Well, the die seems to be cast. President Obama will call for a big-bang switchover to IFRS, this much is likely. I personally predict that the last year GAAP may be used in the U.S. by SEC reporting companies is for fiscal years ending December 31, 2010. The Obama administration will rework the proposed Road Map.
Today’s topic, though, is a preliminary discussion on how accounting education must change under the new regime. I think accounting professors must now teach financial statement planning and strategy in the same way that tax professors teach tax planning.
Under IFRS, flexibility and alternatives are the key words. According to Harvey Pitt, former Chairman of the SEC, “The reality is that it will likewise be possible that two companies in the same industry will report differently under IFRS. Investors and regulators will have to adjust to life under this new regime, and there is no time like the present—or at least the near future—to start getting used to it. ” (Pitt, 2008) The only limiting factor will be for corporate executives to decide what, in their professional judgment, they wish to report in the financial statements. Almost anything will go.
If corporate executives are being given the freedom to report any number they wish in the financial statements, then what should be the guiding principle(s) behind their choices? The answer, loyal readers, is that Income Smoothing has again come to the United States.
Once upon a time in the United States, Income Smoothing was a common practice in the United States. Income Smoothing, quite simply, is judicial use of accounting machinations to change accounting reports so that they tell a desired story. In its purest form, Income Smoothing takes a time-series of reported net income and smooths it until a trend is apparent. Peaks are squashed, valleys are filled in, and an aesthetic trend line remains.
The underlying concept is that financial statements should be cast in such a fashion so as to help potential investors and lenders understand the vision, hopes and expectations that corporate management has for future earnings. Such understanding is an essential element of the quest for new capital in the international financial market system of the twenty first century. Future earnings can best be properly understood in the context of earnings that have been reported in the past. If historical earnings must be modified, saving income (or expense) for future periods, so be it. It is not fraudulent to change actual revenue/expense numbers to managed numbers in the present so as to make it possible for a range of possibilities to be reported in the future. No, it will now be public policy.
A caveat to this new policy is that motives of corporate executives are deemed to be pure until proven otherwise. Under the new policy, it will be virtually impossible to prove otherwise until after a corporate collapse and evidentiary investigations that can only occur in a court of law.
Historically, there was substantial debate over this practice. The consensus that emerged was that income smoothing was tantamount to fraud. New terms were rolled out to descibe the practice. Terms such as manipulation, cooking the books and accounting fraud were substituted for income smoothing. The Committee on Accounting Procedures couldn’t reign in income smoothing, so it gave way to the Accounting Prinicples Board. The Accounting Principles Board couldn’t stop it, so (1) the International Accounting Standards Committee was formed to have a go at it, and (2) the APB gave way to the FASB. The FASB was somewhat successful in ending it. It’s success can be measured by the many examples of regularory disobedience as corporate executives willfully chose not to follow accounting rules. Pitt, Cox, Herz and others, though, cite this regulatory disobedience as proof that the FASB was not successful in ending income smoothing The IASC gave way to the IASB. Both international groups decided not to fight income smoothing, but to embrace it as the foundation for financial reporting.
So, the attempts to limit income smoothing led directly to a political reversal, the adoption of IFRS in the United States. Now that it is soon to be the regulatory law of the land, how should we teach it?
The answer is that we as accounting educators should embrace it. If it is to be supported by the laws of the land, and is not fattening, then why not? What does embracing IFRS in the classroom entail?
I think that a defensible IFRS approach in the classroom is to expand Intermediate Accounting to three semesters. All the existing rules still need to be taught, including many alternatives not previously taught. Then, financial reporting planning and strategy needs to be taught. How best should income smoothing be accomplished? Now that all accounting practices are fair game, what could be used to get desired earnings numbers? What are the ramifications of modifying number A instead of number B?
Under IFRS, reported earnings numbers are expected to increase by 10-30% in the United States. How best should this income inflation be accomplished? Such will be the job of educatiors in the twenty first century.
Over and out–David Albrecht