It is said frequently by politicians, SEC and other regulators, journalists and special interests that the accounting standard setting process should and must be insulated from politics. As I explain in this essay, this runs counter to everything we understand about accounting theory. For decades it has been taught in every graduate accounting program in the country that accounting standards have economic consequences. As a result, I contend it is natural and predictable that competing economic interest attempt a political solution to proposed accounting standards.
This is an important issue at this time, because they are proposing major changes in the accounting regulatory landscape that run counter to this conventional wisdom of the financial reporting and capital market world.
Recently, current (Mary L. Schapiro) and past (Roderick M. Hills, Harvey L. Pitt, and David S. Ruder) chairmen of the Securities and Exchange Commission (SEC) and the current Chairmen of the FASB (Robert Herz) and the IASB (David Tweedie) have been publicly remarking that the accounting standard setting process should and must be insulated from the lobbying of special interest groups and the meddling of government institutions.
Their concern is understandable, because it has become known that various accounting enacted standards (i.e., fair value rules, changing lease rules) have economic consequences that produce adverse effects for certain identifiable corporate interests, and these parties don’t like it. These affected parties only have three opportunities to lobby their positions. They can lobby the FASB (or IASB) during the due process stage before accounting standards are adopted, hoping to get the rule they want. After implementation of a new rule, they can lobby their auditors for favorable treatment when they consider how to account for transactions. If these two fail to produce favorable results, the affected corporations have one final alternative. They can continue to complain and seek the assistance of politicians to get the accounting rule changed. Of course, the FASB and the IASB wish to maintain their rule making franchise, and so they try to protect their rules and their responsibilities.
The defense of the SEC/FASB/IASB position (insulate accounting standard setting from politics) is based on a number of premises, such as, (1) accounting standards are designed to benefit all users and interests, (2) there is a best accounting rule for every occasion, (3) accounting standards are economically neutral, and (4) selecting accounting standards because of their economic impact is the devil’s work.
A famous Journal of Accountancy article, “The Politicization of Accounting,” by the late University of Pennsylvania professor David Solomons (1978) is sometimes cited in defense. As reported by FASB Chairman Robert Herz, Professor Solomons argued for the information neutrality of accounting standards. Herz quotes Solomons as saying,
“If it ever became accepted that accounting might be used to achieve other than purely measurement ends, faith in it would be destroyed just as faith in speedometers would be destroyed once it were realized that they were subject to falsification for the purpose of influencing driving habits.”
Well guess what? The speedometers of cars in the U.S. are altered systematically. They are rigged to read at least three mph faster than a car is actually traveling. If American drivers intend to drive faster than the speed limit, and most do, then the federal government can bring about increased compliance if speedometers are rigged to overstate a car’s current speed.
It’s not just speedometers. The SEC/FASB/IASB chairmen are wrong about a lot of things! What follows are the basics of accounting theory as understood by the typical accounting professor.
- There is no such thing as universal accounting truth.
- Accounting standards do not equally benefit all affected parties.
- Accounting standards all have economic consequences.
To these three I add a caveat:
- It is the responsibility of a country’s government to serve as an appeal court of last resort and adjudicate between economic interests in the selection of accounting standards.
There is no such thing as universal accounting truth. Accounting rules spring from the reason of human beings. The rules and principles that guide today’s capital markets are recent inventions. The most cherished accounting axiom–assets equal liabilities plus owners equity–has been around less than six hundred years. Before that there was simply no need for it, therefore it wasn’t yet invented. Accounting rules don’t come anywhere close to the permanence and universality of natural laws.
Moreover, when new accounting standards are considered there are always alternatives. Eventually one alternative is selected by majority vote of the board members of the standard setting organization, because it seems reasonable for them to do so. Other theorists acting in good faith may still have justifiable reasons for promoting an unchosen alternate accounting rule. There is no right or wrong in an absolute accounting sense. The best that a proposed accounting rule can hope for is that it seems better than the alternatives, and this desirability will be durable.
Here are some accounting standard setting alternatives that at one time have been the “law of the land.”
- Research and development expenditures were once capitalizable, but now must be expensed as incurred.
- Lease obligations can be treated as operating leases or capital leases (or both at the same time as per IFRS). A current proposal calls for all to be treated as capital leases. Some economic interests would prefer operating lease treatment.
- Measurement for the income statement was once the main priority, now it is the balance sheet.
- Accrual of a contingent liability must be probable or likely to happen (US GAAP–frequently interpreted by accountants as ≥ 90% probability), or more likely than not (IFRS–interpreted by accountants as a hair above a 50% probability).
I think this first point is the most difficult for regulators and professional accountants to come to grips with. In accounting standard policy discussions, participants frequently revert to a default position of searching for the one best accounting standard. They just don’t understand that it is impossible for one to exist.
Accounting standards do not equally benefit all affected parties. Accounting rules that govern the formation of corporate financial statements all have economic consequences. It has always been this way. Every rule puts some interest group at an advantage over another. From the start, investors have clamored for more disclosure than the executives running corporations have wanted to supply. This tension is natural. Metaphorically speaking, investors want an open window into the corporation, corporate executives want a closed door. It is up to standard setters to draw the line in such a place so as to serve as an effective compromise between them.
Capital market regulators in the U.S. learned this one the hard way. Traveling back in time to when the AICPA was in charge of accounting standard setting, historians conclude that early efforts by the Committee on Accounting Procedures and the Accounting Principles Board were focused on providing accounting standards with alternatives. These standards were problematic to investors because (1) companies used the flexibility to obfuscate their financial condition, and (2) investors had a difficult time in figuring out what was going on. Some companies, if they weren’t outright fudging the numbers, were switching accounting rules back and forth to get acceptable numbers and were firing the audit firm so as to shop for a favorable audit opinion to authenticate reported numbers. As the SEC prioritized the needs of investors over those of companies, the eventual solution was to charge the newly formed FASB with the task of reducing alternatives and choices in accounting standards. As alternatives were eliminated, rules in the U.S. became one size fits all.
One of the most troubling arguments I hear from regulators and accounting firms is that when accounting standards are designed to advantage reporting companies, then investors will naturally benefit. It just doesn’t work that way. In a zero-sum game, both parties can’t be simultaneous winners.
All accounting standards have economic consequences. If an accounting standard has no economic consequences, then the standard is not needed. There are several ways to justify this statement about economic consequences, and there are many examples in support.
First, financial statements are intended to provide information to investors for making investment decisions. The decisions that result from using financial statements are themselves economic consequences.
Second, all human communication is persuasive. There is no such thing as an unbiased fact. This is supported by a recent Hollywood release, Vantage Point, in which an event is observed by seven individuals. Each has a different vantage point. Because each of the seven as a different perspective, each telling of the observed event differs. All are different, and all can be correct. Similarly, there is no such thing as neutrality and objectivity in either accounting measurements or accounting standards.
Third, there are many instances where corporate executives have failed to comply with accounting standards because they did not desire to report bad numbers (financial results that fail to reach a target). These executives certainly believed that numbers disclosed in accounting statements have economic consequences, and they were willing to go to great lengths to reach their targets. And, they still believe this way. Sometimes this means structuring business events for the timing of revenue or expense recognition. Sometimes executives manage their earnings using accounting tricks. Of course, there are negative consequences to being perceived or caught managing earnings. Sometimes executives attempt to influence the composition of accounting standards. By using the system to change the accounting rules, they can set the stage for reporting good numbers (or at least more desirable numbers). The actions that corporate executives take are themselves economic consequences of accounting standards. The current fair value issue is a good and current example of this.
Can participants think they are working toward the best accounting standard? Sure. They always say so, whether or not they actually mean it. If they mean it, they don’t realize that they are only advocating their self-interest.
If it is agreed that accounting standards have economic consequences, I believe the next point follows very directly. It is obvious, as we say in academe.
It is the responsibility of a country’s government to adjudicate between competing economic interests in the selection of accounting standards. This is what government does. For example, governments are good at levying and collecting taxes, which has been going on since the beginning of human history. And what is tax but one group being forced to transfer it’s money to another group. In the U.S., the federal government is the ultimate economic arbiter. Serving presidential administrations appoint cabinet secretaries and agency heads (for example President Obama appointed Geithner, Romer and Schapiro, and reappointed Bernanke), and together they determine the policy that guides economic and regulatory policies that remain in effect until changed (either because an administration changes its own policies, or a new administration is elected).
How does a government decide between competing interests? By politics: negotiation and compromise, posturing and popularity.
We have not always realized the political nature of standard setting in the U.S. However, since the formation of the FASB every potential accounting standard has had to go through a political process: discussion memorandum, then exposure draft. And the SEC always has the ability to override (which it has upon occasion).
Not only does the federal government have the authority to determine accounting standards (the Securities and Exchange Act of 1934 affirms it), but it has the responsibility to do so. This is because accounting standard setting is an integral part of the economic regulatory system of the U.S. And maintaining a stable and sound economy is a basic underpinning of national security. Because of its primal importance, there is no other organization in the U.S. that could possibly do it.
So, what are some of the ramifications of this lesson in accounting theory.
First, I don’t think that there are Republican issues or Democrat issues. When competing economic interests appeal to politicians for support, there is probably chance as to which political party supports a particular economic interest. Remember, two party politics as we have in the U.S., is confrontational politics. The first party to an issue will choose whom to support. The second party will necessarily pick an opposing side.
Second, when standard setters climb into the political arena and ask that accounting standards be insulated from politics, they actually mean that accounting standards should be insulated from other people’s politics, because the speaking standards setters like their own politics just fine.
Third, although wishing for a politics free environment for accounting standard setting sounds like it should be a good idea, it probably isn’t any more possible than Democrats and Republicans getting together to start churning out non-partisan legislation that puts the country first.
Fourth, the Obama administration has proposed shifting responsibility for accounting standard setting to a foreign institution, completely out of the control of the U.S. government. This means that the U.S. government is delegating a key aspect of financial/economic regulation to a foreign body. And this foreign institution does not have promoting the American national interest as its guiding mission. It means also that the U.S. government is rejecting its obligation to engage in politics in adjudicating between competing economic interests. Isn’t that what we’re paying government officials for?
Do you agree or disagree with what I’ve written? Please leave a comment?
Debit and credit – - David Albrecht