One of my partners at Financial Reporting Advisors is fond of saying about accounting, “The questions never change.” He’s been watching accounting policy for a lot longer than I have, but even in my relatively brief time, I’ve seen enough to know he’s right.
In a 2006 speech about the issue of judgment in accounting, I used quotes on the topic from SEC chief accountants going back to the 1950s. Of course, issues like fair value versus historical cost, principles versus rules, and off-balance sheet accounting have been kicked around for decades. And in those decades, we’ve generally tried multiple solutions for each of these and many other topics. Which brings us to the second half of my partner’s saying—the questions never change, “but the answers do.”
Again, he’s absolutely correct. Sometimes the answers change because business changes, but in many situations, consensus around what is the right answer changes even though the facts remain the same. I’m sure many would say that this happens too frequently, but regardless of whether it happens more often than it should, there are cautions for all kinds of accountants in the realization that sometimes we change the answers just because we think we’ve gotten smarter.
For example, not all that long ago, treating a disposal as a discontinued operation was highly unusual, because only disposal of an entire business segment qualified. But the Financial Accounting Standards Board concluded that more frequent use of discontinued operations presentation would result in improved financial reporting and passed new guidance along those lines. Now, FASB is close to finishing a project that pushes things back toward the way they used to be, because the Board now believes that discontinued operations presentation is triggered too often.
For another example, we need only look to recent updates to Generally Accepted Accounting Principles on revenue recognition. Emerging Issues Task Force Consensus No. 00-21 prohibited revenue recognition for partially completed contracts if there was no objective evidence of fair value of the as-yet undelivered items. This provision was added to stop what was perceived as abusive accounting, where flimsy evidence of value was used to justify revenue recognition before its time. By 2009, the EITF had concluded that this provision inappropriately delayed revenue recognition, and ASU 2009-13 removed it.
Concurrently, ASU 2009-14 significantly reduced the scope of accounting rules on software revenue recognition; it declared that when hardware and software work together, not only should the hardware not be covered by the software rules, but the software shouldn’t be included either. This was a direct reversal of guidance published in SOP 97-2 and EITF 03-05, which made the whole transaction subject to the software guidance when hardware and software work together—again to stop what were considered abusive practices at the time.
In both of these situations, the standard setters had promulgated guidance intended to achieve a particular purpose, only to decide a relatively short time later that the guidance had worked so well that other problems had been created.
One of my favorite examples of changing answers pertains to accounting for recapitalizations and leveraged buyouts. These deals proliferated in the 1980s, with little equity financing and large amounts of debt. Those promoting the transactions generally desired to use “new basis accounting,” where the assets would be stated at their current values instead of historical cost. This would generally result in the financial statements showing more equity, making debt financing easier to arrange. To ensure that only transactions of real substance resulted in a new basis for the company’s asset and liabilities, the Securities and Exchange Commission issued guidance, making new basis accounting in a recapitalization difficult to qualify for.
By the late 1990s, the preferred method of exiting these deals for the private equity investors had turned to equity; it was generally believed that historical cost looked better for that, because the lower asset values made return on equity look higher, and resulted in lower amortization expenses. Using the SEC staff’s guidance, it was quite easy for companies to avoid new basis accounting, despite clearly substantive changes in ownership and control. Although the SEC staff has since chipped away a little bit at the ability to avoid new basis accounting, many transactions that are clearly acquisitions in substance still are not accounted for as such.
Regulators and standard setters are not the only ones to fall victim to a “be careful what you wish for” situation. When AICPA Statement of Position No. 03-3 was being drafted, it was intended to require that all purchased loans be recorded at their fair value at the time of purchase, without carrying over loan loss reserves. The (correct) principle involved was that a purchaser of a loan has not incurred a loss on that loan at purchase date, and therefore should have no loan loss reserve. Financial institutions and their regulators objected vigorously because they didn’t want to lose carryover of loan loss reserves, which, among other things, provides added flexibility in accounting as compared to recording loans at their fair value. The banks’ view prevailed, and only loans purchased with evident credit quality problems were scoped into SOP 03-3.
A few years later, Financial Accounting Standard No. 142(R), Goodwill and Intangible Assets, did away with carrying over loan loss reserves in a business combination. At that point, banks realized that if they weren’t going to have the flexibility of carrying over loan loss reserves, they preferred the interest recognition model of SOP 03-3, based on expected payments, over the otherwise-required model that looked to contractual cash flows. Once again, their desires were granted, as the SEC staff allowed the banks to apply SOP 03-3 to loans beyond the scope that the banks had short-sightedly insisted upon.
I often work with companies facing questions about long-standing accounting policies. In a lot of these situations, the policies were established long ago and have been applied consistently with little thought about whether subsequent developments warranted a change. Sometimes, obvious changes in GAAP were missed or ignored. But it isn’t just that new standard whose title clearly covers your transaction that can require a change.
One lesson is that every accounting policy and decision deserves a periodic fresh look. Of course, preparers should not rely on auditors to find and track these issues; this is the company’s responsibility.
For example, FAS 141(R) on business combinations included a new definition of “business.” Several other areas of accounting rely partly on whether a grouping of assets constitutes a business. None of the words in those standards were changed by FAS 141(R), but their application changed nonetheless.
Sometimes it isn’t even a new accounting standard that changes the answers so much as a gradual change in thinking. In the past, the “matching principle” and “conservatism” were often considered sufficient justification to support, respectively, capitalizing some expenses and recording other expenses before they were incurred. Today, an accounting policy based on one of these so-called principles is likely to lead to a restatement.
The gradually increasing acceptance of fair value measures provides another such example. Fifteen years ago, it was generally accepted that since the current value of an equity investment in a private company isn’t readily available, one could assume that historical cost was a reasonable estimate of value absent any obvious changes in business prospects, even for several years. Today, a policy that looked back at purchase price as an estimate of fair value for more than a few months would be considered an obvious violation of GAAP.
One more fact pattern that frequently trips up companies is non-GAAP accounting policies that were originally deemed acceptable because of materiality considerations. Things that start out being small and insignificant don’t always stay that way, and there is no way to avoid restating if they become material before they are fixed.
The point of all of this is not to say that the answers should never change. But we should be aware of this tendency and learn from it. For standard setters and regulators, it may mean reacting more slowly when problems are perceived or shiny new models are proposed, to make sure the response is measured and appropriate and that the new model doesn’t cause new problems as it solves old ones. And it reinforces the point that fighting abusive transactions by changing standards often causes more problems. It also means, however, that the standard setters and regulators shouldn’t be embarrassed to change again if it becomes clear that the new guidance isn’t working well.
For preparers, one lesson is that every accounting policy and decision deserves a periodic fresh look. Of course, preparers should not rely on auditors to find and track these issues; this is the company’s responsibility. But another lesson is that sometimes embracing the new answer might be an improvement. After all, the answers change because we think we can do better. Indeed, I’ve run into a couple of instances recently where my clients changed accounting methods after SEC comment letters because, once they considered the SEC staff’s point, they concluded that the alternative was more transparent.
And perhaps one last lesson: Given that the questions have been the same for so long, perhaps more study and understanding of past attempts to deal with the issue can help us avoid problems in the future. As the saying goes, those who don’t learn from history are doomed to repeat it.