standing at the crossroads

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STANDING AT THE CROSSROADS Peter R. Bible Today the accounting profession is standing at the crossroads. The corpo- rate world recently closed two decades of unprecedented greed and corrup- tion. As accountants, we presently find ourselves with an overly complex rules-based, mixed-attribute accounting model, the future of which could reside in the public sector. We will be faced with numerous problems as we attempt to converge U.S. standards with international accounting standards. 1. THE CROSSROADS Which road to take: fair value or historical cost, private sector or public sector, principle-based or rule-based standards, and convergence or non- convergence with international standards setters? 2. PERSPECTIVE: THE DECADES TO THE 1980S AND 1990S Much of the history can be viewed as a succession of actions and reactions. Accordingly, to comprehend the forces at play as we entered the twenty-first century, it is useful to understand the decades of the 1980s and 1990s that in many ways spawned the corporate scandals and the dysfunctional account- ing model that greeted us as we began a new century. I graduated from college in the spring of 1980, took the CPA exam, and began my professional career with the firm of Deloitte, Haskins & Sells in Research in Accounting Regulation, Volume 18, 295–302 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/doi:10.1016/S1052-0457(05)18017-5 295

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Page 1: Standing at the Crossroads

STANDING AT THE CROSSROADS

Peter R. Bible

Today the accounting profession is standing at the crossroads. The corpo-rate world recently closed two decades of unprecedented greed and corrup-tion. As accountants, we presently find ourselves with an overly complexrules-based, mixed-attribute accounting model, the future of which couldreside in the public sector. We will be faced with numerous problems as weattempt to converge U.S. standards with international accounting standards.

1. THE CROSSROADS

Which road to take: fair value or historical cost, private sector or publicsector, principle-based or rule-based standards, and convergence or non-convergence with international standards setters?

2. PERSPECTIVE: THE DECADES TO

THE 1980S AND 1990S

Much of the history can be viewed as a succession of actions and reactions.Accordingly, to comprehend the forces at play as we entered the twenty-firstcentury, it is useful to understand the decades of the 1980s and 1990s that inmany ways spawned the corporate scandals and the dysfunctional account-ing model that greeted us as we began a new century.

I graduated from college in the spring of 1980, took the CPA exam, andbegan my professional career with the firm of Deloitte, Haskins & Sells in

Research in Accounting Regulation, Volume 18, 295–302

Copyright r 2005 by Elsevier Ltd.

All rights of reproduction in any form reserved

ISSN: 1052-0457/doi:10.1016/S1052-0457(05)18017-5

295

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PETER R. BIBLE296

Columbus, Ohio. At that time, the U.S. economy had weathered a sustainedperiod of inflation; the Financial Accounting Standards Board (FASB) hadissued 38 statements and four concept statements; the Emerging Issues TaskForce (EITF) did not exist; the Dow was at 600; the yellow pages forattorneys were actually yellow and required only three pages; the prime ratewas at 21 percent; and the United States and Russia had accumulatedenough nuclear power to destroy each other several times over. I neverthought then that I would view these as the ‘‘good old days.’’

During the course of the 1980s, the economy recovered, the Cold Warcame to an end, the securities markets flourished, and the FASB – includingthe EITF – set sail on an overload of rules-based fair-value standards.

Something much more fundamentally wrong was emerging, however. In1986, I went to Deloitte’s National office to work in accounting research fortwo years. During that time, I helped develop EITF 86-16 and 88-16 onaccounting for leveraged buyouts. After this two-year assignment, I relocatedto the New York practice office to continue working on mergers and acqui-sitions activity until that market collapsed in 1991 with the RJR Nabisco deal.

From 1991 to 1994, I continued to work with Wall Street investmentbankers on the development, pricing, and issuance of collateralized mort-gage obligations. The transactions I worked on during this eight-year periodbecame the subject of three movies and/or books: Wall Street, Barbarians atthe Gate, and Liar’s Poker.

If any of you have read these books or seen the movies, I can assure youthat the excesses displayed were not exaggerated and, in fact, most werepresented in the most favorable light possible.

In 1988, Michael Douglas in his famous ‘‘greed is good’’ speech in WallStreet laid out for us to ponder the fact that during the 1980s somethingfundamentally wrong was emerging. We will have to leave the root causes ofthis newly found obsession with wealth and power to the sociologists andhistorians. One thing had become unfortunately clear: JFK’s rising tide wasfinding only certain yachts.

Very few of the transactions that I worked on were done to benefit MainStreet; to the contrary, they were done to enrich a select few, many timesexcessively.

So the roaring 1980s came to a screeching halt. Ivan Boesky and MichaelMilken were sent to jail by a young U.S. attorney for the Southern Districtof New York named Rudy Giuliani. Many of the corporate raiders andinvestment bankers sailed into the sunset. Unfortunately, their legacy oframpant misuse of insider information, obsession with wealth and power,and complete disregard for the U.S. securities laws would carry on. The

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FASB’s and the EITF’s onslaught of rules-based fair-value pronouncementswould also, unfortunately, carry on.

2.1. Sustained Economic Expansion, Unprecedented Market Performance:

Greed, Rationalization, and Entitlement

The 1990s started as a period of reflection and reform, but would end inmuch the same manner as had the 1980s.

In 1994, I was assigned to a special unit in the firm tasked with defend-ing partners and clients who had strayed over the line in the 1980s. In thisrole, I also conducted independent investigations for audit committees ofalleged accounting irregularities. I believe this work is now called forensicaccounting.

The two most memorable of these investigations involved publicly tradedcompanies, which, at the time, were darlings of Wall Street. Both had grownexponentially through acquisitions accounted for by the purchase method.Both companies used purchase accounting to record what are now referredto as ‘‘cookie-jar’’ reserves that were subsequently released into income tocreate the illusion of profitability. One of these two companies liquidated inbankruptcy and the other survived and is now a household name.

What struck me at the time is that while the FASB and the EITF werepreceding down the path that fair-value accounting was the answer to cor-porate corruption, here were two companies that used the oldest of the fair-value models to manipulate earnings.

In 1995, after four years as a partner, I left the firm and joined corporateAmerica, first at GTE and now at General Motors. Little did I realize thatthe real fun was just about to begin.

Among other things, the decade of the 1990s was defined in large part bysustained economic expansion and unprecedented stock market perform-ance. But the 1990s also sowed the seeds of the scandals that would follow,causing some to describe the decade, in hindsight, as a decade of greed,rationalization, and entitlement.

What happened? On the base of a long-standing bull market, the Dowstarted to grow as if it were on steroids. Reaching 2,000 for the first time inthe late 1980s, the Dow peaked at 11,700 in January 2000. By the late 1990s,investor participation in the capital markets had broadly expanded withalmost half of the households in the United States owning stocks.

The allure of the unlimited potential of technology and, more specifically,the Internet caused many of us to suspend judgment and common sense.Several of us threw money and careers at anything with dot.com at the end of

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its name. Fortunes were being made overnight by young kids emerging fromgarages and by financial brokers playing fast and loose with the market.

The marketplace is a stern taskmaster, however, and the rules of the mar-ketplace will always prevail. Sooner or later, dreams collide with harsh re-ality. Eventually, only real value that results in cash flow is rewarded. Thosewho took shortcuts were discovered, and they reaped what they had sowed.

The dot.com bubble burst, the economy slowed, and the scandalsemerged. The Dow lost 35 percent by July 2002. Depending on the asset mix,many investors lost one-third to two-thirds of their retirement accounts.

2.2. Reasons for the Dysfunctional Behavior

Why did this happen? There have been numerous explanations and will bemany more to answer this question. Ultimately, no matter what the sur-rounding climate, dysfunctional behavior during the 1990s and the scandalsthat followed can be traced to failures of the human condition more thanfinancial manipulation or wizardry with numbers.

In the 1990s, there existed in many people a sense of entitlement to wealththat seemed to be there for the taking, even it if meant bending the rules abit. The supposedly smart but misguided move was to be aggressive andtake risks on a future that would certainly bail out or cover up today’smanipulation. This was a time ripe for abuse.

As stocks declined and the market correction continued, losses mounted, andimproper practices within the capital markets were discovered. Horrendousstories emerging from Global Crossing, Enron, WorldCom, Health South,Tyco, Adelphia, Xerox, Rite-Aid, and many more rocked the marketplace.

2.3. Results of the Climate in the 1990s

What did we get? Congress stepped in with the Sarbanes–Oxley Act of 2002,and the Public Company Accounting Oversight Board was born. TheFASB, under harsh criticism, issued FIN 45, FIN 46, and EITF 01-08, threeof the worst accounting standards ever issued.

The New York Stock Exchange weighed in with its own set of corporategovernance standards, and the SEC issued a slew of new rules. We lost botha major accounting firm and the AICPA’s ability to set auditing standards.

Ultimately, the legacy of the 1990s was a period of euphoric economicoptimism combined with a crisis in the human condition resulting incorporate scandals that rocked the marketplace and changed how we dobusiness forever.

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3. AGAIN AT THE CROSSROADS

So now we are back at the crossroads. Which road do we take? Without thebenefit of time travel, we have only history to guide us down the appropriatepath.

3.1. Standards Setting: Private or Public Sector?

Let us start with the easy issue: private versus public sector standardssetting. Unlike others in the preparer community, I do not believe thatthe FASB has been a failure. I believe that the FASB has advanced theaccounting model to the benefit of the markets and the economy.

The FASB allowed itself to be unduly influenced, however, by those whobelieve that fair value is the answer to all ills including those of the humancondition. Proponents of fair value claim that it is a more relevant conceptthan others, but have yet to articulate why this is so.

As a result, today’s preparers of financial statements must contend with aset of rules that preclude a thorough knowledge, are not easily translated forthose responsible for operating the business, and produce financial state-ments that even the most sophisticated users cannot readily understand. Inshort, what we are left with is a model that I fear has lost its relevance.

Standards setting, however, should be allowed to remain in the privatesector. Some believe that this battle has already been lost and that theFinancial Accounting Foundation will eventually be folded under the Se-curities and Exchange Commission. For this reason, I believe that it isimportant for the FAF to act quickly to revamp the way accounting stand-ards are developed. For example, I find it interesting that the preparercommunity’s participation on the EITF has been limited so that it cannotblock a consensus.

On one occasion a member of the FASB told me that if Statement 133 hadbeen issued earlier, the collapse of Enron could have been avoided. Onanother occasion, a different board member told me that we should not beallowed to apply Statement 106 to the Medicare reform passed in late 2003because it will serve only to increase our year-end bonuses.

One does not need to look much past the accounting for negative good-will in Statement 141 or the accounting for exit activities in Statement 146 torealize that much of the modern hierarchy is based on the perceived need tocounter abuses. This is not the framework on which an advanced societyshould be setting accounting standards.

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3.2. International Standards: Convergence or Nonconvergence?

Let us look at the other easy issue: Convergence or nonconvergence withinternational standards setters.

I have been very impressed by the members of the International Ac-counting Standards Board whom I have dealt with, and I believe that ul-timately convergence is in the best interest of efficient global capital markets– but what is the hurry? After all, we are principally dealing with a continentwhose individual members have been at war with each other for most ofrecorded history. Even Sir David’s home country has yet to join the Eu-ropean Union. I believe that the rush to converge was brought about un-fortunately by the EU’s reaction to Sarbanes–Oxley.

In the information systems world there is a movement toward what iscalled global common systems. Those of us who have pursued this strategyhave found it to be a fool’s errand because customs, regulations, and gov-ernments are still very much based on the geographic rather than the mar-ketplace paradigm. I think we are years away from local governmentsembracing world markets.

Perhaps the lower cost labor pools in Eastern Europe, India, Korea, andChina will help advance this paradigm shift. For now, however, short-termconvergence, like global common systems, looks to be a fool’s errand. Onedoes not need to look further than the attempt to converge on APB 23 torealize that we are moving too fast.

3.3. Basis of Standards?

Now for the two more difficult issues: Should the profession be governed byrules-based or principle-based standards and historical cost versus fair-valuebased standards? These two issues are perhaps the most affected by thelegacy of the 1980s and 1990s. A cold reality today is that those of us leftstanding have to reap what others have sowed.

The Federal Bureau of Investigation, along with the SEC EnforcementDivision and the Internal Revenue Service, are presently investigating 158large-scale corporate fraud cases, 16 of which have losses in excess of $1billion each. These agencies are opening two to six new corporate fraudcases a month and are presently handling more than 2,500 cases involvingsecurities fraud. In 1998, 5 percent of financial fraud actions involved For-tune 500 companies; in 2003, 17 percent involved Fortune 500 companies.

The downfall of both principle-based and fair-value based standards is thatboth required the use of judgments. Judgments in today’s world come with

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the harshest of 20-20 hindsight. Even NFL quarterbacks have an easier life.First, they make a lot more money, and second, they are subject to criticismonly on Monday mornings – not for years of subpoenas and depositions.

As much as I would like to go back to the days of the Accounting PrinciplesBoard, the legacies that we have inherited and the litigious country in whichwe live make principle-based standards, like the APB itself, a fond distantmemory. Perhaps some day, with tort reform and a shift in the present humancondition, we can return to the good old days and principle-based standards.

Most fair-value accounting measurements are mathematical or marketbased and are only as relevant as the prevailing conditions at the time.Valuation experts and actuaries alike will tell you that their work is as muchabout the brush as it is about the pen. I want to contrast that statement withthe illustration of a check written for $1,000, cashed for $1,000, and re-corded as $1,000. Throughout all of humankind, this transaction will remaina $1,000 transaction. Historical cost is the most relevant measure, and it canbe audited leaving nothing to doubt or to chance. Fair value does have itsplace – and to think that Statement 33 had it right! – in a footnote.

My proposal for fair-value financial statements is to first take the currentaccounting literature and throw out Concept Statement 7 and all standardson which it was based. Next throw out Statement 133 and any other stand-ard that requires market-based accounting subsequent to initial recognitionexcept for, of course, lower of cost or market. Take the resulting financialstatements and make them the primary financial statements.

Take those financial statements, replace historical cost equity with thecompany’s market cap at the end of the reporting period, and record anasset or liability for the market’s perception of the company’s future earn-ings and dividend capacity.

Take those financial statements and put them in a footnote – radical? Yes;doable – yes; auditable – yes; relevant – yes. After all, why pursue valuationtheories for assets and liabilities when the equity markets value our com-panies for us every day?

4. AT THE CROSSROADS: EUGENE

FLEGM’S PREDICTION

In conclusion, I would like to pay tribute to Eugene Flegm, who held myposition in the 1980s. In 1984, he wrote the book Accounting: How to Meet

the Challenges of Relevance and Regulation? Much has changed in theUnited States and overseas since that book was published 20 years ago.

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Significant economic, political, and social events; developments in thefields of medicine, science, and communications; and increased threats ofterrorism have changed the way we live and how enterprises conduct busi-ness.

In that book, Gene warned that

y if the accounting profession cannot provide financial data that meets the challenges of

high expectations, validity, relevancy, and objectivity, it will become an army of tech-

nicians filing detailed, specific reports with regulatory agencies pursuant to an ever rising

tide of rules and regulations that will still not meet the need for objective relevant data.

Unfortunately, his warning was prophetic.