This is part four of an eight-part series in which I review the seven IFRS critics (Sunder, Niemeier, Ball, Ketz, Selling, Jensen & Albrecht) of whom I am aware. The series continues over the next two weeks on regular posting dates, MWF.
In today’s essay, I review the work of J. Edward Ketz. Ed writes an editorial column at AccountingWeb.com, called The Accounting Cycle. I have read it regularly over the years, envying Ed for finding issues to write on, and for taking such interesting and principled stands. I have so admired him that the first blog article I wrote was about him, Not Afraid to Call a Schumck a Schmuck.
It always seemed to me that Ed would oppose the U.S. push to adopt IFRS. So, I asked him point blank if he favored the switch. He responded “NO” in 80-point type. As do all of the critics in this series, Ed brings a unique perspective to the IFRS opposition. But first, a few biographical remarks.
Dr. Ketz’s biography from the Penn State Smeal College of Business web site reveals that like the rest of the IFRS critics, he has a public forum:
Dr. J. Edward Ketz has authored numerous articles and nine books and has edited six others. His book Hidden Financial Risk examines the corporate culture and the institutional setting that engendered the recent accounting scandals, informs investors how to protect themselves, and suggests improvements for the profession. His forthcoming Critical Perspectives in Accounting Ethics investigates the accounting profession over the last century by scrutinizing its positions on ethics and its roles in myriad accounting scandals and by exploring whether the industry will ever reduce the number of accounting frauds. His forthcoming Fair Value Measurements summarizes the FASB’s efforts in this area, supplies the conceptual ideas behind this topic, describes methods employed by valuation assessors, and reviews criticisms of fair value measurements.
Dr. Ketz writes a column about financial reporting issues, Accounting Cycle: Wash, Rinse, and Spin, which appears on http://www.SmartPros.com. Professor Ketz has been cited in the popular and business press, including The Wall Street Journal, The New Yor k Times, The Washington Post, Business Week, USA Today, and Chicago Tribune, on topics such as the reconstitution of the Financial Accounting Foundation, accounting for stock compensation, business combination accounting, and evaluations of specific corporate accounting practices at Enron, Tyco, Rite Aid, HealthSouth, and Fannie Mae.
Although no one is counting, Ed Ketz has been particularly effective in getting his views out to the practicing professional.
Dr. Ketz has not published a manifesto on the SEC proposal to move the U.S. to IFRS. Never the less, he does have a well thought out position on the subject. This is what I’ve pieced together from a review of his published work (well over 100 editorials) on the Accounting Cycle.
First, Dr. Ketz firmly believes “The real problem is that corporations are distorting, exaggerating, massaging, and sometimes outright prevaricating about the values, whether they are fair values or historical costs.” (September 2008 With Advisers Like These, Who Needs the SEC?) He has said this, over and over and over again, “… complexity is not the central problem of financial reporting. It is the lack of integrity. Any investor who has real money in the game would prefer complex, truthful financial statements to simple ones riddled with deceit, including those with the white lies of exaggeration and omission.” (October 2007, Suggestions for the SEC Advisory Committee on How to Improve Financial Reporting.)
Second, proponents of the SEC push to IFRS have justified it in part because American accounting rules are too complex. Dr. Ketz strongly disagrees. “If Cox thinks that principles-based accounting will make financial reporting simpler, I wish he would say that. Then we could discuss the absurdity of that position.” (December 2005, Cox Encourages Simpler Accounting: Bah, Humbug!) Dr. Ketz reasons:
When business enterprises report on their financial condition and on their results during the past year (or quarter), they can more precisely convey their message by applying a more precise accounting language. This text, however, is meant for those trained in finance and in accounting. Complexity can actually improve the communication process when the recipient is a sophisticated user. Naïve financial statement readers may not understand the language of accounting, but they are not necessarily hurt by that situation. Just as general practitioners can revert from a medical language to everyday language when they speak with patients, financial analysts and brokers can employ plain English when they speak with clients. In this manner, the messages contained in an annual (or quarterly) report become disseminated to a wide audience. (December 2005, Herz Encourages Simpler Accounting: Again, Bah, Humbug!)
Third, Dr. Ketz does not favor the push to a more principles-based set of accounting standards. One reason for his disagreement is that those who favor this push have not defined what they mean by the difference between “rules” and “principles”. “[Herz] touts principles-based accounting as the savior for the world of financial reporting, but again provides no argumentation to support his hypothesis. Maybe it’s because there is none.” (December 2005 Herz Encourages Simpler Accounting: Again, Bah, Humbug!) Anyway, he sees too much arbitrariness in both U.S. GAAP and IFRS.
However, his main point of contention is with the claim that accounting scandals show that American accounting rules simply don’t work. It is as if American accounting rules cause scandals. Dr. Ketz strongly disagrees. In part, his disagreement is based on the fabric of American society and the economic incentives present that induce managers to act dishonestly.
American investors tend to be ridiculously near-sighted, whereas most foreign investors are relatively content with long-term results. U.S. investors want stock appreciation and they want it now. Moreover, they look at corporate earnings as one of the signals upon which to bid up or down the stock price, despite the fact that quarterly earnings have relatively low reliability. A principles-based system won’t change this insane, short-term focus, nor will it add to the reliability of the earnings numbers. Because of this investor myopia, corporate boards tend to compensate and to evaluate their top brass on the basis of short-term income. Contracts based on quarterly earnings give business managers incentives to inflate the numbers. Executives find it easy to inflate these accounting numbers because of the inherent limits on their reliability. The U.S. society provides managers with wrong incentives, and it supplies them with a means to distort the truth and look good to investors and creditors. A principles-based accounting regime will not modify investor focus in the short run, nor will it change the economic incentives for managers, nor will it affect the reliability of accounting numbers.
As [IFRS proponents] ignore these economic realities, they overlook social and economic variables that explain the incidence of accounting fraud in America versus the rest of the world. They overlook the explanatory variables and replace them with some dogma to justify their own agenda. (March 2006 Debunking the Supposed Link Between Rules and Accounting Scandals.)
Dr. Ketz claims that rules have value. Speaking to those who support IFRS principles because of its lack of rules, he says,
I have often heard people remark that society cannot legislate morality… All governments have been doing this from the beginning of time, they are doing it now, and I have every confidence that they will continue to do so in the future.
Those who allege that society cannot legislate morality or ethics, however, usually mean … that the federal government or the states or the local entities may enact such bills, but that does not imply that there is a change in anybody’s heart or soul to make them act a certain way. For example, saying that a person should not murder another human being does not imply that people won’t dislike, distrust, hate, or envy another, perhaps so much so that they would carry out this deed. Likewise, prohibiting a manager from defrauding investors and creditors does not imply that any manager will have the compassion, concern, and empathy to treat investors and creditors in a decent fashion. Managers might just as well carry out some get rich scheme despite whatever legislation is on the books.
This argument misses the point, for laws that prohibit murder, kidnapping, theft, perjury, and fraud are not directed to the heart or the spirit. They are aimed at human behaviors. The idea is to create incentives for actions that society wants to encourage and disincentives for deeds that society desires to deter.
… it is true that you cannot legislate honesty. You can, however, create enough disincentives to make people most uncomfortable and unhappy if they lie. (November 2004 “You Can’t Legislate the Truth!”)
Speaking specifically to accounting rules, Dr. Ketz says, “… bright lines serve the useful function of delineating relatively unambiguously what is what. That is a better process than allowing managers to pick and choose what they want and decide how to report it and allowed to nuance the meaning of any and all accounting constructs. (September 2008 With Advisers Like These, Who Needs the SEC?) Ketz also says, “Besides, principles-based accounting requires principled people for it to work because principles-based accounting will be easier to manipulate. (December 2005, Cox Encourages Simpler Accounting: Bah, Humbug!) As a concluding statement in this string of thought, “Simplify the standards-setting process? Sure. Simplify the GAAP hierarchy? By all means. But use principles-based accounting? Only if you want more accounting scandals.” (April, 2005, FASB’s Efforts Toward Simplification)
I think the crux of Dr. Ketz’s philosophy is that what is needed more than anything is better enforcement of the rules already in place, “ If anything, we need to create more deterrents and increase the probability of discovering falsehoods. Such a world would have much better financial reports than we do today.“ (November 2004 “You Can’t Legislate the Truth!”)
To emphasize this point, another quotation, “To improve financial reporting and to encourage truth telling by managers, there is nothing like enforcement of the securities laws and class-action lawsuits. President Bush ought to strengthen these processes instead of appointing somebody like Cox.” (June 2005, Christopher Cox Doesn’t Reside at Pooh Corner)
In particular, Dr. Ketz is extremely critical of SEC Chairman Christopher Cox’s motivations and his resulting deemphasis of investor interests in favor of business interests. His recent “A Pox on Christopher Cox” (September 2008) is well worth the read in its entirety. I quote the following passages:
I would like to add my voice to those criticizing Securities and Exchange Commission Chairman Christopher Cox and holding him responsible in part for the collapse of the U.S. financial sector. I definitely agree with those calling for his resignation or saying they would fire him if they were president. Actually, these critics are joining my position. I knew from the beginning that Cox was pro-managers and anti-shareholders, and so I criticized his appointment. President Bush appointed Cox chairman of the SEC on June 2, 2005. In Christopher Cox Doesn’t Reside at Pooh Corner, published in June 2005, I said, “In a flash, the SEC will turn from a pro-investor agency to one that will oppose meaningful change. Managers will note the alteration and start ‘managing earnings’ as they did in the roaring 90s.” That’s precisely what happened in the financial industry and now we are paying for it.
I presented this analysis because Cox had a history of promoting lies and exaggerations in the financial statements instead of calling for truth and transparency when he was a member of the House of Representatives. [Ketz then proceeds to cite a long list of Cox actions while in Congress.]
During his tenure as SEC Chairman, Christopher Cox blunted any stockholder reforms, thus continuing the enervation of company owners. He promoted principles-based accounting so managers do not have to follow accounting rules and have more flexibility in manipulating their financial statements.
Finally, it should also be said that Dr. Ketz has problems with several specific IFRS standards.
I appreciate the important addition that Dr. Edward Ketz brings to the anti-IFRS argument, and I look forward to his continued remarks every month at The Accounting Cycle.