Legal Imperative” written by Catharyn Baird, CEO of EthicsGame; Don Mayer, University of Denver; and Anita Cava, University of Miami.  They presented the paper at the 2012 Academy of Legal Studies in Business conference and won the “Virginia Maurer Best Ethics Paper” award.  One may obtain a copy of the paper by emailing Kathi Quinn at kquinn@ethicsgame.com.

“Too big to fail” has become a mantra for our times, but frankly the phrase does not capture the essence of this story.  Matt Taibbi has referred to the era as “too crooked to fail,” and this seems more apropos.  Even better in our minds is the slogan “too in bed with government to fail.”  That, at least, provides an explanation for the impotence of our so-called watchdogs.  As Baird, Mayer, and Cava suggest, “Government may have gradually become the chief enabler of ‘too big to fail’ as well as ‘too big to jail.’”

This injustice has to end.  “Some high-level criminal prosecutions for fraud are essential to restore balance in the financial system, a balance that would come from a healthy fear of individual indictment rather than fines paid by the firm [i.e., shareholders].”

The authors of this paper explore the deficiency of various assumptions and theories, such as that of self-interest.  They point to Alan Greenspan’s confession that he relied on the self-interests of corporations to protect themselves and their shareholders.  We disagree with this point.  The real errors by Greenspan are his reification of the firm, thinking it can maximize utility, and that maximization of shareholder wealth is an application of the self-interest principle.  The truth is that CEOs and CFOs are maximizing their own utility and they care about shareholder wealth only to the extent that it coincides with their interests.  Greenspan should have known that managers do not maximize the wealth of shareholders.

We do however appreciate the authors’ discussion about ethical “blind spots,” applying a concept of bounded ethicality.  Business decision-making often must be quick, preventing a deeper analysis of ethical issues.  Individuals often put their ethical principles aside, complying with superiors or trying to win promotions or bonuses based on successful business transactions.  And individuals seldom pay attention to the conflicts of interest that frequently intersect their lives.  The authors illustrate these blind spots in their analysis of the crimes at Ameriquest, Countrywide, Lehman Brothers, Goldman Sachs, and Wells Fargo.

Sam Antar, former CFO at Crazy Eddie, would add the blind spots of auditors.  He says that many young accountants tell him about reprimands received from their superiors for actually “auditing”—even when they are just reading questions from a firm checklist.  They are not allowed to demonstrate any skepticism of their “client.”

Baird, Mayer, and Cava mention that too much faith has been put into self-regulation.  They point to reliance on the efficient market hypothesis instead of government oversight, the repeal of the Glass-Steagall Act, and the inertia that impedes the regulation of derivatives.  We would add that in our experience self-regulation always drifts into no regulation.  We need look no further than the accounting and auditing profession for a current example.

The best part of the paper is the analysis of “why current laws [and regulations] are either inadequate or under-enforced.”  Baird, Mayer, and Cava posit nine possible reasons for this state of affairs:

• “Some deception is accepted as part of marketplace behavior.  Caveat emptor is still a practical ‘default’ position.…the duty to favor the firm becomes almost automatic.”
• “Juries are mystified by the complexities of financial transactions.”
• The hurdle of the reasonable doubt standard is too high as “jurors are generally likely to find ‘reasonable doubt’” which masquerades for their ignorance.
• “Financial wrong-doing at the highest levels often has the protection of corporate attorneys representing the alleged wrong-doers.”  Ironically, these fees are paid by the shareholders who have been injured by the fraud.
• “The FBI’s resources are limited, and the Department of Justice can only prosecute the files that the FBI prepares; in addition, agents are promoted within the ranks based on successful convictions…”  The number of employees at the FBI and the SEC is simply too small to confront these demons.
• “There is the appearance that major civil lawsuits and government-sponsored settlements create sufficient accountability, but individuals are not held accountable as criminal laws would, and the firms themselves often pay just a portion of the monies they ‘earned’ as a result of deceptive practices.”
• “Neither political party has the nerve to alienate the major banks as potential funders of their political campaigns.”
• “Financial fraud detection requires a whole different type of training.  Creating these types of specialized agents takes significant time and money.”
• “It is possible that new criminal statutes need to be crafted that will meet the due process and vagueness concerns of” recent court cases.

While the authors do discuss some legal “fixes” for financial fraud, we found their suggestions amorphous and inchoate, so we do not repeat them here.  Indeed, the inability to address adequately the accounting and corporate scandals during the last several decades indicates something is wrong in our cultural fabric.  We do think Baird, Mayer, and Cava are correct when they state “the crisis is not just financial, but legal and ethical as well.”

We do not pretend to have the answers, but hope that these observations will serve as a wake-up call.  As trust is a requirement for economic actors to transact business deals, and since regulators and courts seem unwilling or unable to supply justice to capital providers, the capital markets will be in danger unless some fundamental changes are made.

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

Thurm’s article reminded us that it was time to revisit the list of companies that we provided to Deloitte back in November of 2011 to help them with their audits of intangible assets (in “Are Fourth Quarter Write-Offs Looming for Deloitte’s Clients?”  We wanted to know how many firms in our suggested list of write-off candidates actually recorded goodwill impairment.

As you may recall, we applied simple intuition and financial analysis to create a list of 24 companies, based on their relative level of intangible assets and anemic returns on equity (ROE), that we asserted were at significant risk for some type of impairment charge in 2011.  We found that, of the 24 companies we enumerated, 9 (37.5 percent) reported some type of earnings charge for impairment of goodwill or other intangibles during 2011.  So, it appears that common sense and fundamental financial statement analysis may have won out over auditing, yet again!  Maybe the FASB should add these two traits to their “qualitative criteria” for evaluating goodwill impairment—and Thurm’s as well.

To assess impairment charges for our 24 company listing, we again turned to the Wharton Research Data Services COMPUSTAT North America (WRDS) data set to search for P&L charges for the following variables: pre-tax goodwill impairments (GDWLIP) , pre-tax restructuring costs (RCP), and pre-tax write-downs (WDP).  And we were not disappointed!  The following nine companies reported intangible related earnings charges (in millions of dollars).

The total pre-tax charge includes impairment losses for both goodwill and any other intangibles reported by the company for 2011.  These amounts include charges reported as restructuring costs or other write-downs.  Except for CHINA REAL ESTATE INFO–ADR which has been delisted, all amounts were verified by tracing them to 2011 10-K filings.  The percentage write-down indicates the percentage of the 2011 impairment loss recognized to the total intangibles we originally raised concerns about.

So, what can we conclude?  Did Deloitte take our advice and check out these companies?  Or did the companies police themselves and “come clean” about the real value prospects of these fake assets?  Or, most likely, did our simple model serve as a predictive tool for analysts to evaluate companies’ goodwill positions?

And what does Thurm’s goodwill to market cap rubric show us at the end of 2011 for the above eight companies that are still listed?  Once again, we turned to WRDS data,  this time using common share outstanding data (CSHO), end of period share price (prcc_c and prcc_f), and market cap data (mkvalt).  Unfortunately, of the remaining eight companies (recall that CHINA REAL ESTATE INFO was delisted), three more companies are no longer publicly traded: APRIA HEALTHCARE GROUP, NATIONAL MENTOR HOLDINGS INC, and LANTHEUS MEDICAL IMAGING.  That leaves us with the following five companies:

INFUSYSTEM HOLDINGS reports a zero percentage because the company has no goodwill.  It was all written off during 2011.  As the percentages exceed 50 percent for only three companies, apparently the market continues to believe that the reported goodwill still has some value.

So what do we conclude from this analysis?  We hope that our accounting colleagues, academic and practitioner alike, wake up and realize that sometimes common sense and fundamental analysis can give us insights about asset value. As Emanuel Derman in his recent book Models Behaving Badly states:

Finding the truth about nature takes cunning and intuition.  The invisible worm of financial economics is its dark secret love of mathematical elegance regardless of its efficacy, and its belief that rigor can replace fact and intuition.

In today’s world of fair value reporting, maybe we should require companies to prove that an intangible has value (above and beyond what managers tell us)!  No consulting reports based on “pie in the sky” estimates and discounted cash flow analysis allowed.  Show us the actual, asset specific cash flows coming from these so called assets.  Prove that they are generating above average returns.  Show us the money!  If you can’t, then don’t book it!  Probably too uncomplicated for anyone to grasp, except for two grumpy simpletons.

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

Let’s begin with a brief review of the FASB’s pension rules in ASR 715.  The firm reports pension assets and liabilities in the balance sheet, netted.  The entity’s pension assets can include cash, investments, and any other assets that are in the pension plan, and these are valued at fair value.  The firm also measures its liability, the projected benefit obligation (PBO), which equals the present value of the estimated pension cash outflows to retirees, which these former employees have already earned.  The pension assets and liabilities are then netted against each other, yielding what we actually see on the balance sheet. If assets exceed liabilities, the net amount is displayed in the asset section of the balance sheet.  If the liabilities are greater, the net amount is shown in corporate liabilities.

In the income statement, the firm reports pension expense, a complex amalgam quite different from pension contributions.  GAAP pension expense is defined as the period service cost (increase in PBO), plus the period’s interest on the PBO, minus the expected (not actual) return on the plan assets, less any amortization of prior service cost, and finally, plus or minus any amortization of pension gains and losses.  And as we would expect from our accounting standard-setters, some items bypass the income statement: prior service costs and pension gains and losses.  These two items are shown in the shareholders’ equity section of the balance sheet, in accumulated other comprehensive income (loss).  Given the complexity of the FASB’s rules, the financial statements are supplemented with an ever increasing myriad of footnote disclosures that describe various details and assumptions so the reader can “better” assess the company’s pension position.

While one can do a lot of analysis when it comes to pension expense, our focus is on the interest cost and the expected return on pension assets components. These two items warrant particular scrutiny given management’s considerable discretion in their measurement, and because changes in their measurements can have major effects on the bottom line and on reported liabilities.

The following analysis relies in part on a very good study written by Nick Gibbons, an analyst at Gradient Analytics.  The study is entitled “Pension Issue Commentary #4,” and was published on June 21, 2012.  Last year’s report may be found at http://www.earningsquality.com/commentary.do?action=View.

As stated before, the PBO is the present value of estimated future retiree cash outflows discounted at some appropriate rate, and the interest cost component of pension expense is that same assumed rate multiplied by the beginning-of-the-year value of the PBO.  Both items depend on the assumed rate that is used.  Not surprisingly, higher rates will lower the PBO liability, but increase the interest charge, and related pension expense.

From Weyerhaeuser’s 2011 10-K footnote 8, one sees that the firm applies a discount rate of 4.5% and obtains a PBO of $5,841 (all dollar amounts in millions).  (The 4.5% rate is for U.S. plans, while the rate for Canadian plans is 4.9%).  In his study, Gibbons created a sample of 354 companies, analyzed their 2011 pension disclosures, and found a median discount rate of 4.75%. So, given the proximity of Weyerhaeuser’s discount rate to the median rate, we are somewhat comfortable with Weyerhaeuser’s choice.

However, if one is uncomfortable with a company’s assumed rate, or if one desires to do a sensitivity analysis, there is an easy tack to employ.  Given that pension payouts already earned extend several decades into the future, one can assume the debt is a perpetuity, a stream of cash payments that continues forever.  Since the present value interest factors get pretty small 20 years out, and further, the error should be relatively small.  Then the value of an “adjusted” PBO would equal the reported PBO times the reported rate divided by the “adjusted” rate believed to be more realistic.

For example, let’s say we question the reasonableness of Weyerhaeuser’s rate…let’s say we think it really should be 3.5%.  What happens?  Well, the PBO soars by almost 28.6% to $7,510:

 (($5,841 X 4.5%) ÷ 3.5%) = $7,510

 Conversely, if we believe that the “adjusted” rate should be 5.5%, the PBO liability drops 18.2% to $4,779.

(($5,841 X 4.5%) ÷ 5.5%) = $4,779

 And if the “adjusted” rate is assumed to be 4.75% (to standardize everybody’s rate and increase comparability given Gibbons’ study), the PBO value is $5,533.  A change of merely one quarter of one percent decreases the liability by $308, a change of 5.3%.

(($5,841 X 4.5%) ÷ 4.75%) = $5,533

 These examples demonstrate the impact of the discount rate on the projected benefit obligation and on the pension expense.  Given how easily managers can manipulate reported pension liabilities, such a sensitivity analysis is an important aspect of pension analysis.

The second big assumption that managers may not be able to resist “tinkering” with is the expected rate of return on the pension assets.  Allegedly, the FASB employs the expected rate of return (rather than the actual rate of return) to try to supply a long-term perspective and smooth the pension costs.

Weyerhaeuser uses an expected rate of return of 9.5%, giving it an expected return of $421, according to its reported pension expense calculation.  Unfortunately, according to Gibbons, this 9.5% expected rate ranks in the 99^th percentile!  In other words, a 9.5% expected rate of return exceeds the rate applied by 99% of the firms in Gibbons’ sample.  As the median rate of return is only 7.75% (according to Gibbons), one wonders why management applied the 9.5% rate of return.  If management had used a 7.75% rate instead, the Company’s expected return would have been $363.  So, that difference would have meant a higher pension cost of $58, and a lower bottom line.

Now to be fair, Weyerhaeuser did lower its expected long-term rate of return at the end of 2011 to 9%.  And surprisingly enough, 7.75% was assumed for direct investments, and 1.25% for derivatives…thus, the 9% total.

Clearly, corporate pension accounting is light-years ahead of the governmental world.  Nonetheless, there are still some significant soft spots, such as the assumed PBO discount rate, and the assumed expected rate of return.  Corporate managers, their accountants, and auditors have a long way to go to live up to the assumption standard outlined in the Modeler’s Hippocratic Oath penned by Paul Wilmott and Emanuel Derman in response to our recent financial crisis:

I will make the assumptions and oversights explicit to all who use them.

In the meantime, investors need to be aware of pension related assumptions and their implications, and should employ sensitivity analysis to better understand corporate financial disclosures.

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

So, in a move to provide some constructive advice, we offer Mr. Stevens a few simple suggestions.  First, do not merely mouth “transparency” as some sort of mantra, but embrace financial reporting transparency, believe it, live it, and report transactions and events as if your economic life depended on it.  That means no more gross/net revenue games, no more peculiar or low quality gains, as investment gains can be, and no more disclosures about inventory management systems when there is no inventory account on the balance sheet.

Second, make accounting quality a strategic choice and not a matter just for public consumption.  Be conservative in your measurements, especially when they involve Level 3 idiosyncratic data.  Write down deferred tax assets fully and completely and not in driblets.  Record impairments of goodwill and other intangibles.  And show merchant payables as a financing cash flow instead of an operating activity.

Third, while GAAP has its problems, it is better than the alternatives.  Quit reporting the non-GAAP performance metrics that cast doubts on the quality of Groupon’s financial statements and makes us wonder about the rest of the SEC filings.  You might need to explain that to your CFO.

In short, remember that the investment community is a key player for your firm.  Instead of trying to find ways to exaggerate the good stuff and hide the bad stuff, just tell it like it is.  Not only will you regain trust from investors and creditors, but then the management team can concentrate its efforts on rebuilding and growing the business.

We shall illustrate exactly what we mean by reviewing ethics instruction in a popular introductory accounting textbook.  Accounting Tools for Business Decision Making by Kimmel, Wegandt, and Kieso (KWK) incorporates ethics and integrates its discussion throughout the book.  The authors provide a model to help students address ethical “dilemmas.”  Then, each chapter includes one or more “feature stories” that touch on accounting ethics, some “business insight boxes” that focus on ethical situations in real business settings, and an “ethics case” for students to apply the ethics decision model.

The text’s overly simplistic ethics decision model has only three steps.  First, one must recognize an ethical issue in some situation.  Second, one should “identify and analyze the principal elements in this situation.”  And third, one identifies the alternative actions and weighs “the impact of each alternative on various stakeholders.”  We should point out that other accounting texts employ similar approaches, so our comments that follow also apply to them.

The Positives

We begin with what is good about this text’s approach.  The most obvious advantage is that it helps sensitize students to the topic of ethics.  It makes them aware of ethical issues and helps alert their consciences to when things might be amiss.  As might be expected, the model’s effectiveness is a function of the contexts, examples, and cases presented to the student, as well as the instructors’ ability to deliver the material convincingly.

This text’s approach also highlights the importance of ethics in the accounting profession.  By introducing ethics in Chapter One and integrating it throughout the text, the authors have elevated it to a very important plane.  By applying the ethical model across chapter content to such diverse topics as financial statements, budgeting, and cost analysis, one realizes that ethics pervades the accounting discipline.  So, if instructors actually assign and “teach” the ethics content, students clearly will address ethical issues in a variety of accounting and business contexts.

Third, the model is simple, so simple that a 10-year old can understand it.  Every college student will be able to read and understand this ethical model.

The Negatives

We also find a number of defects in this three-pronged model.  While the model is simple, in our eyes it is too simple and does not challenge college minds.  If one is to take this approach to ethics training, we think a model more appropriate for university education can be found in a 1981 paper by Laura Nash, “Ethics Without the Sermon” in the Harvard Business Review (November – December, pages 79-89).  She introduced a 12-step model to guide professionals in their daily decision-making:

1. Have you defined the problem accurately?

2. How would you define the problem if you stood on the other side of the fence?

3. How did this situation occur in the first place?

4. To whom and what do you give your loyalties as a person and as a member of the corporation?

5. What is your intention in making this decision?

6. How does this intention compare with the likely results?

7. Whom could your decision or action injure?

8. Can you engage the affected parties in a discussion of the problem before you make your decision?

9. Are you confident that your position will be as valid over a long period of time as it seems now?

10. Could you disclose without qualm your decision or action to your boss, your CEO, the board of directors, your family, or society as a whole?

11. What is the symbolic potential of your action if understood? If misunderstood?

12. Under what circumstances would you allow exceptions to your stand?

Now that’s an ethics model!  Nash’s model highlights just how superficial the efforts of today’s accounting texts are in addressing ethics education.  This model adds teeth to the KWK model and fleshes some important details that students should think about.

A second issue concerns the application of the KWK model.  Recall that the first step requires one to recognize an ethical issue, whereas the second step requires one to identify and analyze the ethical issues.  Our concern is that this model puts these two key steps in a vacuum because the decision maker (in this case, the student) has no framework to provide guidance in issue recognition or problem evaluation.  In essence, decision makers bring their own ethical frameworks to the situation, however inchoate they might be, guaranteeing chaos across observers.

In one sense the model’s ethical vacuum is understandable inasmuch as social forces have pushed pluralism to excess, and society seemingly has embraced the notion that values are personal, and not subject to debate.  We think this is an extreme position even in a pluralistic society!

Can’t we at least agree on some notions of value?  For example, we posit three values: (1) one should tell the truth, (2) one should not steal from others, and (3) one should not defraud others.  Think of these as a business application of the so-called “golden rule:” people should treat others as they want others to treat them.  With values like these, individuals have a better chance of recognizing and evaluating ethical issues.

A third concern focuses on step three in the KWK’s model.  By mandating that the ethical decision maker consider all stakeholders and weigh the impact of any potential ethical decision on them, KWK seemingly slide into utilitarianism, which advocates trying to maximize the welfare of all stakeholders in some collective function.  But utilitarianism itself suffers from several defects.  For example, how does one aggregate social welfare across a set of stakeholders? Also, why are intentions omitted even though moral intent often is important in ethical matters?  And finally, why must individuals be subjugated to some vague and indefinable collectivity?  Even worse, moral values such as honesty and respect for private property need not play any role within a utilitarian framework.

We much prefer a deontological approach, which stresses duties and responsibilities.  Such an approach would define what a person should do or not do, for example, supporting a client’s interests when you have a fiduciary responsibility to do so, and/or not revealing privileged client information.  The three “golden rule” values we proposed earlier clearly would be duties and responsibilities of economic actors.

Some Grumpy Suggestions

We offer two constructive ideas to help KWK and other authors improve ethics training in accounting textbooks.  First, include the principles of the AICPA’s Code of Professional Conduct (as well as those of the Institute of Management Accountants, Institute of Internal Auditors, and PCAOB) in the text by highlighting them in a table and discussing key commonalities in Chapter One.  These organizational statements on ethics clearly voice the purpose of the accounting profession, and represent a magnificent declaration of the values held by its members.  This approach would signal to the student reader that these values are not merely those of the authors, but also those of professional accountants throughout the land.

Our second suggestion is to use SEC Litigation Releases to highlight ethical lapses.  While one would want to avoid the substitution of the legal for the ethical (which by the way students often confuse), it could still be instructive to observe and dissect real world ethical corpses, thereby demonstrating the overlap of ethics and law, especially when the public already has a sense that the accounting profession has failed too many times.  Poignant examples like Sensormatic Electronic and Waste Management would be easy to discuss and infuse into an accounting text.

So, in closing, accounting textbook authors and their publishers need to stop “short-cutting” the ethics issue.  Discussing ethics is insufficient; it needs depth and breadth and meat and muscle.  Most of today’s texts are simply insufficient when it comes to ethics instruction, given their nondescript discussions of ethics.  Moreover, their overly simplistic ethics models, which are devoid of useful frameworks, simply trivialize ethics and lead to public relations games rather than any real changes in behavior.  To impact ethical decision-making, we need a framework for ethical principles that enunciates professional values and spells out duties and responsibilities.  We need a discourse that challenges students and touches on current, “real world” applications.  We need a usable (not theoretical) guide to help students with their daily battles in applying the “golden rule” in an increasingly morally bankrupt accounting and business world.

Clearly, there are some strategic and organizational issues in play.  For example, what is Facebook’s long-term relationship with Zynga?  Also, can the Company’s management team meet the challenges facing the Company, particularly those from competitors, and its own staff?

However, we shall stick to the accounting issues, our forte.  And again we dredge up Zynga’s revenue recognition policy, which we have discussed before (“Zippy Zynga” and “Zynga’s First 10-K: Zestful Zephyrs”).  Recall the revenue recognition enunciated in the firm’s 10-K:

For purposes of determining when the service has been provided to the player, we have determined that an implied obligation exists to the paying player to continue displaying the purchased virtual goods within the online game over their estimated life or until they are consumed. The proceeds from the sales of virtual goods are initially recorded in deferred revenue. We categorize our virtual goods as either consumable or durable. Consumable virtual goods, such as energy in CityVille, represent goods that can be consumed by a specific player action. Common characteristics of consumable goods may include virtual goods that are no longer displayed on the player’s game board after a short period of time, do not provide the player any continuing benefit following consumption or often times enable a player to perform an in-game action immediately. For the sale of consumable virtual goods, we recognize revenue as the goods are consumed (emphasis added). Durable virtual goods, such as tractors in FarmVille, represent virtual goods that are accessible to the player over an extended period of time. We recognize revenue from the sale of durable virtual goods ratably over the estimated average playing period of paying players for the applicable game, which represents our best estimate of the average life of our durable virtual goods (emphasis added). If we do not have the ability to differentiate revenue attributable to durable virtual goods from consumable virtual goods for a specific game, we recognize revenue from the sale of durable and consumable virtual goods for that game ratably over the estimated average period that paying players typically play our games (as further discussed below), which ranged from eight to 25 months in 2011 (emphasis added). Future paying player usage patterns and behavior may differ from the historical usage patterns and therefore the estimated average playing periods may change in the future.

We stated in previous columns, and we still maintain, that this method is too arbitrary as it depends on virtual tractors and such.  We would prefer that Zynga record revenue as cash streams are received, and forgo all of the subjective deferral manipulations.  And we continue to laugh at the so-called non-GAAP metric “bookings” which adjusts revenues for the change in deferred revenue.  We are amused because bookings look more like GAAP revenue than the method actually employed.

Cory Johnson at Bloomberg also explored this revenue recognition issue recently (“The Ins and Outs of Zynga’s Nifty Accounting Tricks”).  He notes that Zynga has changed the estimates of customer usage for these virtual gaming assets in five of the last six quarters.  By changing these estimates, Zynga has been able to convert some quarterly losses into quarterly profits.  A marvelous tool for injecting extra revenues when necessary—and without any additional expenses!

We also note that Zynga’s revenue recognition practices allow it to claim higher quarterly growth rates than it would if it quit deferring any revenues.  The average growth rate of quarterly revenues over previous adjacent quarters is 15 percent, and the average growth rate of quarterly revenues over the previous year’s quarter is 74 percent.

If one adjusts revenues by eliminating the deferred revenues, as we advocate, the growth rates become more realistic.  The average growth rate of quarterly revenues over previous adjacent quarters is only 6 percent, and the average growth rate of quarterly revenues over the previous year’s quarter is 30 percent.

Apparently, Zynga recognizes revenue the way it does and also discloses bookings so it can have the best of both worlds.  It more than doubles revenue growth rates by applying its revenue recognition method of choice, but also shows higher revenues via the bookings metric.  Ah, what magic!

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