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Archive for April, 2010

Global Rules

One of the courses I teach is Intermediate Accounting 2. This semester’s paper assignment is to take a position on whether the U.S. should adopt IFRS (or some form of global accounting standards) or retain its unique GAAP. To improve the quality of papers I receive, I instituted a system of peer review, requiring each paper to go though one round of double non-blind review. The end result was 28 pretty good papers (21 for GAAP, 7 for IFRS or global accounting standards). I’ll be posting the three best. This paper is by a junior in accounting.

Global Rules

by Pepper Potts (pseudonym)

When over 100 different entities are bound – by choice or mandate – to a certain policy, there comes a sense of urgency for others to analyze the situation, make a decision, and take a stand. In this instance, the matter to be addressed is whether or not the United States should join the majority of other countries in adhering to International Financial Reporting Standards (IFRS), or retain Generally Accepted Accounting Principles (GAAP). Many opportunities are opened with the prospect of a global set of standards: communication, efficiency, comparability, and the advantage of working in a global market. However, caution needs to be taken when considering which global standards to use. IFRS has become popular, but it is not a suitable option because its principle-based nature sacrifices quality. Everyone needs to be involved in developing a new global system that achieves high-quality through a rules-based method. While the need for a global set of accounting standards grows, IFRS is not the solution. The United States should not abandon GAAP for IFRS, but a change to a global system needs to occur.

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One of the courses I teach is Intermediate Accounting 2. This semester’s paper assignment is to take a position on whether the U.S. should adopt IFRS (or some form of global accounting standards) or retain its unique GAAP. To improve the quality of papers I receive, I instituted a system of peer review, requiring each paper to go though one round of double non-blind review. The end result was 28 pretty good papers (21 for GAAP, 7 for IFRS or global accounting standards). I’ll be posting the three best. This paper is by Jon Taves, a junior in accounting.

Just Say No:

Why the US Shouldn’t Switch to IFRS

by Jon Taves

My mother frequently told me that just because everyone else is doing it doesn’t mean that I should. For example, if everyone else was going to jump off a bridge, should I? That was never fun to hear and I always wished she would have just let me do whatever I wanted to do with my friends. Nevertheless, the image of me standing on a bridge with all of my friends and watching them jump off has stuck with me through the years. It might be one of life’s most simple analogies, but it makes a lot of sense. It certainly would have been more convenient to just go along with what my friends had done, more efficient for my social image, and therefore, better to have jumped sooner rather than later, since I would undergo less scrutiny for being a “wuss” and not jumping right away. However, the result would have been the same, regardless of when I had jumped: death. While switching to International Financial Reporting Standards (IFRS) might not literally kill anyone, there are lots of parallels that can be drawn from the example above. Just because everyone else is doing it, approximately 100 countries worldwide, doesn’t mean it’s the right move for the US (Albrecht 2010, Lecture). While the move might be convenient, more efficient, and better to switch sooner rather than later, like jumping off a bridge, convenience, efficiency, and timeliness aren’t always advantageous. After talking with classmates, listening to Dr. Albrecht’s lectures, and doing extensive research, I’ve concluded that the US shouldn’t switch to IFRS because the benefits don’t outweigh the costs.

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One of the courses I teach is Intermediate Accounting 2.  This semester’s paper assignment is to take a position on whether the U.S. should adopt IFRS (or some form of global accounting standards) or retain its unique GAAP.   To improve the quality of papers I receive, I instituted a system of peer review, requiring each paper to go though one round of double non-blind review.  The end result was 28 pretty good papers (21 for GAAP, 7 for IFRS or global accounting standards).  I’ll be posting the three best.  This paper is by Peter Zender, a junior in accounting.

GAAP VS IFRS: Protecting Investors

by Peter Zender

It is seventy-one degrees in Scottsdale, Arizona. Perfect weather for a round of eighteen holes (golf cart used of course), an early dinner (early bird special!), and then finish off the day with a relaxing evening sitting on the patio, cold beer in hand, feet up (we’ll skip the shuffle board to avoid stereotypes). Or, I could wake up in my kid’s basement, head for an eight hour shift at the local Wal-Mart, come home to an evening of the hectic rushing most American families face, all while enjoying the freezing cold temperatures of Minnesota. Which one do I want for my retirement? Let me think…I’m going to go with Option A. Currently standing between myself and the desired dream retirement is roughly fifty years of work to make some hard earned money and then using my hard earned cash to fund thoughtful, solid investment growth. And the key to making the right investments is correct and truthful business information, including financial statements. The Generally Accepted Accounting Principles (GAAP) currently provides investors with a reasonably acceptable amount of faith to make their investments and my belief is that a switch to International Financial Reporting Standards would only hamper that faith.

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William Brighenti of The Barefoot Accountant blog asks, “Are You an Accounting Nerd?”  As a professor, I deal with words and interesting (and not so interesting) ideas.  Maybe there’ s something here.  Hmmm …

Part of the accounting field?  Check.  Nerd?  Certainly not me.  Maybe I should look up the definition just to be sure.

  • The Free Online Dictionary:  A person who is single-minded or accomplished in scientific or technical pursuits but is felt to be socially inept.    Yeah, so what’s your point?
  • Dictionary.com:  an intelligent but single-minded person obsessed with a nonsocial hobby or pursuit.  Playing solitaire versions of computer games is what I’m good at.
  • Merriam-Webster:  an unstylish, unattractive or socially inept person, especially: one devoted to intellectual or academic pursuits.  Unkempt is de rigueur in academia.
  • Wikipedia on “nerd”:  a person who passionately pursues intellectual activities, esoteric knowledge, or other obscure interests that are age-inappropriate, rather than engaging in more social or popular activities. Therefore, a nerd is often excluded from physical activity and considered a loner by peers, or will tend to associate with like-minded people.  It is not age-inappropriate.

Is “accounting nerd” an oxymoron?  Or is it two redundant words?  Better take the quiz to find out.

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Lehman Brothers used an accounting gimmick to increase a key percentage in its balance sheet, thereby appearing to be better off that it actually was.  This accounting gimmick was used to hit certain target numbers in an attempt to (1) keeping stock prices from dropping, and (2) forestall regulators from stepping in and forcing bankruptcy at an earlier date.

In the end, it was not enough to save the company.

Lehman capitalized on a “bad” accounting rule that allows what is called off-balance sheet financing.  Specifically, Lehman was able to remove liabilities from the balance sheet, thereby reducing leverage (the relative percentage of financial liabilities) and increasing the relative percentage of capital (or stockholders equity).

Was it an attempt to deceive?  Obviously, but activities that fudge some number happen every day in every company.  Was it material, or large enough to deceive?  At first glance the numbers involved are pretty small.  I’ll walk you through the analysis, but you have to go through a lot to find any percentages boosted a material amount.  But materiality is a judgment call, and Ernst & Young might not have reasoned the Repo 105 use was material (I’ll explain how to justify E&Y’s position).

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How well does the average person understand financial statement manipulation?  Sometimes the numbers are gimmicked up because of odd nonsensical transactions, ala Lehman Brothers.  Sometimes the numbers are out and out fictionalized.  Sometimes investor attention is simply distracted away.

Bob Jensen passed along a post over at the AECM listserv, in which he used a few Barbie dolls to make a point.  Sprucing it up just a bit, here’s the story. [Disclaimer: I do not support the “culture of thinness” promoted by Barbie Dolls.]

Lehman Brothers Balance Sheet “Before”

Lehman Brothers balance sheet bloated with too many financial liabilities

Lehman Brothers Balance Sheet “After”

The balance sheet after cash from Repo 105/108 has paid down financial liabilities

SEC’s Mary Schapiro Called to the Rescue

There were no pictures of Barbie as a white knight in shining armor


Switching the subject, just a bit.  Over the years, Mattel (producer of Barbie dolls) has used child actors to promote its toys.  Recently, it used two of the cutest to present a disclaimer that precedes an interactive edition of its annual report.  I can’t embed the video (as much as I’d like to), so click on the following link and press the start button.  In my opinion, this is inappropriate.  Financial reporting is serious business for serious people.  It shouldn’t be made light of.  And, after watching this “kid” disclaimer, I think the viewer is happy enough to cut Mattel some slack for whatever follows.

http://corporate.mattel.com


My apologies to the copyright owners of these images.  I’ve borrowed without permission.  If you come across this page, would you grant me permission to use these images?

Debit and credit – – David Albrecht

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I’m grateful for the provocative writing of Jim Peterson (re:Balance), Francine McKenna (re: The Auditors) and Sara McIntosh (Sara McIntosh).  Without their blogging, I might never have realized how naively I was conceptualizing the audit model.

The simple view of the audit model is that public accountants (aka auditors) serve the public (and investor) interest when they render an opinion as to whether financial statements have been prepared in accordance with the rules.  This is their raison d’être (reason for being).   At least, this was the intent of the original legislation (Securites Act  of 1933 & The Securities and Exchange Act of 1934).  Since then, the SEC has many times stated that (1) it is the auditor opinion of the financial statements that makes them credible, and (2)  without credible financial statements there can be no effective capital markets in the U.S.  In other words, auditors work for the public, but get paid by companies.

I wonder if this model works, anymore.  First of all, there is nothing “public” about auditors.  They are in business for themselves–to make a profit.  Audit firms seek to maximize revenues and minimize expenses.  Secondly, auditors are more likely to describe their relationship to companies as a partnership instead of being “independent of.”  Thirdly, auditors serve their paying companies, not the public.

I’ve been pondering theory, going way back to the original principal-agent theory and motivation for auditing (described by Jensen & Mecking, summarized by Thornton, expanded by Simunic and Stein, interpreted and dressed up by Watts and Zimmerman).  The basic theory is that in the absence of government regulation companies (and their management) are motivated to secure independent audits of their financial statements, and investors are not.  If ownership is dispersed, then no single investor can own a large enough share of ownership to make worthwhile the funding of an audit.  These independent auditors are motivated to provide opinions free from bias or influence from management because they compete for clients on the basis of reputation and audit quality. The market for auditors is characterized by perfect competition (lots of auditors competing only on basis of reputation and quality).  The theory also describes that audit opinions serve the public interest.

In the same way that we’ve discovered EMH doesn’t really exist in the real world, I think it safe to say that the above auditing scenario doesn’t exist in the real world.

The asymmetry of information flow between the company and auditors is problematic and expensive for auditors to overcome.  The market for audit services is not characterized by perfect competition.   Governments have stepped in to limit competition by providing barriers to entry.   Unchecked consolidation has had many side effects.  In theory, the cost to audit firms of poor quality is loss of clients and lawsuits. Theory doesn’t mention that audit firms face legal costs unrelated to audit quality (biz failure provokes lawsuits, so auditors have interest in seeing long-term survival of companies). Also, in the real world, lack of auditor competition means that audit quality is less important. Firms don’t need to compete on quality, being able to exist at all is a basis for competition. When pressures for audit quality are diminished, then firms can benefit from getting along with management. When firms are predisposed to get along with management, management is sometimes more willing to reveal information if auditors won’t act on it in their opinions. This cuts costs to audit, but simultaneously increases barriers to effective audit opinions.   When companies realize that audit costs have decreased, they start forcing auditors to accept lower fees.   This price competition means that once audit firms have accepted competing on the basis of price, they must now be even more compliant to management desires than ever before.

I think this condition results in a situation similar to that which preceded the 1929 market crash. Prior to 1929, companies were free to disclose whatever financial info they wanted (a blue sky situation). Public outcry over the stock market crash (that followed the financial reporting abuses) resulted in government regulation in the form of SEC.   We are now back to a situation where bad information is leading to frequent and extreme market bubbles.  Public outcry over the bubble pops is getting loud and overwhelming. The government is likely now motivated to step in.

If the government is going to step in, what is the best way to do it?  The market for auditors is very imperfect and has resulted in many unintended consequences.  Is the audit profession resurrectible?   I simply don’t see how breaking up the big 4 (actually the top eight) into 20 or 30 audit firms is realistic or able to be accomplished.  After audit firms have learned to get along with corp execs, can they unlearn it? No.

A completely new form of attestation is needed, I think we should fire all the audit firms.

Debit and credit – – David Albrecht

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