On August 1, 2008, the advisory committee issued its final report. This document consists of four chapters: substantive complexity; standards-setting process; audit process and compliance; and delivering financial information. Alas, the very chapters illustrate that this committee is out of tune with today's investors and the illicit proclivities of today's managers.
The first chapter is moronic, as it maintains the myth that the central problem today is complexity. The committee begins with a sophomoric example dealing with the mixed use of fair value and historical cost accounting. While such usage might be a problem, at worst it deals with second-order concerns. 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. I'm at the point that I am willing to accept a full-blown system of either model or any mixture of the two if only managers would report the numbers correctly, completely, accurately, and with full disclosure. As that isn't happening, financial reporting isn't as informative as it could be, and the employment of a mixed model has no bearing on these woes.
The committee also lambasted bright lines, forgetting that 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. The committee favors something called "proportionate disclosure," which is a strange concept given the parsing that executives performed in their 10-Ks and 10-Qs during this past decade. If we continue down that path, we shall find annual and quarterly reports in the grocery store along with the smoked pork.
The committee recommends some comprehensive disclosure framework. that integrates everything into some meaningful whole. Strange, I thought the MD&A section was supposed to be where managers provided a comprehensive and unified discussion of the fiscal transactions and events. Perhaps the committee is telling us that the MD&A section isn't functioning very well. They should not have bothered—we know that already.
Chapter 2 is peculiar inasmuch as it covers the standards-setting process. With the SEC ready to ditch the FASB and outsource standards-setting to the IASB, why should we worry about the standards-setting process? Indeed, what authority would the SEC have over the IASB concerning their operations?
One recommendation by this advisory panel is for the FASB to issue statements with clearly defined objectives and principles to meet the needs of users for clarity and transparency and comparability. What the committee is really saying is that every Karen, Lou, and Janet should be able to read financial reports, regardless of how well they know accounting and finance. This is just a variation of the complexity mantra, and is patently absurd. If the SEC insists that companies make reports readable to seemingly everybody, then firms will not have to report anything on special purpose entities, derivatives, foreign currency translations, pensions, or leases. Otherwise, the average schmuck won't be able to read the financial statements! The error, of course, is that the user must have expertise in accounting and finance. Those without such expertise must rely on intermediaries who can assist them in their investment decision making.
Chapter 3 turns the reader's attention to auditing. The first recommendation ask the FASB or the SEC to supplement existing standards so that auditors judge materiality from the viewpoint of investors. That sounds reasonable, but is nothing new. I wonder whether any of the committee members read or studied the Continental Vending case (U.S. v. Simon). In that 1969 case, Judge Friendly stated, "But it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." While the judge did not employ exactly the language of the committee, I feel that the case already deals with this topic. As an aside, the investment community would have been better off during the last decade had the audit industry heeded the words of Judge Friendly.
The fourth and last chapter examines the technology behind the delivery of financial reports. While this is an interesting and worthwhile topic, it is a third-order issue, at best. After all, if the information itself is not useful, who cares whether it is delivered cheaply, quickly, and efficiently? The issue is the integrity of the information, which in turn requires the integrity of the authors of the financial report.
The committee misses the mark and misses it badly. Let's reiterate the fundamental problem of financial information: it is the management teams who prepare defective, flawed instruments and then publishes them with the flair and patter of a magician. Until we can rein in the temptation of managers to consider the modern corporation as their personal piggy bank, we shall remain in trouble. You cannot fix a problem if you continue to misstate what it is. This is especially hurtful when the likes of Conrad Hewitt, who should know better, turns his head and refuses to examine the essence of financial reporting in the real world.
This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.
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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.2008 SmartPros Ltd. All Rights Reserved. Editorial and opinion content does not represent the opinions or beliefs of SmartPros Ltd.