Brief Summary of Accounting Theory

Bob Jensen at Trinity University


Accounting History in a Nutshell

Accounting Research Versus the Accountancy Profession

Methods for Setting Accounting Standards

Underlying Bases of Balance Sheet Valuation

Accrual Accounting and Estimation 

Earnings Management:  The Controversy over Earnings Smoothing and Other Manipulations 

Goodwill Impairment Issues 

Leases:  A  Scheme for Hiding Debt That Won't Go Away 

Insurance:  A Scheme for Hiding Debt That Won't Go Away

Debt Versus Equity 

Intangibles:   Theory Disputes Focus Mainly on the Tip of the Iceberg (Intangibles)

Intangibles: Measuring the Value of Intangibles and Valuation of the Firm

Intangibles:  An Accounting Paradox

Intangibles:  Selected References On Accounting for Intangibles

EBR:  Enhanced Business Reporting (including non-financial information)

The Controversy Over Revenue Reporting and HFV 

The Controversy Over Employee Stock Options as Compenation  

The Controversy over Accounting for Securitizations and Loan Guarantees  

The Controversy Over Pro Forma Reporting

Triple Bottom Reporting  

The Controversy Over Fair Value (Mark-to-Market) Financial Reporting

Online Resources for Business Valuations

Understanding the Issues 

Issues of Auditor Independence 

Quality of Earnings:  Standard & Poor's Redefines Core Earnings

Economic Theory of Accounting

"Visualization of Multidimensional Data" --- 

Bob Jensen's threads on XBRL are at 

Accounting for Electronic Commerce, Including Controversies on Business Valuation, ROI, and Revenue Reporting --- 

Comparisons of International IAS Versus FASB Standards --- 

Paul Pacter has been working hard to both maintain his international accounting site and to produce a comparison guide between international and Chinese GAAP.  He states the following on May 26, 2005 at 

May 26, 2005:  Deloitte (China) has published a comparison of accounting standards in the People's Republic of China and International Financial Reporting Standards as of March 2005. The comparison is available in both English and Chinese. China has different levels of accounting standards that apply to different classes of entities. The comparison relates to the standards applicable to the largest companies (including all non-financial listed and foreign-invested enterprises) and identifies major accounting recognition and measurement differences. Click to download:



The chronology of events leading up to European adoption if common international accounting standards ---

This is a Good Summary of Various Forms of Business Risk  --- 

  1. Enterprise Risk Management

  2. Credit Risk

  3. Market Risk

  4. Operational Risk

  5. Business Risk

  6. Other Types of Risk?

Accounting History in a Nutshell

Early accounting was a knotty issue
South American Indian culture apparently used layers of knotted strings as a complicated ledger.

Two Harvard University researchers believe they have uncovered the meaning of a group of Incan khipus, cryptic assemblages of string and knots that were used by the South American civilization for record-keeping and perhaps even as a written language. Researchers have long known that some knot patterns represented a specific number. Archeologist Gary Urton and mathematician Carrie Brezine report today in the journal Science that computer analysis of 21 khipus showed how individual strings were combined into multilayered collections that were used as a kind of ledger.
Thomas H. Maugh, "Researchers Think They've Got the Incas' Numbers," Los Angeles Times, August 12, 2005 ---,1,6589325.story?coll=la-news-science&ctrack=1&cset=true

Jensen Comment:  I'm told that accounting tallies in Africa and other parts of the world preceded written language.  However, tallies alone did not permit aggregations such as accounting for such things as three goats plus sixty apples.   Modern accounting awaited a combination of the Arabic numbering ( ) and a common valuation scheme for valuing heterogeneous items (e.g., gold equivalents or currency units) such that the values of goats and apples could be aggregated.  It is intriguing that Inca knot patterns were something more than simple tallies since patterns could depict different numbers and aggregations could possibly be achieved with "multilayered collections."

Let me close by citing Harry S. Truman who said, "I never give them hell; I just tell them the truth and they think its hell!"
Great Speeches About the State of Accountancy

"20th Century Myths," by Lynn Turner when he was still Chief Accountant at the SEC in 1999 ---

It is interesting to listen to people ask for simple, less complex standards like in "the good old days." But I never hear them ask for business to be like "the good old days," with smokestacks rather than high technology, Glass-Steagall rather than Gramm-Leach, and plain vanilla interest rate deals rather than swaps, collars, and Tigers!! The bottom line is—things have changed. And so have people.

Today, we have enormous pressure on CEO’s and CFO’s. It used to be that CEO’s would be in their positions for an average of more than ten years. Today, the average is 3 to 4 years. And Financial Executive Institute surveys show that the CEO and CFO changes are often linked.

In such an environment, we in the auditing and preparer community have created what I consider to be a two-headed monster. The first head of this monster is what I call the "show me" face. First, it is not uncommon to hear one say, "show me where it says in an accounting book that I can’t do this?" This approach to financial reporting unfortunately necessitates the level of detail currently being developed by the Financial Accounting Standards Board ("FASB"), the Emerging Issues Task Force, and the AICPA’s Accounting Standards Executive Committee. Maybe this isn’t a recent phenomenon. In 1961, Leonard Spacek, then managing partner at Arthur Andersen, explained the motivation for less specificity in accounting standards when he stated that "most industry representatives and public accountants want what they call ‘flexibility’ in accounting principles. That term is never clearly defined; but what is wanted is ‘flexibility’ that permits greater latitude to both industry and accountants to do as they please." But Mr. Spacek was not a defender of those who wanted to "do as they please." He went on to say, "Public accountants are constantly required to make a choice between obtaining or retaining a client and standing firm for accounting principles. Where the choice requires accepting a practice which will produce results that are erroneous by a relatively material amount, we must decline the engagement even though there is precedent for the practice desired by the client."

We create the second head of our monster when we ask for standards that absolutely do not reflect the underlying economics of transactions. I offer two prime examples. Leasing is first. We have accounting literature put out by the FASB with follow-on interpretative guidance by the accounting firms—hundreds of pages of lease accounting guidance that, I will be the first to admit, is complex and difficult to decipher. But it is due principally to people not being willing to call a horse a horse, and a lease what it really is—a financing. The second example is Statement 133 on derivatives. Some people absolutely howl about its complexity. And yet we know that: (1) people were not complying with the intent of the simpler Statements 52 and 80, and (2) despite the fact that we manage risk in business by managing values rather than notional amounts, people want to account only for notional amounts. As a result, we ended up with a compromise position in Statement 133. To its credit, Statement 133 does advance the quality of financial reporting. For that, I commend the FASB. But I believe that we could have possibly achieved more, in a less complex fashion, if people would have agreed to a standard that truly reflects the underlying economics of the transactions in an unbiased and representationally faithful fashion.

I certainly hope that we can find a way to do just that with standards we develop in the future, both in the U.S. and internationally. It will require a change in how we approach standard setting and in how we apply those standards. It will require a mantra based on the fact that transparent, high quality financial reporting is what makes our capital markets the most efficient, liquid, and deep in the world.

Origins of Double Entry Accounting are Unknown

In her notes compiled in 1979, Professor Linda Plunkett of the College of Charleston S.C., calls accounting the "oldest profession"; in fact, since prehistoric times families had to account for food and clothing to face the cold seasons. Later, as man began to trade, we established the concept of value and developed a monetary system. Evidence of accounting records can be found in the Babylonian Empire (4500 B.C.), in pharaohs' Egypt and in the Code of Hammurabi (2250 B.C.). Eventually, with the advent of taxation, record keeping became a necessity for governments to sustain social orders.

The following is a controversial quotation from 

"The power of double-entry bookkeeping has been praised by many notable authors throughout history. In Wilhelm Meister, Goethe states, "What advantage does he derive from the system of bookkeeping by double-entry! It is among the finest inventions of the human mind"... Werner Sombart, a German economic historian, says, "... double-entry bookkeeping is borne of the same spirit as the system of Galileo and Newton" and "Capitalism without double-entry bookkeeping is simply inconceivable. They hold together as form and matter. And one may indeed doubt whether capitalism has procured in double-entry bookkeeping a tool which activates its forces, or whether double-entry bookkeeping has first given rise to capitalism out of its own (rational and systematic) spirit".

If, for a moment, one considers the credibility crisis of practical accounting, it would be quite impossible to dismiss the following paradox: the conflict between the enthusiastic praise of the system's strength on the one hand, and on the other, the many financial failures in the real world. How can such a powerful system, even when applied meticulously, still result in disasters? Although it is hardly necessary to argue more in favour of double-entry book-keeping, I still want to underline the two qualities of the system which I find are valid explanations of the system's very important and world-wide role in financial development for five centuries.

The Logic of Double-Entry Bookkeeping, by Henning Kirkegaard
Department of Financial & Management Accounting 
Copenhagen Business School 
Howitzvej 60


Along this same double-entry thread I might mention my mentor at Stanford.
Nobody I know holds the mathematical wonderment of double-entry and historical cost accounting more in awe than Yuji Ijiri.  For example, see Theory of Accounting Measurement, by Yuji Ijiri (Sarasota:  American Accounting Association Studies in Accounting Research No. 10, 1975).  

Dr. Ijirii also extended the concept to triple-entry bookkeeping in (Sarasota:  Triple-Entry Bookkeeping and Income Momentum
American Accounting Association Studies in Accounting Research No. 18, 1982).

Also see the following:

Brush up your Shakespeare:  Medieval manuscripts to hit Internet
Stanford University Libraries, the University of Cambridge and Corpus Christi College, Cambridge, will make hundreds of medieval manuscripts, dating from the sixth through the 16th centuries, accessible on the Internet.
"Medieval manuscripts to hit Internet," Stanford Report, July 13, 2005 ---

A summary of the medieval times and literature is available at

Brush up your Shakespeare:  Medieval manuscripts to hit Internet
Stanford University Libraries, the University of Cambridge and Corpus Christi College, Cambridge, will make hundreds of medieval manuscripts, dating from the sixth through the 16th centuries, accessible on the Internet.
"Medieval manuscripts to hit Internet," Stanford Report, July 13, 2005 ---

A summary of the medieval times and literature is available at

May 28, 2005  reply from Barbara Scofield [scofield@GSM.UDALLAS.EDU]

Thank you for the notice about the availability of the medieval manuscripts on the Internet through the project Parker on the Web at Stanford University. Two manuscripts are currently available, and on page 11 of the English translation of Matthew Paris's "English History From 1235 to 1273" I have already found references to accounting (see below).

Accountants are still using the principle "under whatever name it may be called" and entities are still making up new names for inconvenient economic events in the hopes of avoiding full disclosure.

At this Catholic liberal arts university Shakespeare is modern, and the medieval world is revered, so I'm interested in gaining some insight into the medieval worldview.

Barbara W. Scofield, PhD, CPA
Associate Professor of Accounting
University of Dallas
1845 E. Northgate Irving, TX 75062
Braniff 262 


Going Concern and Accrual Accounting Evolved in the 1500s

Limited liability Corporations (divorced professional management from ownership shares)

Speculation Fever
Fraud and corruption festered and grew with the trading of joint stock, especially after 1600 A.D.  The South Seas Company scandal (reporting stock sales as income and paying dividends out of capital) led to England's Bubble Act in 1720 A.D. that focused on misleading accounting practices that helped managers rip off investors, especially by crediting stock sales to income.

Laissez-Faire Accounting survived endless debates and scandals until the Great Depression in 1933

After 1933, the AICPA and the SEC seriously attempted to generate accounting standards, enforce accounting standards, and provide academic justification for promulgated standards.

Wow Online Accounting History Book (Free)
Thank you David A.R. Forrester for providing a great, full-length, and online book:
An Invitation to Accounting History --- 
Note especially Section B2 --- "
Rational Administration, Finance And Control Accounting:  the Experience of Cameralism" --- 

Accounting history lecture worth noting ---

Monumental Scholarship (The following book is not online.)
The Early History of Financial Economics 1478-1776
by Geoffrey Poitras (Simon Fraser University) --- 
(Edward Elgar,  Cheltenham, UK, 2000) --- 

Jack Anderson sent the following message:

A good book on accounting history in the U.S. is

A History of Accountancy in the United States by Gary John Previts and  Barbara Dubis Merino


It's available through The Ohio State University Press (see web site )


I'm unaware of a good history of international accounting but would like to hear of one.


Jack Anderson


The FASB's website is at 

The future of the FASB and all national standard setters is cloudy due to the globalization of business and increasing needs for international standards.  The primary body for setting international standards was the International Accounting Standards Committee (IASC) that evolved into the International Accounting Standards Board (IASB) having a homepage at  For a brief review of its history and the history of its standards, I recommend going to

In 2001, the IASC was restructured into the new and smaller International Accounting Standards Board (IASB).  The majority of the IASB members will be full-time, whereas the members of the IASC were only part-time and did not have daily face-to-face encounters with other Board members or the IASC staff.  The IASB will operate more like the FASB in the U.S.  

In the early years of its existence, the IASC tended to avoid controversial issues and there was nothing to back up its standards (except in the U.S. where lawyers will use almost anything to support litigation brought by investors against corporations).  

Times are changing at the IASC.  It has been restructured and is getting a much greater budget for accounting research.  Most importantly, IASC standards are becoming the standards required by large international stock exchanges (IOSCO).

The Global Reporting Initiative (GRI) was established in late 1997 with the mission of developing globally applicable guidelines for reporting on the economic, environmental, and social performance, initially for corporations and eventually for any business, governmental, or non-governmental organisation (NGO). Convened by the Coalition for Environmentally Responsible Economies (CERES) in partnership with the United Nations Environment Programme (UNEP), the GRI incorporates the active participation of corporations, NGOs, accountancy organisations, business associations, and other stakeholders from around the world business plan --- 

Jagdish Gangolly recommends the following book:
Dollars & scholars, scribes & bribes: The story of accounting by Gary Giroux # Dame Publications, Inc (1996) # ASIN: B0006R6WQS ---  

Jim McKinney recommends the following book;
It is not a lot more recent but I would consider the US centric text: A History of Accountancy in the United States: The Cultural Significance of Accounting by Previtz & Merino published in 1998. It is available in paperback.

Accounting Research Versus the Accountancy Profession

Academics Versus the Profession

The real world is only a special case, and not a very interesting one at that.
--Attributed to C. E. Ferguson and forwarded by Ed Scribner

Imagination is not to be divorced from facts: it is a way of illuminating the facts. It works by eliciting the general principles which apply to the facts, as they exist, and then by an intellectual survey of alternative possibilities which are consistent with these principles. It enables men (sic) to construct an intellectual vision of a new world, and it preserves the zest of life by the suggestion of satisfying purposes.
Alfred North Whitehead in an address to the AACSB in 1927 and quoted in the paper by Bennis and O'Toole cited below.

During the past several decades, many leading B schools have quietly adopted an inappropriate --- and ultimately self-defeating --- model of academic excellence.  Instead of measuring themselves in terms of the competence of their graduates, or by how well their faculties understand important drivers of business performance, they measure themselves almost solely by the rigor of their scientific research. They have adopted a model of science that uses abstract financial and economic analysis, statistical regressions, and laboratory psychology.  Some of the research produced is excellent, but because so little of it is grounded in actual business practices. the focus of graduate business education has become increasingly circumscribed --- and less and less relevant to practitioners ...We are not advocating a return to the days when business schools were glorified trade schools.  In every business, decision making requires amassing and analyzing objective facts, so B schools must continue to teach quantitative skills.  The challenge is to restore balance to the curriculum and the faculty:  We need rigor and relevance.  The dirty little secret at most of today's best business schools is that they chiefly serve the faculty's research interests and career goals, with too little regard for the needs of other stakehollders.
Warren G. Bennis and James O'Toole, "How Business Schools Lost Their Way," Harvard Business Review, May 2005.
The article be downloaded for a fee of $6.00 ($3.70 to educators) ---

Accentuate the Obvious
Not every scientist can discover the double helix, or the cellular basis of memory, or the fundamental building blocks of matter. But fear not. For those who fall short of these lofty goals, another entry in the "publications" section of the ol' c.v. is within your reach. The proliferation of scientific journals and meetings makes it possible to publish or present papers whose conclusion inspires less "Wow! Who would have guessed?" and more "For this you got a Ph.D.?" In what follows (with thanks to colleagues who passed along their favorites), names have been withheld to protect the silly.
Sharon Begley, "Scientists Research Questions Few Others Would Bother to Ask," The Wall Street Journal, May 27, 2005; Page B1 ---,,SB111715390781744684,00.html
Jensen Comment:  Although some of the studies Begley cites are well-intended, her article does remind me of some of the more extreme studies that won Senator Proxmire's Golden Fleece Awards ---
Also see
Accounting research in top accounting journals seldom is not so much a fleecing as it is a disappointment in drawing "obvious" conclusions that practicing accountants "would not bother to ask."  Behavioral studies focus on what can be studied rather than what is interesting to study.  Studies based on analytical mathematics often start with assumptions that guarantee the outcomes.  And capital markets event studies either "discover" the obvious or are inconclusive.

Year 2005 American Accounting Association Annual Meeting in San Francisco August 5-10, 2005
The AAA meetings were very good this year except for the first plenary session. Bravo to Tracie, Dee, and their helpers for great logistics. The Hilton did a great job. Bravo to Jane and her helpers for a great program.

I think Katherine's plenary (Tuesday) session on disclosures will be posted by the AAA. Katherine made reference to quite a lot of academic research. She might also make her PowerPoint file available at the FASB.

I hope the AAA will also post Denny's terrific luncheon speech. If not, I think Denny will share it in some way with all of us on the AECM.

A highlight of the meetings for me was the XBRL workshop conducted by Glen, Roger, and Skip. Eric Cohen also participated with a great demo of Rivet Software's Dragon Tag software which finally makes it possible to teach XBRL hands on to students.

Another highlight was the great debate between Katherine Schipper (for fair value accounting) versus more negative positions taken by Ross Watts and Zoe-Vanna Palmrose. All three did a great (actually unforgettable) job on Monday afternoon.

This 2005 AAA meeting set a record with nearly 2,700 registrations plus over 500 registered guests. This topped the previous record which was also set in San Francisco some years ago. Such a registration number is very high considering that there are only about 8,000 worldwide members of the AAA ---

I returned to Trinity University from New Hampshire today. Trinity is still seeking somebody to fill my chair (the Jesse H. Jones Distinguished Professor of Business Chair) after I retire in May 2006. Anyone interested in applying should contact Dan Walz at 210-999-7289 or I am very grateful to have had the privilege to fill it for 24 years.

Life is good!

August 13, 2005 reply from Glen Gray [glen.gray@CSUN.EDU]

Gee, thanks for your kind words regarding our XBRL workshop.

For those who want to know more about XBRL, you should:

See XBRL cover story in August 2005 Journal of Accountancy at 

Visit  -- includes general and technical information about XBRL

Check out the 5-years of XBRL abstracts at 

Review FAQs at  , which cover a broad range of XBRL questions

Visit  , a blog-like coverage of XBRL 

Check out the free XBRL teaching materials that will be available (Sept 1) at

Bob Jensen's threads on XBRL are at

Bob Jensen's threads on fair value reporting are at

August 15, 2005 reply from McCarthy, William [mccarthy@BUS.MSU.EDU]

I agree that some of the annual meeting sessions mentioned already were quite good this year, but for me, the clear highlight of the convention was the policy speech given by new AAA president Judy Rayburn at the Wednesday luncheon.

Judy made a strong case for expanding the scope and volume of the AAA journal set by using comparisons to publication trends and citation trends in management, marketing, and finance. She also mentioned some specific AAA committee work that was going to assess these matters. Judy finished by coming down to the floor and answering all individual questions on rather difficult matters such as the acceptability of research paradigms from other countries and disciplines, and the effect of expansion on AAA section journals.

Many attendees did not have a ticket to the Wednesday luncheon, but I am sure Judy's slides will be made available to all.

Bill McCarthy
Michigan State

August 15, 2005 reply from Ali Mohammad J. Abdolmohammadi

I agree with Bill. While I found many presentations to be excellent this year, I was particularly impressed with Judy Rayburn's luncheon policy speech on Wednesday. I found the speech to be honest and gutsy. My nonscientific observation of the crowd was that the speech resonated well with the majority. It'll take a lot of hard work to make serious changes to the current publication culture of AAA journals, but it is well worth trying.

Ali Mohammad J. Abdolmohammadi, DBA, CPA 
John E. Rhodes Professor of Accounting
Bentley College
175 Forest Street
Waltham, MA 02452

Fraudulent Conferences that Rip Off Colleges:  Do you really want to participate in these frauds?
I've written about this before, but I want to elaborate.  Academics either unwittingly or willingly sometimes allow themselves to get caught up in fraudulent "conferences."  Spam is on the rise for these frauds.  The degree of fraudulence varies.  At worst, there is no conference and organizers merely charge an exorbitant fee that allows the paper to be "refereed"  and published in a conference proceedings, thereby giving a professor a "publication."  See

Even when the conferences meet, they may be fraudulent.  Generally these conferences are held in places where professors like to travel in Europe, South America, Latin America, Las Vegas, Canada, the Virgin Islands, or other nice locations for vacations that accompany a trip to a conference paid for by a professor's employer.  The professor gets credit for a presentation and possibly a publication in the conference proceedings. 

But wait a minute!  Here are some warning signs for a fraudulent conference:

  1. Even though there is a high registration fee, there are no conference-hosted receptions, luncheons, or plenary sessions.  The conference organizer is never called to account for the high registration fee.  The organizer may allude to the cost of meeting rooms in a hotel, but often the meeting rooms are free as long as the organizer can guarantee a minimum number of guests who will pay for rooms in the hotel.

  2. All or nearly all submissions are accepted for presentation.

  3. The only participants in most presentation audiences are generally other presenters assigned to make a presentation in the same time slot.  There is virtually no non-participating audience.  Hence only a few people are in the room and each of them take turns making a presentation.  Most are looking at their watches and hoping to get out of the room as soon as possible.

  4. Presenters present their papers and then disappear for the rest of the conference.  There is virtually no interaction among all conference presenters.

  5. The papers presented are often journal rejects that are cycled conference after conference if the professor can find a conference that will accept anything submitted on paper.  Check the dates on the references listed for each paper.  Chances are the papers have few if any references from the current decade.

  6. These conferences are almost always held in popular tourist locations and are often scheduled between semesters for the convenience of adding vacation time to the trip.  They are especially popular in the summer.

Bob Jensen's threads on various types of fraud in academe are at

August 17, 2005 reply from Jagdish Patha


I was about to be fleeced by one such conference cheat claiming himself some Dr.----. generally organizes conferences at almost all the exotic locations of US, Cancun, Venice etc. This organizer double blind peer reviewed my submission (almost 35-40 pages) within 52 hours! Asked for per page charges if required to be placed in "proceedings" which happens to be a CD-ROM. This organizer has also got 4-5 journals which can ultimately accommodate any paper written from any angle of any sphere of business. You may get into any journal of your choice which will claim to be "double blind peer reviewed'!

I wish there should be some agency of regulators who can tame them. These people are bogus, there conferences are bogus and often I feel that what will be the face of a person who will come out and claim a paper presented and published in such bogus outlet to be considered suitable for tenure and promotion!

Jagdish Pathak, PhD
Guest Editor- Managerial Auditing Journal (Special Issue)
Associate Professor of Accounting & Systems Accounting & Finance Area
Odette School of Business
University of Windsor 401 Sunset Windsor, N9B 3P4, ON Canada

August 17, 2005 reply from David Albrecht

My answer is at the bottom of the paper, but please read my supporting argument.

Generally speaking I am not in favor of my department funding conference presentations for other faculty. I just don't think much is gained from it, and it is a very expensive CV line. I'd say that a lot of sponsored conferences haven't distinguished themselves from the rip-offs. However, the research-oriented faculty at my school are funded to attend conferences and conference presentations are the name of the game. So like it or not, I have to play the game.

But are quality conferences, such as AAA conferences, a rip-off? Is the phrase quality conference an oxymoron for the AAA? Here's my experience at the recent AAA in San Francisco. Tell me what you think.

I'm really upset with people making presentations, but then refusing by their actions to share their paper with members of the audience. I attended research presentations at eight of the nine time slots in SF, and tried to surf over to a simultaneous session a couple of times. In all of the sessions I attended, only 2 of 30 presenters had copies of the paper to distribute. The responsible presenters (both in education-related sessions) were Freddie Choo and the co-authoring team of Elizabeth Haywood, Dorothy McMullen and Donald Wygal. In the non-education related sessions I attended, there were no available copies of any paper. I then had to approach each presenter afterward and ask for a copy of the paper to be sent to me (seems reasonable that they would be available, as the papers had to be submitted 8-9 months in advance). Not one of the non-education presenters has sent anything to me. This is my usual experience. A few years ago I asked for a copy of a conference paper, and was assured that I would be sent one. Stereotypically, I received an e-mail two years later informing me that the paper was now available in some journal's most recent edition, and I was free to track it down. Of course, I was thanked for my interest in the paper.

Most of the time when someone says that I will sent a copy of the paper, it is an empty promise apparently designed to get rid of me. I hardly ever get one.

If one of the purposes of the AAA is to share research, then why are most of the presenters so proprietary and reluctant to share details? I don't think that much knowledge is shared when a presenter makes a very brief presentation using ineffective public speaking methods and then has no copy of the paper to share.

I've attended three conferences so far this year, two of which I had to pay for myself. In the Ohio AAA regional (BGSU paid for this one) there were no copies available, but Tim Fogarty was very good in sending me a copy of each of his papers presented. I learned so much from actually reading the papers. At a second conference, I think I was the only presenter at the conference to bring copies for attendees. I asked a few people for a copy his/her paper, but I have yet to be sent one. In the third conference, the SF AAA, I haven't received any requested papers from any concurrent session presenter* except for Tom Buttross, and his paper is education-related.

The teaching-related forums put on by the T&C section (the best section of the AAA, IMHO) were good, and it's my guess that about 20% had some write-up or paper to share at the forums. I picked up material there from Torben Thomson, the co-authoring team of Graeme Dean, Sandra Van Der Laan and Cameron Esslemont, the co-authoring team of Patsy Lee, Cheryl Prachyl and Carol Sullivan, the team of Gary Siegel & Gail Kucuiba, the team of Paul Mihalek, Milo Peck and Patricia Poli, the team of Elsie Ameen, Daryl Guffey and Cynthia Jackson, the team of Violet Rogers and Aileen Smith, the team of Michael Garner, Karen Papke-Shields, Ellen Pettingill and Denise Rotondo, and the sole author Christie Johnson. Well, maybe the rate is closer to 10%.

Following the conference, I've received materials from teaching forum participants George Schmelzle, Wendy Tietz, Gail Kucuiba, Yan Bao and Angela Lee. If I've misclassified anyone, I'm sorry.

My point is, the lid seems to be open for people eager to share their teaching ideas, but when it comes to the research-oriented presenters I'm SOL. Ironic, given that the major reason I attended AAA was to get caught up on financial reporting and auditing research ideas. Oh, I got my money's worth from the people mentioned above (as well as Thomas Calderon and Denny Beresford), but I really wish the conference would have been more research-oriented.

So, are AAA conferences rip-offs? Not entirely, but pretty much so. And since I spend my own money to attend them, I'm much less likely to attend one in the future.

David Albrecht

August 17, 2005 reply from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU]


Although I agree that a paper should be available to you, I do not agree that the paper should be available in paper form. Rather, the links to the papers should be provided by the author. Requiring the author to haul papers to the conference is unreasonable, imo, but I think the authors should provide a handout with the title of the paper, the abstract, author information, and a link to the paper. As Bob Jensen mentioned in an earlier posting, an author can easily put a file on his/her web server. Personally, I would prefer to see links to the papers on an electronic version of the AAA program, but many argue that such availability could be construed to be a “publication” of the paper. I find this reasoning suspect because no one has a problem with SSRN postings.

I missed this AAA conference for the first time in years, and I really regret not being able to go. I find the meetings very useful, not only for the various sessions, but also from a networking perspective. This year, I heard there were also excellent CPE sessions. Far from being a “rip-off,” the AAA annual meeting is a valuable resource that takes incredible time on the part of the faculty volunteers who organize that meeting with the help of the AAA staff.

Amy Dunbar


August 18, 2005 reply from Bob Jensen

Hi David,

Although I disagree with the general negativism of your opinions about the AAA annual meetings, I will begin with one item of support.  Years ago when these meetings were held in San Diego, a CD recording company recorded every session (concurrent sessions to panel discussions to luncheons to plenary sessions).  The company had a booth were participants could buy the CD after each session at a rather modest cost  The sad part was that there was almost no demand to buy the CDs, especially the CDs from the research presentation sessions.  The reasons for this are unknown.  My own conclusion is that this is no fault of the AAA.  The problem is accounting research itself.  Most of it is just not very interesting whether or not it is presented at an AAA meeting.

The CD recording company lost a bundle on this venture and since then no effort is made to record AAA meeting sessions other than occasional plenary and luncheon sessions that are captured by the AAA itself on video as part of the projection system for large audiences.

There is a general lack of interest in accounting research.  Amy mentioned the SSRN working paper series --- . The big sellers in SSRN are economics and finance papers.  Demand for accounting research is dismal, especially when you factor out those papers billed as accounting papers that are economics research papers in accounting clothing.  I can't get the ranking system to work this morning, but the last time I looked there was not a single accounting paper in the SSRN listing of top downloads ---

I discuss problems with accounting research at
The biggest problem is that our accounting journals themselves do not even judge it worthy to publish research  replications.  If our findings were really of interest our journals would be like science journals that actively seek out replications of findings in science.

Your comments focus on whether the benefit of sending a professor to the AAA meetings justifies the cost.  If we had interactive teleconferencing or Webcasting of sessions available, perhaps you would be correct in terms of the sessions themselves.  But this fails to weigh in the many other benefits of the AAA meetings, benefits that include the following:

I think you're asking too much in benefits from of the AAA meetings.  Such meetings serve many audiences from Glendale Community College to Ivy League research centers.  Such meetings serve many interests from teaching ideas to empirical/analytical research methods to issues of great concern in accountancy and business in the real world (that "other world").   Such meetings serve many audiences from the U.S. to Europe, to India, to Africa, to Russia to Japan to China to Kangaroo and Kiwi lands.

All we can expect from the AAA meetings are peep holes to opportunities, knowledge, and happenings in our corner on the world of teaching and research and professional practice.

Lastly David, I might add that the annual AAA meetings pass the market test.  Thousands of people would not take the time, trouble, and cost to come to these meetings from all over the world if they were not serving an important purpose.  You have every right to protest in an effort to make the meetings better.  However, I’m afraid that you must first demonstrate how to make accounting research itself better.

Bob Jensen

August 18, 2005 reply from Ruth Bender [r.bender@CRANFIELD.AC.UK]

The European Accounting Association has the papers available for download from its website before the conference and for a week after the conference has ended. My experience was that about 90% of what I wanted was available, and a couple of other authors who I emailed for papers were happy to oblige. Likewise, when I was emailed for a paper about a month after the conference, I sent it by return.

The great advantage of having downloads available before the conference was that it meant that the discussion at sessions could be a bit better informed.

Mind you, I do wish you'd stop putting down the 'Fraudulent Conferences'. One of my minor enjoyments on a wet English morning is looking at that conference email and working out which exotic locations I could possibly get Cranfield to pay for me to visit :-)

Regards Ruth

Dr Ruth Bender
Cranfield School of Management

Thursday, April 28, 2005
The Chronicle of Higher Education
Business Schools' Focus on Research Has Ensured Their Irrelevance, Says Scathing Article

Business schools are "institutionalizing their own irrelevance" by focusing on scientific research rather than real-life business practices, according to a blistering critique of M.B.A. programs that will be published today in the May issue of the Harvard Business Review.

The article, "How Business Schools Lost Their Way," was written by Warren G. Bennis and James O'Toole, both prominent professors at the University of Southern California's Marshall School of Business. Mr. Bennis is also the founding chairman of the university's Leadership Institute, and Mr. O'Toole is a research professor at Southern Cal's Center for Effective Organizations.

Mr. Bennis and Mr. O'Toole conclude that business schools are too focused on theory and quantitative approaches, and that, as a result, they are graduating students who lack useful business skills and sound ethical judgment. The authors call on business schools to become more like medical and law schools, which treat their disciplines as professions rather than academic departments, and to expect faculty members to be practicing members of their professions.

"We cannot imagine a professor of surgery who has never seen a patient or a piano teacher who doesn't play the instrument, and yet today's business schools are packed with intelligent, highly skilled faculty with little or no managerial experience," the two professors write. "As a result, they can't identify the most important problems facing executives and don't know how to analyze the indirect and long-term implications of complex business decisions."

While business deans pay lip service to making their courses more relevant, particularly when they are trying to raise money, their institutions continue to promote and award tenure to faculty members with narrow, scientific specialties, the authors contend.

"By allowing the scientific-research model to drive out all others, business schools are institutionalizing their own irrelevance," the authors write.

Most business problems cannot be solved neatly by applying hypothetical models or formulas, they say. "When applied to business -- essentially a human activity in which judgments are made with messy, incomplete, and incoherent data -- statistical and methodological wizardry can blind rather than illuminate."

Not surprisingly, the head of the association that accredits business schools in the United States disagrees with the authors' assessment. John J. Fernandes, president and chief executive officer of AACSB International: the Association to Advance Collegiate Schools of Business, said most business schools today are making an effort to teach broad skills that are directly applicable to real-world business practices.

He pointed out that in 2003, the association updated its accreditation standards to emphasize the teaching of "soft skills" like ethics and communication, and to require that business schools assess how well students are learning a broad range of managerial skills.

"I think the authors are looking at a very limited group of business schools that emphasize research," said Mr. Fernandes. "Most schools have done an excellent job of producing graduates with a broad range of skills who can hit the ground running when they're hired."

Mr. Bennis and Mr. O'Toole are not convinced. They say that business schools, which in the early 20th century had the reputation of being little more than glorified trade schools, have swung too far in the other direction by focusing too heavily on research. The shift began in 1959, they say, when the Ford and Carnegie Foundations issued scathing reports about the state of business-school research.

While the Southern Cal professors say they do not favor a return to the trade-school days, they think business schools, and business professors, have grown too comfortable with an approach that serves their own needs but hurts students.

"This model gives scientific respectability to the research they enjoy doing and eliminates the vocational stigma that business-school professors once bore," the article concludes. "In short, the model advances the careers and satisfies the egos of the professoriate."

The authors point out a few bright spots in their otherwise gloomy assessment of M.B.A. education. The business schools at the University of California at Berkeley and the University of Dallas are among those that emphasize softer, nonquantifiable skills like ethics and communication, they write. In addition, some business schools operate their own businesses, such as the student-run investment fund offered by Cornell University's S.C. Johnson Graduate School of Management.

The evidence lies in lack of interest in replication
I wrote the following on December 1, 2004 at

Faculty interest in a professor’s “academic” research may be greater for a number of reasons. Academic research fits into a methodology that other professors like to hear about and critique. Since academic accounting and finance journals are methodology driven, there is potential benefit from being inspired to conduct a follow up study using the same or similar methods. In contrast, practitioners are more apt to look at relevant (big) problems for which there are no research methods accepted by the top journals.

Accounting Research Farmers Are More Interested in Their Tractors Than in Their Harvests

For a long time I’ve argued that top accounting research journals are just not interested in the relevance of their findings (except in the areas of tax and AIS). If the journals were primarily interested in the findings themselves, they would abandon their policies about not publishing replications of published research findings. If accounting researchers were more interested in relevance, they would conduct more replication studies. In countless instances in our top accounting research journals, the findings themselves just aren’t interesting enough to replicate. This is something that I attacked at

At one point back in the 1980s there was a chance for accounting programs that were becoming “Schools of Accountancy” to become more like law schools and to have their elite professors become more closely aligned with the legal profession. Law schools and top law journals are less concerned about science than they are about case methodology driven by the practice of law. But the elite professors of accounting who already had vested interest in scientific methodology (e.g., positivism) and analytical modeling beat down case methodology. I once heard Bob Kaplan say to an audience that no elite accounting research journal would publish his case research. Science methodologies work great in the natural sciences. They are problematic in the psychology and sociology. They are even more problematic in the professions of accounting, law, journalism/communications, and political “science.”

We often criticize practitioners for ignoring academic research Maybe they are just being smart. I chuckle when I see our heroes in the mathematical theories of economics and finance winning prizes for knocking down theories that were granted earlier prizes (including Nobel prices). The Beta model was the basis for thousands of academic studies, and now the Beta model is a fallen icon. Fama got prizes for showing that capital markets were efficient and then more prizes for showing they were not so “efficient.” In the meantime, investment bankers, stock traders, and mutual funds were just ripping off investors. For a long time, elite accounting researchers could find no “empirical evidence” of widespread earnings management. All they had to do was look up from the computers where their heads were buried.

Few, if any, of the elite “academic” researchers were investigating the dire corruption of the markets themselves that rendered many of the published empirical findings useless.

Academic researchers worship at the feet of Penman and do not even recognize the name of Frank Partnoy or Jim Copeland.

Bob Jensen

My 67th birthday April 30, 2005 commentary on how research in business schools has run full circle  since the 1950s.  We've now completed the circle of virtually no science (long on speculation without rigor) to virtually all science (strong on rigor with irrelevant findings) to criticisms that science is not going to solve our problems that are too complex for rigorous scientific methods.

The U.S. led the way in bringing accounting, finance, and other business education and research into respectability in separate schools or colleges the business (so called B-schools) within top universities of the country.  The movement began in the 1960s and followed later in Europe after leading universities like Harvard, Chicago, Columbia, Chicago, Pennsylvania, UC Berkeley and Stanford showed how such schools could become important sources of cash and respectability. 

A major catalyst for change was the Ford Foundation that put a large amount of money into first the study of business schools and second the funding of doctoral programs and students in business studies.  First came the Ford-Foundation's Gordon and Howell Report (Gordon, R.A., & Howell, J.E. (1959). Higher education for business. New York: Columbia University Press) that investigated the state of business higher education in general.  You can read the following at

The Gordon and Howell report, published in 1959, examined the state of business education in the United States. This influential report recommended that managerial and organizational issues be studied in business schools using more rigorous scientific methods. Applied psychologists, well equipped to undertake such an endeavor, were highly sought after by business schools. Today, new psychology Ph.D.s continue to land jobs in business schools. However, we believe that this source of academic employment will be less available in the future because psychologists in the business schools have become well established enough to have their own "off-spring," who hold business Ph.D.s. More business school job ads these days contain the requirement that applicants possess degrees in business administration.

Prior to 1960, business education either took place in economics departments of major universities or in business schools that were viewed as parochial training programs by the more "academic" departments in humanities and sciences where most professors held doctoral degrees.  Business schools in that era had professors rooted in practice who had no doctoral degrees and virtually no research skills.  As a result some universities avoided having business schools altogether and others were ashamed of the ones they had. 

The Gordon and Howell Report concluded that doctoral programs were both insufficient and inadequate for business studies.  Inspired by the Gordon and Howell Report, the Ford Foundation poured millions of dollars into universities that would upgrade doctoral programs for business studies.  I was one of the beneficiaries of this initiative.  Stanford University obtained a great deal of this Ford Foundation money and used a goodly share of that money to attract business doctoral students.  My relatively large fellowship to Stanford (which actually turned into a five-year fellowship for me) afforded me the opportunity to get a PhD in accounting.  The same opportunities were taking place for other business students at major universities around the country.

Another initiative of the Gordon and Howell Report was that doctoral studies in business would entail very little study in business.  Instead the focus would be on building research skills.  In most instances, the business doctoral programs generally sent their students to doctoral studies in other departments in the university.  In my own case, I can only recall having one accounting course at Stanford University.  Instead I was sent to the Mathematics, Statistics, Economics, Psychology, and Engineering (for Operations Research) graduate studies.  It was tough, because in most instances we were thrown into courses to compete head-to-head with doctoral students in those disciplines.  I was even sent to the Political Science Department to study (critically) the current research of Herb Simon and his colleagues at Carnegie Mellon.  That experience taught me that traditional social science researchers were highly skeptical of this new thrust in "business" research. 

Another example of the changing times was at Ohio State University when Tom Burns took command of doctoral students.  OSU took the Stanford approach to an extreme to where accounting doctoral students took virtually all courses outside the College of Business.  The entire thrust was one of building research skills that could then be applied to business problems.

The nature of our academic research journals also changed.  Older journals like The Accounting Review (TAR) became more and more biased and often printed articles that were better suited for journals in operations research, economics, and behavioral science.  Accounting research journal relevance to the profession was spiraling down and down.  I benefited from this bias in the 1960s and 1970s because I found it relatively easy to publish quantitative studies that assumed away the real world and allowed us to play in easier and simpler worlds that we could merely assume existed somewhere in the universe if not on earth.  In fairness, I think that our journal editors today demand more earthly grounding for even our most esoteric research studies.  But in the many papers I published in the 1960s and 1970s, I can only recall one that I think made any sort of practical contribution to the profession of accounting (and the world never noticed that paper published in TAR).

I even got a big head and commenced to think it was mundane to even teach accounting.  In my first university I taught mostly mathematical programming to doctoral students.  When I got a chair at a second university, I taught mathematical programming and computer programming (yes FORTRAN and COBOL) to graduate students.  But my roots were in accounting (as a CPA), my PhD was in accounting (well sort of), and I discovered that the real opportunities for an academic were really in accounting.  The reasons for these opportunities are rooted the various professional attractions of top students to major in accounting and the shortage of doctoral faculty across the world in the field of accountancy.  So I came home so to speak, but I've always been frustrated by the difficulty of making my research relevant to the profession.  If you look at my 75+ published research papers, you will find few contributions to the profession itself.  I'm one of the guilty parties that spend most of my life conducting research of interest to me that had little relevance to the accounting profession.

I was one of those accounting research farmers more interested in my tractors than in my harvests.  Most of my research during my entire career devoted to a study of methods and techniques than on professional problems faced by accounting standard setters, auditors, and business managers.  I didn't want to muck around the real world gathering data from real businesses and real accounting firms.  It was easier to live in assumed worlds or, on occasion, to study student behavior rather than have to go outside the campus. 

What has rooted me to the real world in the past two decades is my teaching.  As contracting became exceedingly complex (e.g., derivative financial instruments and complex financial structurings), I became interested in finding ways of teaching about this contracting and in having students contemplate unsolved problems of how to account for an increasingly complex world of contracts.

In accounting research since the 1950s we've now completed the circle of virtually no science (long on speculation without rigor) to virtually all science (strong on rigor with irrelevant findings) to criticisms that science is not going to solve our problems that are too complex for rigorous scientific methods.  We are also facing increasing hostility from students and the profession that our accounting, finance, and business faculties are really teaching in the wrong departments of our universities --- that our faculties prefer to stay out of touch with people in the business world and ignore the many problems faced in the real world of business and financial reporting.  For more on this I refer you to

Things won’t change as long as our "scientists" control our editorial boards, and they won’t give those up without a huge fight. I’m not sure that even Accounting Horizons (AH) is aimed at practice research at the moment. The rigor hurdles to get into AH are great as of late. Did you compare the thicknesses of the recent AH juxtaposed against the latest Accounting Review? Hold one in each of each in your hands.

What will make this year’s AAA plenary sessions interesting will be to have Katherine defending our economic theorists and Denny Beresford saying “we still don’t get it.” Katherine is now a most interesting case since, in later life, she’s bridging the gap back to practice somewhat. Denny’s an interesting case because he came out of practice into academe only to discover that, like Pogo, “the enemy is us.”

I think what is misleading about the recent HBR article is that focusing more on practice will help us solve our “big” problems. If you look at the contributions of the HBR toward solving these problems in the last 25 years, you will find their contributions are superficial and faddish (e.g., balanced score card). The real problem in accounting (and much of business as well), is that our big problems don’t have practical solutions. I summarize a few of those at 
Note the analogy with “your favorite greens.”

Focusing on practice will help our teaching. We can never say “never” when it comes to research, but I pretty much stand by my claims at 

So what can we conclude from having traveled the whole circle from virtually no scientific method to virtually all scientific method to new calls to back off of scientific method and grub around in the real world?  What do we conclude from facing up to the fact that research rigor and our most pressing problems don't mix?

My recommendation at the moment is to shift the focus from scientific rigor to cleverness and creativity in dealing with our most serious problems.  We should put less emphasis on scientific rigor applied to trivial problems.  We should put more emphasis on clever and creative approaches to our most serious problems.  For example, rather than seek optimal ways to classify complex financial instruments into traditional debt and equity sections on the balance sheet, perhaps we should look into clever ways to report those instruments in non-traditional ways in this new era of electronic communications and multimedia graphics.  Much of my earlier research was spent in applying what is called cluster analysis to classification and aggregation.  I can envision all sorts of possible ways of extending these rudimentary efforts into our new multimedia world.

Bob Jensen on my 67th birthday on April 30, 2005


December 15, 2004 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU

In a recent issue of Golf World, a letter writer was commenting on the need for professional golfers to be more "entertaining."  He went on to say:

"Fans pay top dollar to attend tournaments and to subscribe to cable coverage.  Not many would pay to see an accountant work in his office or watch The Audit Channel."

That's probably a true comment.  On the other hand, wouldn't at least some of us have liked to watch The Audit Channel and see what was being done on Enron, WorldCom, HeathSouth, or some of the other recent interesting situations?

Denny Beresford

December 15, 2004 reply from Bob Jensen

You know better than the rest of us, Denny, that academic accounting researchers won't tune in to watch practitioners on the Audit Channel. They're locked into the SciFi Channel.

Bob Jensen

December 1, 2004 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU
Denny is now a professor of accounting at the University of Georgia.  For ten years he was Chairman of the Financial Accounting Standards Board and is a member of the Accounting Hall of Fame.

I've enjoyed the recent "debate" on AECM relating to the Economist article about the auditing profession.  I'm delighted to see this interest in such professional issues.  But I'm concerned that academic accountants, by and large, aren't nearly enough involved in actually trying to help solve professional issues.  Let me give an illustration, and I'd certainly be interested in reactions.

Last night our Beta Alpha Psi chapter was fortunate to have Jim Copeland as a guest speaker.  Jim retired as the managing partner of Deloitte a couple of years ago and he continues to be a leading voice in the profession through, among other things, his role in chairing a major study by the U.S. Chamber of Commerce on the auditing profession.  Jim also serves as a director of three major corporations and on their audit committees.  In short, he is the kind of person that all students and faculty should be interested in meeting and hearing.

Students turned out in fairly large numbers, as did quite a few practitioners who always are there to further their recruiting efforts.  However, only four faculty members attended (out of a group of about 18) and this included our department head and the BAP advisor, both of whom were pretty much obligated to be there. No PhD students attended.  I'm sure that some faculty members had good excuses but most simply weren't sufficiently interested enough to attend.  Perhaps at some other schools more faculty would have been there but my own experience in speaking to about 100 schools over the years would indicate that this lack of interest is pretty common.

On the other hand, this coming Friday a very young professor from another university will present a research workshop and I expect that nearly all faculty members and PhD students will be there.  The paper being discussed is replete with formulas using dubious (in my humble view) proxies for real world economic matters that can't be observed directly.  The basic conclusion of the paper is that companies are more inclined to give stock options rather than cash compensation because options don't have to be charged to expense.  Somehow I thought that this was a conclusion that was pretty clear to most accountants and business people well before now.

I've heard some faculty members say that they feel obligated to attend such workshops even if they aren't particularly interested in the paper being discussed.  They want to show support for the person who is visiting as well as reinforce the importance of these events to the PhD students.  I certainly understand that thinking and tend to share it.  However, for the life of me I can't understand why faculty members don't feel a similar "obligation" to show respect for a person like Jim Copeland, one of the most important people in the accounting profession in recent years and someone who is making a personal sacrifice to visit our school.

My purpose in this brief note is not to belittle the research paper.  But I simply observe that it would be nice if there were a little more balance between interest in professional matters and such high level research among faculty members at research institutions.  As the Economist article noted, and as should be clear to all of us in the age of Sarbanes-Oxley, etc., there are tremendous issues facing the accounting profession.  Rather than simply complaining about things, it seems to me that academics could become more familiar with professionals and the issues they face and then try to work with them to help resolve those issues.

When is the last time that you called an auditor or corporate accountant and asked him or her to have lunch to just kick around some of the tremendously interesting issues of the day?

Denny Beresford

December 1, 2004 reply from Bob Jensen  (The evidence lies in lack of interest in replication)

Hi Denny,

Jim gave a plenary session at the AAA meetings in Orlando. You may have been in the audience. I thought Jim’s presentation was well received by the audience. He handled himself very well in the follow up Q&A session.

I think academics have some preconceived notions about the auditing “establishment.” They may be surprised at some of the positions taken by leaders of that establishment if they took the time to learn about those positions. I summarized some of Jim’s more controversial statements at  
Note that he proposed eliminating the corporate income tax (but he said he hoped none of his former partners were in the audience).

Faculty interest in a professor’s “academic” research may be greater for a number of reasons. Academic research fits into a methodology that other professors like to hear about and critique. Since academic accounting and finance journals are methodology driven, there is potential benefit from being inspired to conduct a follow up study using the same or similar methods. In contrast, practitioners are more apt to look at relevant (big) problems for which there are no research methods accepted by the top journals.

Accounting Research Farmers Are More Interested in Their Tractors Than in Their Harvests

For a long time I’ve argued that top accounting research journals are just not interested in the relevance of their findings (except in the areas of tax and AIS). If the journals were primarily interested in the findings themselves, they would abandon their policies about not publishing replications of published research findings. If accounting researchers were more interested in relevance, they would conduct more replication studies. In countless instances in our top accounting research journals, the findings themselves just aren’t interesting enough to replicate. This is something that I attacked at

At one point back in the 1980s there was a chance for accounting programs that were becoming “Schools of Accountancy” to become more like law schools and to have their elite professors become more closely aligned with the legal profession. Law schools and top law journals are less concerned about science than they are about case methodology driven by the practice of law. But the elite professors of accounting who already had vested interest in scientific methodology (e.g., positivism) and analytical modeling beat down case methodology. I once heard Bob Kaplan say to an audience that no elite accounting research journal would publish his case research. Science methodologies work great in the natural sciences. They are problematic in the psychology and sociology. They are even more problematic in the professions of accounting, law, journalism/communications, and political “science.”

We often criticize practitioners for ignoring academic research Maybe they are just being smart. I chuckle when I see our heroes in the mathematical theories of economics and finance winning prizes for knocking down theories that were granted earlier prizes (including Nobel prices). The Beta model was the basis for thousands of academic studies, and now the Beta model is a fallen icon. Fama got prizes for showing that capital markets were efficient and then more prizes for showing they were not so “efficient.” In the meantime, investment bankers, stock traders, and mutual funds were just ripping off investors. For a long time, elite accounting researchers could find no “empirical evidence” of widespread earnings management. All they had to do was look up from the computers where their heads were buried.

Few, if any, of the elite “academic” researchers were investigating the dire corruption of the markets themselves that rendered many of the published empirical findings useless.

Academic researchers worship at the feet of Penman and do not even recognize the name of Frank Partnoy or Jim Copeland.

Bob Jensen

As you recall, this thread was initiated when Denny Beresford raised concern about the University of Georgia's accounting faculty lack of interest in listening to an on-campus presentation by the recently retired CEO of Deloitte & Touche (Jim Copeland).  A leading faculty member from another major research university raises much the same concern.  Jane F. Mutchler is the J. W. Holloway/Ernst & Young Professor of Accounting at Georgia State University.  She is also the current President of the American Accounting Association.

"President's Message," Accounting Education News, Fall 2004, Page 3.  This is available online to paid subscribers but cannot be copied due to a terrible policy established by the AAA Publications Committee.  Any typos in the following quotation are my own at 4:30 this morning.

I raise these questions because I worry that we are all too quick to blame all the problems on the practitioners.  But we must remember that we were the ones responsible for the education of the practitioners.  And unless we analyze the issues and the questions I raised, I fear that we won't make any changes ourselves.  So it is important that we examine our approaches to the classes we are teaching and ask ourselves if we are doing all we canto assure that our students are being made aware of the pressures they will face in practice and if we are helping them develop the skills they need to appropriately deal with those pressures.  In my mind these issues need to be dealt with in every class we teach.  It will do no good to simply mandate new stand alone ethics courses where issues are examined in isolation.  

Continued in  Jane’s Message to the Membership of the American Accounting Association

December 5, 2004 reply from Stone, Dan [Dan.Stone@UKY.EDU

I enjoyed Denny's commentary on the interplay between accounting research and practice, and, Jane's AAA President's statement on this issue.

A few thoughts:

1. Yes, accounting research is largely, though not entirely, divorced from accounting practice. This is no coincidence or anomaly. It is by design. Large sample, archival, financial accounting research -- which dominates mainstream academic accounting -- is about the role of accounting information in markets. It is not about understanding the institutions and individuals who produce and disseminate this information, or, the technologies that make its production possible. We could have an accounting scholarship takes seriously issues of accounting practice. The US institutional structures of accounting scholarship currently eliminate this possibility. Change these institutional structures and we change accounting scholarship.

2. There is a particular and peculiar hubris of financial accounting academics to assume that all accounting scholarship is, or should be, about financial accounting. Am I reading this into Denny's argument? Am I reading beyond the text here?

The unity model of accounting scholarship increasingly, which says that all accounting scholarship is or should be about financial accounting, is no coincidence or anomaly. It is by design. The top disseminators of accounting scholarship in the US increasingly publish, and the major producers of accounting scholars increasingly produce scholars who know about, only 1 small sub-area of accounting -- financial, archival accounting. Change the institutional structures of the disseminators and the producers and we change accounting scholarship.


Dan Stone 
Gatton Endowed Chair 
University of Kentucky 
Lexington, Kentucky

December 6, 2004 reply from Paul Williams [williamsp@COMFS1.COM.NCSU.EDU

To add to Dan's observations. He is correct that until we change the structure of the US academy nothing is going to change re practice. As Sara Reiter and I argued (with evidence) in our AOS piece, accounting in the academy has been transformed from an autonomous, professional discipline into a lab practice for a discipline for which lab practices are incidental to the main activity, i.e, accounting is an empirical sub discipline of a sub discipline of a sub discipline for which empirical work is irrelevant. The purpose of scholarship in accounting is now purely instrumental -- to create politically correct academic reputations. 

The powers that be are not interested in accounting research for its intrinsic value or for improving practice broadly understood, but only as a means to enhance their own careers (to get "hits" in the major journals). The profession is not powerless to assist in changing that structure. For example, KPMG funds (or at least used to) the JAR conferences. Stop doing that!! Why subsidize that which is doing you more harm than good? The profession has abandoned the AAA in droves -- in the mid-60s the AAA had nearly 15,000 members, 2/3 of which were practitioners. Now we are approximately 8,000 of which only about 1/7 are practitioners. If practitioners aren't happy about the academy they are not powerless to engage it. 

Bob sent us an excerpt from Jane Mutchler's presidential address suggesting things that should be done. They already have been. At the Critical Perspectives conference in New York in 2002 there were numerous sessions devoted to how academics have failed in their educational responsibilities (someone credentialed Andy Fastow). Do the firms help fund that conference? Of course not -- too left wing. Accounting Education: An International Journal dedicated an entire issue to accounting education after Enron, as has the European Accounting Review. Have any AAA journals done so? The insularity of the US academy is evident in that Jane doesn't seem aware that there already has been significant activity for at least the last three years, but none of it as visible as that which is promoted by AAA. Let's have genuine debates in Horizons where others besides those vetted for political correctness are permitted to speak to the issues. 

Let me remind you of the Briloff affair -- Abe wrote a piece for Horizons critical of the COSO report. Abe argued that the "problem" was not just small firms with small auditors. Was Abe right? Less than two years after he wrote that article we had Enron, WorldCom, Tyco, Andersen's implosion, etc. See the special issue of Critical Perspectives on Accounting, "AAA, Inc." to see first hand how the structure of the academy handles candid discussion of the profession's problems. If people aren't happy with the way the AAA manages the academy, they are not powerless to change it. The structure stays the same because of the apathy of the membership. It only takes 100 signatures to challenge for an AAA office. Since less than 100 people bother to vote (out of 8,000) it wouldn't take much effort for someone with the resources to effect significant changes. Denny could get his colleagues' attention and get them interested in attending his guests' talks by running for president of AAA -- I will gladly sign his petition to be put on the ballot for 2005. That will shake them up! Change won't happen unless enough members of the academy recognize that we have some very real, serious problems that require candid, adult conversation and a willingness to accept responsibility. 

Realize that there are more of us than there are of them (that is the whole idea of the current structure - to keep the number of them very, very small). Change the executive committee, select editors of the AAA journals that aren't committed to the narrow notion of rigor that now predominates and, as Dan says, things will change. There are plenty of qualified, thoughtful people who could manage an academy more dedicated to the practice of accounting (in all its many manifestations besides financial reporting, likely the most insignificant of accounting's functions). It just takes people with the political and financial leverage to put their efforts into altering that intellectually oppressive structure. PFW

December 1, 2004 reply from Jagdish Gangolly [JGangolly@UAMAIL.ALBANY.EDU

I could not agree more. May be most "top" journals suffer a case of "analysis paralysis". In a practical field such as accounting, how do we know what relevant problems are if we have little contact with the real world (and I would not count sporadic consulting as contact).

There are ways in which the academia and industry mingle in a meaningful way. In the areas I am interested in (computationally oriented work in information systems and auditing), for example, I have found a very healthy relationship between the academia and industry, and in fact far more exciting research reported in computing journals during the past three years than in accounting/auditing journals during the past 30. (I can think of work in computational auditing done by folks at Eindhoven and Delloitte & Touche; work on role-based access control at George Mason and Singlesignonnet, work on formal models of accounting systems as discrete dynamical systems done also at Delloitte and Eindhoven, work on interface of formal models of accounting systems and back-end databases done at Promatis and Goethe-Universität Frankfurt & University of Karlsruhe, to name just a few). In fact it has got to a point where I attend AAA meetings only to meet old friends and have a good time, and not for intellectual stimulation. For that, I go to computing meetings.

The reason for the schism between academia and the profession in accounting, in my opinion, is the almost total lack of accountability in academic accounting research. Once the control of "academic" journals have been wrested, research is pursued not even for its own sake, but for the preservation of control and perpetuation of ones genes. We have not had a Kuhnian paradigm shift for close to 40 years in accounting, because we haven't found the need for anomalies. We use "academic" journals the same way that the proverbial Mark Twain's drunk uses a lamp post, more for support than for illumination.

Respectfully submitted,


December 1, 2004 reply from Paul Williams [williamsp@COMFS1.COM.NCSU.EDU

Bob is right that the accounting academy in the US (not so much the rest of the world) is driven mainly by the interests of methidoliters -- those that suffer from a terminal case of what McCloskey described as the poverty of economic modernism. Sara Reiter and I had a study published in AOS last summer that included an analysis of the rhetorical behavior of the JAR conferences through time to see if the discursive practices of the "leading" forum were conducive to progressive critique -- all sciences "advance" via destruction -- received wisdom is constantly under assault. When the JAR conferences started practiioners and scholars from other disciplines like law and sociology were invited to participate. These were the people that asked the most troublesome questions, the ones who provided the most enervating critique. How did the geniuses at JAR deal with the problem of heretics in the temple? They simply stopped inviting practitioners and scholars from other disciplines. The academy in the US is an exceedingly closed society of only true believers. Accounting academics are now more interested in trying to prove that an imaginary world is real, rather than confront a world too messy for the methods (and, it must be noted, moral and political commitments) to which they unshakeably devoted REGARDLESS OF WHAT THE EMPIRICAL EVIDENCE SAYS! (As Bob notes, who in their right mind can still say market efficiency without a smirk on their face. The stock exchange, after all, has members. Does anyone know of any group of "members" that writes the rules of the organization to benefit others equally to themselves? Invisible hands, my a..)

But it must be said the profession is not without guilt in all of this. I avoid listening to big shots from the Big 4 myself because they are as predictable as Jerry Falwell. Accountants have a license, which is a privilege granted to them by the public to serve the broad society of which they are citizens. But whenever you hear them speak, all they do is whine about the evils of government regulation, the onerous burden of taxes on the wealthy (I have never heard a partner of a Big 4 firm complain that taxes were too regressive); they simply parrot the shiboleths that underlay the methodologies of academics. No profession has failed as spectacularly as accounting has just done. If medicine performed as poorly as public accounting has just done in fulfilling its public responsibilities, there would be doctor swinging from every tree. Spectacular audit failures, tax evasion schemes for only the wealthiest people on the planet, liability caps, off-shore incorporation, fraud, etc., a profession up to its neck in the corruption that Bob mentioned. But have we heard one word of contrition from this profession? Has it dedicated itself to adopting the skeptical posture toward its "clients" required of anyone who wants to do a thorough audit? Don't think so. All we still hear is the problem ain't us, it all those corrupt politicians, etc. (Who corrupted them?). And PWC has the gall to run ads about a chief courage officer -- do these guys have no shame? If the profession wants to engage with the academy with an open mind and the courage to hear the truth about itself, the courage to really want to become a learned profession (which it isn't now), then maybe we could get somewhere. But for now, both sides are comfortable where they are -- the chasm serves both of their exceedingly narrow interests. 

There are now 7 volumes of Carl's essays. Thanks to Yuji Ijiri's efforts, the AAA published the first 5 volumes as Studies in Accounting Research #22, Essays in Accounting Theory. A sixth volume, edited by Harvey Hendrickson, Carl Thomas Devine Essays in Accounting Theory: A Capstone was published by Garland Publishing in 1999. A seventh volume was being edited by Harvey when he died. I was asked to finish Harvey's work and that volume, Accounting Theory: Essays by Carl Thomas Devine has been published by Routledge, 2004. Carl also had a collection of Readings in Accounting Theory he compiled mainly for his teaching during his stint in Indonesia (I think). Those were mimeographed as well, but, to my knowledge, have never been published. I have copies of those 4 volumes but their condition is not good -- paper is yellowed and brittle. Thoughtful, curious, imaginative, humble, and kind -- we don't see the likes of Carl much anymore. His daughter Beth told me that he even approach his death with the same vibrant intellectual curiousity he brought to everything. 


December 6, 2004 reply from Ed Scribner [escribne@NMSU.EDU

Seems to me that most folks on this list take a pretty harsh view of the accounting research "establishment" for being closed, methodology-driven, irrelevant to practice, self-serving, and just generally in the wrong paradigm. Yet I see things like the following in the JAR and the AR that appear relevant and "practice-oriented" to me.

--- Journal of Accounting Research, Volume 42: Issue 3 "Auditor Independence, Non-Audit Services, and Restatements: Was the U.S. Government Right?"

Abstract Do fees for non-audit services compromise auditor's independence and result in reduced quality of financial reporting? The Sarbanes-Oxley Act of 2002 presumes that some fees do and bans these services for audit clients. Also, some registrants voluntarily restrict their audit firms from providing legally permitted non-audit services. Assuming that restatements of previously issued financial statements reflect low-quality financial reporting, we investigate detailed fees for restating registrants for 1995 to 2000 and for similar nonrestating registrants. We do not find a statistically significant positive association between fees for either financial information systems design and implementation or internal audit services and restatements, but we do find some such association for unspecified non-audit services and restatements. We find a significant negative association between tax services fees and restatements, consistent with net benefits from acquiring tax services from a registrant's audit firm. The significant associations are driven primarily by larger registrants.


I also see articles on topics other than financial accounting. Are these just window-dressing?

Journal editors are always saying that they want work that has "policy implications." Yet it seems to me that important questions in accounting tend to be more complicated than, "Does this medication cause nausea in the control group?" Tough questions are tough to address rigorously.

What are some examples of specific questions (susceptible to rigorous research) that academia should be addressing but is not?

Ed "Paton's Advocate" (am I alone?)

P.S. Many years ago a senior faculty member told me the "top" journals were a closed society, and hitting them was a matter of whom you knew. I made some naïve reply to the effect that the top journals reflected the best work--"the cream rises to the top." Next morning I found in my mailbox photocopies of the tables of contents of then-recent JARs, along with the editorial board, with lines drawn connecting names on the board with names of authors, as if it were a "matching question" on an exam.

December 1, 2004 reply from Bob Jensen

Hi Paul,

During one of the early JAR conferences that I attended had an assistant professor present a behavioral research study. A noted psychologist, also from the University of Chicago, Sel Becker, was assigned to critique the paper.

Sel got up and announced words to the affect that this garbage wasn't worth discussing.

I'm not condoning the undiplomatic way Sel treated a colleague. But this does support your argument as to why experts from other disciplines were no longer invited to future JAR conferences.

Bob Jensen

December 1, 2004 reply from Roger Collins [rcollins@CARIBOO.BC.CA

Paul makes some excellent points. Sociologists are interesting to listen to because they tend to get folks' backs up (and if they didn't want to do that they probably wouldn't be sociologists in the first place). That's especially the case in accounting where both the profession and the academics are (with notable exceptions) hidebound in their own way.  If you want a new perspective on things, get a sociologist to comment, throw away any half of what's been said and the remainder will still be an interesting pathway to further thought, whichever half you choose.

The scorn that certain academics in other areas show for accounting academics (and indeed, business academics in general) may be justified (sometimes? often?)- but no-one ever built bridges out of scorn. I think that if Sel Becker was really interested in advancing the cause of academic enquiry he would have figured out that whatever was going on was, from his point of view, an immature contribution and taken the time to give his views on the gap between the contribution and the issues he considered important, and identify some "road map" to move from one position to another.

But then, Sel is a "big, important" person. (From what I can gather), instead of taking a little time to build bridges he indulged in a spot of academic tribalism. Trashing a colleagues paper (isn't that something a noted member of the Rochester School was famous for?) is cheap in terms of effort and may generate some petty self-satisfaction; it may even be justified if the presenter is arrogant in turn -but again, arrogance is a destroyer rather than a builder.

On the other hand, the JAR reaction is just as bad if not worse.  Closing one's ears to criticism will only lead to the prettification of the academy; the dogmatists will have won.

Question - is there a way of enticing the various parties out of their bunkers ? If there is, what are the chances that the "generals" of the profession and academia won't use their power to squash the proposals of the "subalterns" ?

Some years ago a University of Alberta prof. had the temerity to suggest that the local oil companies' financial statements weren't all that they should have been. He was promptly jumped on from every direction. Why ? I suspect, because there is a general (not inevitably true) assumption that business schools are the "cash cows" of the university, and other academics tolerate them on that basis. (Nowadays, pharmaceutical research departments seem to be vying for that label). Maybe the only way out is poverty; poor accounting profs will have less to lose and more reason to explore..

Regards - tongue partly in cheek,

Roger Roger Collins 
UCC (soon to be TRU) School of Business.

December 2, 2004 reply from Paul Williams [williamsp@COMFS1.COM.NCSU.EDU

How do we bridge the chasm?

Good question. We won't be able to do that in the US until we change the structure of the AAA. I was on Council when the great debate over Accounting Horizons occurred. Jerry Searfoss, a person who served time on both sides of the chasm, was a vigorous proponent for creating a medium through which academe and practice could communicate. If you peruse the editorial board of the first issues of Horizons, it reflected this eclectic approach to scholarship. What happened to it? Look at Horizons now. Its editorial board looks just like the editorial board at The Accounting Review and its editor is a University of Chicago PhD! The AAA has a particular structure -- an organizational culture that reproduces itself generation after generation. Horizons, as originally conceived by people like Searfoss, Sack, Mautz, etc., posed a threat to the overwhelmingly anal retentive, ideological commitments (the shadow of William Paton still chills the intellectual climate of the US academy) of the organization. Anti-bodies were quickly mobilized and, voila, Horizons looks just like TAR (two years ago a plan to eliminate Horizons and Issues and roll them into one ill-defined journal was proposed). This body will protect itself at all costs (even declining membership, banal research, etc. will not dissuade them from jumping over the cliff). 

The only way to change that is to create a structure that fosters a place where Sel Beckers and Big 4 partners can say what they have to say IN PRINT and be forced to defend it as often as the Dopuchs, Demskis, Watts and Zimmermans, and Schippers of the world (who never have to defend themselves in print). That will only happen when the selection of executive committees, editors, etc. is democratic. As long as the Politburo structure of the AAA exists and the culture of fear and suspicion of ideas remains, nothing will change. Good models for what the journals should look like are the proceedings of conferences like Tinker's Critical Perspectives conference, Lee Parker's APIRA, and the IPA sponsored by Manchester. Those conferences are so much more exhilirating than the AAA meetings. I'm like Jagdish -- I go to AAA to see old friends and work for the Public Interest Section. The "technical" sessions are of little interest. When the AAA gives Seminal Contribution Awards to "contributions" lifted wholesale from the radical Lockean/monetarist wing of economics, how can you take such an organization seriously. This is particularly true when there are genuinely seminal contributions possessed by the discipline itself, e.g., Ijiri's work, Paton's Accounting Theory, Andy Stredry's budget work, Bill Cooper's QM applications, Sterling/Edwards and Bell/Chambers, etc. (the copyrights on these tell you how long it has been since accounting acted like an autonomous discipline!). 


December 2 reply from Paul Williams (after a request that he elaborate on Bill Paton)

While Carl Devine was still alive, I used to visit him whenever I could. When Jacci Rodgers and I did our work on editorial boards at The Accounting Review I consulted Carl about how the review process worked at TAR since the first time TAR published the members of an editorial board was 1967 (I beleive). According to Carl, Paton edited TAR for many years after its founding via a process that was, shall we say, less than transparent. According to Carl, Paton and Littleton between them virtually hand picked the AAA presidents for years. You can see a pattern of early presidencies -- one president not from one of the elite 15, then two from, then one, etc. This encouraged the illusion that the AAA was open to everyone, but in fact it was pretty tightly controlled. Now there is no attempt whatsoever to create the illusion of an open organization -- every president for the last 30 years (save one or two) is an elite school grad. It was never permitted to veer too far from the nucleus of schools that founded it. 

Everyone should be familiar with Paton's politics -- he was conservative in the extreme (he published a book that was a rather rabid screed on the evils of Fabian socialism). There were competing root metaphors for accounting during the era of Paton, e.g., the institutionalism of DR Scott (whose spin on the role of accounting seems prescient now that we have a few years separating us from him), there was the accounting as fulfilling social needs of Littleton etc. But what clearly has emerged triumphant was the radical free market ideology of Paton. So, even though accounting seems clearly part of the regulatory apparatus and part of the justice system in the US, the language we use to talk about what accountants are for is mainly that of efficent markets, rational economic actors, etc. No wonder Brian West is able to build such a persuasive case that accounting currently has no coherent cognitive foundation, thus, is not a "learned" profession. Accounting enables market functions in a world of economic competitors whose actions are harmoniously coordinated by the magic fingers of invisible hands (a metaphor that Adam Smith didn't set too much stock in -- it was merely an off-hand remark to which he never returned). Carl Devine has a very useful essay in Essays in Accounting theory, volume six, edited by Harvey Hendrickson (Garland) where he provides an insightful analysis of the contributions to theory of those persons of his generation and his generation of mentors (he particularly admired Mattesich.) 

Carl noted that Paton was a very effective rhetorician, so was perhaps more influential than his ideas really merited (like the relative influence of the contemporaries Malthus and Ricardo; Ricardo, the much better writer overshadowed Malthus in their day). Paton influenced a disproportionate number of the next generation of accounting academics; he was, after all, a classicaly trained economist. 

There is, in my view, absolutely no compelling reason why accountants should be the least bit concerned with new classical economic theory, but Paton, because of his influence, set the US academy on a path that brings us to where we are today. It is an interesting thought experiment (ala Trevor Gambling's buddhist accounting) to imagine what we would be doing and talking about if we had taken the institutionalists, or Ijiri's legal imagery more seriously. But, as they say here in NC, "It is what it is." 


December 2, 2004 reply from Bob Jensen

Bill Paton was all-powerful on the Michigan campus and was considered an economist as well as an accountant.  For a time under his power, a basic course in accounting was in the common core for all majors.  One of the most noted books advocating historical cost is called Introduction to Corporate Accounting Standards by William Paton and A.C. Littleton (Sarasota:  American Accounting Association, 1940).  Probably no single book has ever had so much influence or is more widely cited in accounting literature than this thin book by Paton and Littleton .  See

Later on Paton changed horses and was apologetic about once being such a strong advocate of historical cost.  He subsequently favored fair value accounting, while his co-author clung to historical cost.  However, Paton never became widely known as a valuation theorist compared to the likes of Edwards, Bell , Canning, Chambers, and Sterling .  (In case you did not know this, former FASB Board Member and SEC Chief Accountant Walter Scheutz is also a long-time advocate of fair value accounting.)

You can read about the Hall of Fame’s Bill Paton at 

Bob Jensen

December 2, 2004 reply from Jagdish Gangolly [JGangolly@UAMAIL.ALBANY.EDU

My earlier posts unfortunately may have implied that every onbe I mentioned continued to be a historical cost advocate -- that is not true. Paton changed his mind, as Bob mentioned.

The point I was trying to make there was the approach to theory building in accounting (something that crudely initates the axiomatic approach) that Paton essentially started. However, Paton had a "theory" in the sense of a set of axioms, but no theorems. In other words it was a sort of laundry list of axioms with out a detailed study of their collective implications (this is what struck me most while I was a student, but that might have been my problem since I came to accounting via applied mathematics/statistics). In fact most of the work of Paton & Littleton, Ijiri, Sprouse & Moonitz,... never really followed through their thoughts to their logical conclusions. One reason might have been that they did not really state their axioms in logic. Mattesich, as I understand, went a bit further, but he must have realised that a field like accounting where most sentences are deontic (normative, stated in English sentences in the imperative mood) rather than alethic (descriptive, stated in English sentences in the indicative mood). In normative systems, as even Hans Kelsen has admitted, there is no concept of truth and therefore logical deduction as we know it is not possible.

I think this becomes clear in one of the later books of Mattesich on Instrumental Reasoning (all but ignored by accountants because it is more philosophical, but in my opinion one of his most fascinating works).

I would not put Paul Grady, Carman Blough,... in the same group. For Paul Grady, for example, accounting "principles" were no more than a grab bag of mundane rules.

Leonard Spacek, one of my heroes, on the other hand, tried to emphasize accounting as communication of rights people had to resources UNDER LAW. He also emphasized fairness as an objective.

One reason for this chasm between practice and academia is that almost all practice is normatively based, whereas in the academia in accounting, for the past 40 years we have cared just about only for descriptive work of the naive positivist kind.

I hate peddling my work, but those interested might like to take a look at an old paper of mine (I consider it the best that I ever wrote) where some of these issues are discussed :

Generally Accepted Accounting Principles: Perspectives from Philosophy of Law, J. Gangolly & M. Hussein Critical Perspectives on Accounting, vol. 7 (1996), pp. 383-407.

I think we need to realise that we are not the only discipline that has gone astray from the original lofty goals.

Consider economics in the United States. In Britain, at least till the 70s (I haven't kept in touch since then), it was considered important that Economics teaching devoid of political and philosophical discussions was some how deficient; probably the main reason popular Oxford undergraduate major is PPE (Politics, Philosophy, Economics, with Economics taking the third seat). Specially in the US, attempts to make Economics value-free (wertfrei) have, to an extent also succeeded in making it a bit sterile. In his critique of Ludwig von Mises, Murray Rothbard ("Praxeology, Value Judgments, and Public Policy") states:

"The trouble is that most economists burn to make ethical pronouncements and to advocate political policies - to say, in effect, that policy X is "good" and policy Y "bad." Properly, an economist may only make such pronouncements in one of two ways: either (1) to insert his own arbitrary, ad hoc personal value judgments and advocate policy on that basis; or (2) to develop and defend a coherent ethical system and make his pronouncement, not as an economist, but as an ethicist, who also uses the data of economic science."

Or, that Economics is the "value-free handmaiden of ethics".

In accounting too, the positivists have worked hard over the past forty years or so to make it pretentiously value-free (remember disparaging references to non-descriptive work, and Carl Nelson's virtual jihad to rid accounting of "fairness" as an objective?). The result has been that it is perhaps not unfair to speak of "fair" in the audit reports just cheap talk.

Renaissance in accounting will come only when we look as much at Politics and Law as at Economics to inspire research.


December 3, 2004 reply from Paul Williams

For many subscribers this thread may have started to fray; to them I apologize, but I have to chime in to add a contrarian view to Bob's contention that Paton, Edwards and Bell ,etc. were advocates of fair value accounting. Fair value accounting is (in my view) a classic case of eliding into a use of a concept as if it were what we traditionally understood it to be while radically redefining it (see Feyerabend's analysis of Galileo's use of this same ploy). None of the early theorists were proponents of fair value accounting. 

They may have been advocates of replacement cost or opportunity cost, but never of "fair value," which is a purely hypothetical number generated through heroic assumptions about an undivinable future. As Carl Devine famously said, "No one has ever learned anything from the future." All subscribed to the principle that accounting should report only what actually occurred during a period of time -- this was the essence of E&B's argument that accounting data are for evaluating decisions; its value lies in its value as feedback and accounting data, therefore, categorically should not be generated on assumptions about the outcomes resulting from decisions that have already been made. The significant accomplishment of these theorists was to provide a defense of accounting's avoidance of subjective values. i.e., the accounting was in its essence objective (anyone remember Five 

Monographs on Business Income, particularly Sidney Alexander's critique of accounting measures of profit?). Now we accept seemingly without question the radical transformation of accounting affected by FASB to a system of nearly exclusively subjective values, i.e., your guess is as good as mine. In spite of the optimism people seem to express, we have no technology (nor would a believer in rational expectations theory ever expect there to be) that can divine the economic future. Perhaps a renaissance of some of these old ideas is overdo. I believe it was Clarence Darrow who opined that "Contempt for law is brought about by law making itself ridiculous." As writers of LAW (kudos to Jagdish's paper) the FASB seems to make accounting more ridiculous by the day.


December 3, 2004 reply from David Fordham

For those who don't know, Paul is an FSU alum, and Bob is a former Seminole, too, although they pre-dated me and may have had some professional interaction with Carl Devine. ...

David Fordham

December 3, 2004 reply from Bob Jensen

Hi David,

I arrived on the faculty at FSU in 1978. Carl was a recluse for all practical purposes. I don' think anybody had contact with him except a very devoted Ed McIntyre. Paul Williams was very close to Ed and may also have had some contact.  (Paul later reminded me that Carl grew interested in discussing newer directions with Ed Arrington.)

I think Carl was still actively writing and to the walls. His labor of love may have been lost if Ed and Paul didn't strive to share Carl's writings with the world. Carl was a classic scholar who'd lived most of his life in libraries.

Carl could've added a great deal to our intellectual growth and historical foundations if he participated in some of our seminars. He was a renaissance scholar.

It would've been interesting to know how Carl's behavior might've changed in the era of email. Scholars who asked him challenging questions might've gotten lengthy replies (Carl was not concise) that he would not provide face-to-face.

Bob Jensen

Decemeber 3, 2004 reply from Mclelland, Malcolm J [mjmclell@INDIANA.EDU

It almost seems there's a consensus on the AECM listserv on all this! Given the widespread interest and existng intellectual wherewithal among AECMs to do it, maybe it's time to start up the "Journal of Neo-Classical Accounting Theory"? Revisiting Edwards, Bell, Sterling, Chambers, Paton, et al. certainly seems worthwhile; especially if it can be fit into or reconciled with the more recent literature in accounting and finance.

Best regards,


Malcolm J. McLelland, Ph.D.

December 1, 2004 reply from Glen Gray [glen.gray@CSUN.EDU]

Your story does surprise me. A few years ago I convinced Barry Melancon (President) and Louis Matherne (at that time, Director of IT) from the AICPA to come to L.A. and speak at a dinner meeting of the L.A. chapter of the California Society of CPAs. The meeting was at UCLA, not my campus, however, the chapter offered to waive the $35 dinner charge for any CSUN faculty who want to attend. Other than myself, one (out of about 20) other faculty member attended the dinner. I asked some of the faculty members why they did not attend. The most common answer was something like “We know what he (Barry) is going to say—use more computers in your accounting courses.”

December 1, 2004 reply from Richard C. Sansing [Richard.C.Sansing@DARTMOUTH.EDU

Two thoughts in response:

First, I agree with the gist of your sentiment. Hanging around real world accountants can inform both our teaching and research, and most of us underinvest in such activities.

Second, the effect of "citizenship" considerations looks like an easy cost-benefit tradeoff to me. Seminars are attended only by faculty and doctoral students, so one's presence in the room is more noticable for a research seminar than a presentation attended by lots of undergraduates. Furthermore, the personal cost of attending a daytime event is much less than a nightime event. So if one is driven by citizenship considerations, I expect many more faculty to attend the daytime research seminar than the nightime practitioner presentation.

Richard C. Sansing 
Associate Professor of Business Administration 
Tuck School of Business at Dartmouth 

December 1, 2004 reply from Chuck Pier [texcap@HOTMAIL.COM]


I think that you have put your finger on, or maybe stumbled onto, one of the major splits in academic accounting today. You happen to be looking at this situation from one of the "research" universities. Most all of us (I use the term "us" to refer to academic accountants) have been associated with a research university. However, many of us have only been there as students during our doctoral studies. These universities place heavy premiums on both their faculties and students for what we call "basic research" that is quite replete with formulas and theories and the like. Faculty are tenured, promoted and financially rewarded to produce cutting edge research that is published in the top journals, and doctoral students are judged on their ability to analyze and conduct similar research.

On the other hand, many of "us" teach in "teaching universities" that place more emphasis on teaching and "professional" research. In other words, research that has a direct application to either the accounting profession or the teaching of accounting. There is usually not a penalty exerted on those who chose to do the more academic research, but there is also not any special rewartds for that research either.

I feel that many of "us" at teaching schools attend the lectures that you describe with a lot more regularity than your experience at your university. For example, at my school we have a weekly meeting during the fall of our Beta Alpha Psi chapter that inculeds a presentation on a topic by one of the firms in our area. These firms include all of the big four, as well as other national, regional, and local firms. The presentations run the gamut from interview techniques for the students to the latest updates on SOX or forensic accounting. As with any sample, some are better than others and many are appropriate to just the students. Despite the uneveness of the presentations I would estimate that at least 80% of our tenure track faculty are at each meeting, with the missing 20% having some other engagement and unable to attend. There is not a single member of our faculty that routinely does not attend. These meetings are not mandatory, but most of us feel that it supports both or students and the presenters, who hire our students to attend.

I am not trying to indite or point fingers at either side of the academic accounting community but it is obvious that we each have separate priorities. I for one chose the institution that I am at for the very reason that we do have a heavy emphasis on the practioneer and the undergraduate student. I know that many would abhor what I do and could not picture themselves here. They, like me have decided what they like and what they are best suited for. I do feel that at times we who are not at the big research schools feel that we are overlooked, but I wouldn't trade my place with anyone else. I think that I am providing a good service and enjoy the opportunities that it presents.


December 3, 2004 reply from Robin A Alexander [alexande.robi@UWLAX.EDU

Interesting. I too came from a math background and fnally realized there was no accounting theory in the scientific sense. I also came to suspect it was not a system of measurement either because to be so, there has to be something to measure independent of the measuring tool. Rather it seemed to me accounting defined, for instance, income rather than measured it.

Robin Alexander 

December 3, 2004 reply from Bob Jensen

Hi Robin,

I think the distinction lies not so much on "independence" of the measuring tool as it does on behavior induced by the measurements themselves, although this may be what you had in mind in your message to us.

Scientists measure the distance to the moon without fear that behavior of either the earth or the moon will be affected by the measurement process. There may some indirect behavioral impacts such as when designing fuel tanks for a rocket to the moon. In natural science, except for quantum mechanics, the measurers cannot re-define the distance to the moon for purposes of being able to design smaller fuel tanks.

In economics, and social science in general, behavior resulting from measurements is often more impacted by the definition of measurement itself. Changed definitions of inflation or a consumer price index might result in wealth transfers between economic sectors. Plus there is the added problem that measurements in the social sciences are generally less precise and stable, e.g., when people change behavior just because they have been "measured" or diagnosed.

Similarly in accounting, changed definitions of what goes into things like revenue, eps, asset values, and debt values may lead to wealth transfers. The Silicon Valley executives certainly believe that lowering eps by booking stock options will affect share prices vis-a-vis merely disclosing the same information in a footnote rather than as a booked expense. Virtually all earnings management efforts on the part of managers hinges on the notion that accounting outcomes affect wealth transfers. In fact if they did not do so, there probably would not be much interest in accounting numbers See "Toting Up Stock Options," by Frederick Rose, Stanford Business, November 2004, pp. 21 ---

Early accounting theorists such as Paton, Littleton, Hatfield, Edwards, Bell, Chambers, etc. generally believed there was some kind of optimal set of definitions that could be deduced without scientifically linking possible wealth transfers to particular definitions. And it is doubtful that subsequent events studies in capital market empiricism will ever solve that problem because human behavior itself is too adaptive. Academic researchers are still seeking to link behavior with accounting numbers, but they're often viewed as chasing moving windmills with lances thrust forward.

Auditors are more concerned about being faithful to the definitions. If the definition says book all leases that meet the FAS 13 criteria for a capital lease, then leases that meet those tests should not have been accounted for as operating leases. The audit mission is to do or die, not to question why. The FASB and other standard setters are supposed to question why. But they are often more impacted by the behavior of the preparers than the users. The behavior of preparers trying to circumvent accounting standards seems to have more bearing than the resulting impacts on wealth transfers that defy being built into a conceptual framework. Where science fails accounting in this regard is that the wealth transfer process is just too complicated to model except in the case of blatant fraud that lines the pockets of a villain.

It is not surprising that accounting "theory" has plummeted in terms of books and curricula. Theory debates never seem to go anywhere beyond unsupportable conjectures. I teach a theory course, but it has degenerated to one of studying intangibles and how preparers design complex contracts such as hedging and SPE contracts that challenge students into thinking how these contracts should be accounted for given our existing standards like FAS 133 and FIN 46. One course that I would someday like to teach is to design a new standard (such as a new FAS 133) and then predict how preparers would change behavior and contracting. Unfortunately my students are not interested in wild blue yonder conjectures. The CPA exam is on their minds no matter where I try to fly. They tolerate "theory" only to the point where they are also learning about existing standards. In their minds, any financial accounting course beyond intermediate should simply be an extension of intermediate accounting.

Bob Jensen

Bob Jensen's threads on accounting theory are at 

December 7, 2004 message from Carnegie President [

A different way to think about ... Professional Education This month's Carnegie Perspective is written by Carnegie Senior Scholar William Sullivan, whose extensively revised second edition of Work and Integrity was just released by Jossey-Bass. The Perspective is based on the book's argument that in today's environment of unrelenting economic and social pressures, in which professional models of good work come under increasing strain, the professions need their educational centers more than ever as resources and as rallying points for renewal.

Since our goal in Carnegie Perspectives is to contribute to the dialogue on issues and to provide a different way to think and talk about concerns, we have opened up the conversation by creating a forum—Carnegie Conversations—where you can engage publicly with the author and read and respond to what others have to say.

However, if you would prefer that your comments not be read by others, you may still respond to the author of the piece through .

If you would like to unsubscribe to Carnegie Perspectives, use the same address and merely type unsubscribe in the subject line of your email to us.

We look forward to hearing from you.


Lee S. Shulman President 
The Carnegie Foundation for the Advancement of Teaching

Preparing Professionals as Moral Agents By William Sullivan

Breakdowns in institutional reliability and professional self-policing, as revealed in waves of scandals in business, accounting, journalism, and the law, have spawned a cancerous cynicism on the part of the public that threatens the predictable social environment needed for a healthy society. For professionals to overcome this public distrust, they must embrace a new way of looking at their role to include civic responsibility for themselves and their profession, and a personal commitment to a deeper engagement with society.

The highly publicized unethical behavior that we see today by professionals is still often thought by many—physicians, lawyers, educators, scientists, engineers—as "marginal" matters in their fields, to be overcome in due course by the application of the value-neutral, learned techniques of their profession. But this conventional view fails to recognize that professionals' "problems" arise outside the sterile, neutral and technical and instead lie within human social contexts. These are not simply physical environments or information systems. They are networks of social engagement structured by shared meanings, purposes, and loyalties. Such networks form the distinctive ecology of human life.

For example, a doctor faced with today's lifestyle diseases—obesity, addictions, cancer, strokes—rather than with infectious biological agents, soon realizes that he or she must take into account how individuals, groups, or whole societies lead their lives. Or in education, it is often assumed that schools can improve student achievement by setting clear standards and then devising teaching techniques to reach them. But this approach has been confounded when it encounters students who do not see a relationship between academic performance and their own goals, or when the experience of students and parents has made trusting school authorities appear a dubious bargain.

In order to "solve" the apparently intractable problems of health care, education, public distrust, or developing a humane and sustainable technological order, the strategies of intervention employed by professionals must engage with, and if possible, strengthen, the social networks of meaning and connection in people's lives—or their efforts will continue to misfire or fail. And not only will they be less effective in meeting the needs of society and the individuals who entrust their lives to their care, but they will also find in their midst colleagues who do not uphold the moral tenets of the profession.

The idea of the professional as neutral problem solver, above the fray, which was launched with great expectations a century ago, is now obsolete. A new ideal of a more engaged, civic professionalism must take its place. Such an ideal understands, as a purely technical professionalism does not, that professionals are inescapably moral agents whose work depends upon public trust for its success.

Since professional schools are the portals to professional life, they bear much of the responsibility for the reliable formation in their students of integrity of professional purpose and identity. In addition to enabling students to become competent practitioners, professional schools always must provide ways to induct students into the distinctive habits of mind that define the domain of a lawyer, a physician, nurse, engineer, or teacher. However, the basic knowledge of a professional domain must be revised and recast as conditions change. Today, that means that the definition of basic knowledge must be expanded to include an understanding of the moral and social ecology within which students will practice.

Today's professional schools will not serve their students well unless they foster forms of practice that open possibilities of trust and partnership with those the professions serve. Such a reorientation of professional education means nothing less than a broadening and rebalancing of professional identity. It means an intentional abandonment of the image of the professional as superior and detached problem-solver. It also requires a positive engagement. Professional education must promote the opening of professional life to meet clients and patients as also fellow citizens, persons with whom teachers, physicians, lawyers, nurses, accountants, engineers, and indeed all professionals share a larger, common "practice"—that of citizen, working to contribute particular knowledge and specialized skills toward improving the quality of life, perhaps especially for those most in need.

Professional schools have too often held out to their students a notion of expert knowledge that remains abstracted from context. Since the displacement of apprenticeship on the job by academic training in a university setting, professional schools have tilted the definition of professional competence heavily toward cognitive capacity, while downplaying other crucial aspects of professional maturity. This elective affinity between the academy's penchant for theoretical abstraction and the distanced stance of problem solving has often obscured the key role played by the face-to-face transmission of professional understanding and judgment from teacher to student. This is the core of apprenticeship that must not be allowed to wither from lack of understanding and attention.

A new civic awareness within professional preparation could go a long way toward awakening awareness that the authentic spirit of each professional domain represents more than a body of knowledge or skills. It is a living culture, painfully developed over time, which represents at once the individual practitioner's most prized possession and an asset of great social value. Its future worth, however, will depend in large measure on how well professional culture gets reshaped to answer these new needs of our time


"The Practitioner-Professor Link," by Bonita K. Peterson, Christie W. Johnson, Gil W. Crain, and Scott J. Miller, Journal of Accountancy, June 2006 ---

PERIODIC FEEDBACK FROM PRACTITIONERS to faculty about the strengths and weaknesses of their graduates and their program can help to positively influence the accounting profession.

CPAs ALSO CAN INSPIRE STUDENTS’ education by providing internship opportunities for accounting students, or serving as a guest speaker in class.

MEMBERSHIP ON A UNIVERSITY’S ACCOUNTING advisory council permits a CPA to interact with faculty on a regular basis and directly affect the accounting curriculum.

SERVING AS A “PROFESSOR FOR A DAY” is another way a CPA can promote the profession to accounting students and answer any questions they have.

CPAs CAN SUPPORT STUDENTS’ PROFESSIONAL development by providing advice on proper business attire and tips for preparing resumes, and conducting mock interviews.

CPAs CAN SHARE EXPERIENCES with a professor to cowrite an instructional case study for a journal, which can reach countless students in classrooms across the world.

ORGANIZING OR CONTRIBUTING to an accounting education fund at the university can help fund a variety of educational purposes, such as student scholarships and travel expenses to professional meetings.

PARTICIPATION BY PRACTITIONERS in the education of today’s accounting students is a win-win-win situation for students, CPAs and faculty.




Methods for Setting Accounting Standards


Accounting Rules So Plentiful "It's Nuts"
There are perhaps 2,000 accounting rules and standards that, when written out, possibly exceed the U.S. tax code in length. Yet, there are only the Ten Commandments. So Bob Herz, chairman of the rule-setting Financial Accounting Standards Board, is asked this: How come there are 2,000 rules to prepare a financial statement but only 10 for eternal salvation? "It is nuts," Herz allows. "But you're not going to get it down to ten commandments because the transactions are so complicated. . . . And the people on the front lines, the companies and their auditors, are saying: 'Give me principles, but tell me exactly what to do; I don't want to be second-guessed.' " Nonetheless, the FASB (pronounced, by accounting insiders, as "FAZ-bee") is embarking on efforts to simplify and codify accounting rules while improving them and integrating them with international standards.
"Accounting Rules So Plentiful 'It's Nuts' ; Standards Board Takes on Tough Job to Simplify, Codify," SmartPros, June 8, 2005 ---

Jensen Comment:  Shyam Sunder (Yale University) is the 2005 President-Elect of the American Accounting Association ---

From Jim Mahar's blog on July 18 2005 ---

SSRN-Social Norms versus Standards of Accounting by Shyam Sunder ---

A few highlights from the paper:

"Historically, norms of accounting played an important role in corporate financial reporting. Starting with the federal regulation of securities, accounting norms have been progressively replaced by written standards....[and]enforcement mechanisms, often supported by implicit or explicit power of the state to impose punishment. The spate of accounting and auditing failures of the recent years raise questions about the wisdom of this transition from norms to standards....It is possible that the pendulum of standardization in accounting may have swung too far, and it may be time to allow for a greater role for social norms in the practice of corporate financial reporting."

"The monopoly rights given to the FASB in the U.S. (and the International Accounting Standards Board or IASB in the EU) deprived the economies, and their rule makers, from the benefits of experimentation with alternative rules and structures so their consequences could be observed in the field before deciding on which rules, if any, might be more efficient. Rule makers have little idea, ex ante, of the important consequences (e.g., the corporate cost of capital) of the alternatives they consider."

"Given the deliberate and premeditated nature of financial fraud and misrepresentation (and other white color crimes), "clarifications of the rules invite and facilitate evasion"

And my favorite!

"Indeed the U.S. constitution, a document that covers the entire governance system for the republic, has less than 5,000 words. The United Kingdom has no written constitution. A great part of the governance of both countries depends on norms. Do accountants deal with greater stakes?"

BTW: I like the prescriptions called for as well, but will allow you to read those (pages 20 to 22 of paper)

Cite: Sunder, Shyam, "Social Norms versus Standards of Accounting" (May 2005). Yale ICF Working Paper No. 05-14.

Let me close by citing Harry S. Truman who said, "I never give them hell; I just tell them the truth and they think its hell!"
Great Speeches About the State of Accountancy

"20th Century Myths," by Lynn Turner when he was still Chief Accountant at the SEC in 1999 ---

It is interesting to listen to people ask for simple, less complex standards like in "the good old days." But I never hear them ask for business to be like "the good old days," with smokestacks rather than high technology, Glass-Steagall rather than Gramm-Leach, and plain vanilla interest rate deals rather than swaps, collars, and Tigers!! The bottom line is—things have changed. And so have people.

Today, we have enormous pressure on CEO’s and CFO’s. It used to be that CEO’s would be in their positions for an average of more than ten years. Today, the average is 3 to 4 years. And Financial Executive Institute surveys show that the CEO and CFO changes are often linked.

In such an environment, we in the auditing and preparer community have created what I consider to be a two-headed monster. The first head of this monster is what I call the "show me" face. First, it is not uncommon to hear one say, "show me where it says in an accounting book that I can’t do this?" This approach to financial reporting unfortunately necessitates the level of detail currently being developed by the Financial Accounting Standards Board ("FASB"), the Emerging Issues Task Force, and the AICPA’s Accounting Standards Executive Committee. Maybe this isn’t a recent phenomenon. In 1961, Leonard Spacek, then managing partner at Arthur Andersen, explained the motivation for less specificity in accounting standards when he stated that "most industry representatives and public accountants want what they call ‘flexibility’ in accounting principles. That term is never clearly defined; but what is wanted is ‘flexibility’ that permits greater latitude to both industry and accountants to do as they please." But Mr. Spacek was not a defender of those who wanted to "do as they please." He went on to say, "Public accountants are constantly required to make a choice between obtaining or retaining a client and standing firm for accounting principles. Where the choice requires accepting a practice which will produce results that are erroneous by a relatively material amount, we must decline the engagement even though there is precedent for the practice desired by the client."

We create the second head of our monster when we ask for standards that absolutely do not reflect the underlying economics of transactions. I offer two prime examples. Leasing is first. We have accounting literature put out by the FASB with follow-on interpretative guidance by the accounting firms—hundreds of pages of lease accounting guidance that, I will be the first to admit, is complex and difficult to decipher. But it is due principally to people not being willing to call a horse a horse, and a lease what it really is—a financing. The second example is Statement 133 on derivatives. Some people absolutely howl about its complexity. And yet we know that: (1) people were not complying with the intent of the simpler Statements 52 and 80, and (2) despite the fact that we manage risk in business by managing values rather than notional amounts, people want to account only for notional amounts. As a result, we ended up with a compromise position in Statement 133. To its credit, Statement 133 does advance the quality of financial reporting. For that, I commend the FASB. But I believe that we could have possibly achieved more, in a less complex fashion, if people would have agreed to a standard that truly reflects the underlying economics of the transactions in an unbiased and representationally faithful fashion.

I certainly hope that we can find a way to do just that with standards we develop in the future, both in the U.S. and internationally. It will require a change in how we approach standard setting and in how we apply those standards. It will require a mantra based on the fact that transparent, high quality financial reporting is what makes our capital markets the most efficient, liquid, and deep in the world.

Landmark Exposure Draft containing joint proposals to improve and align accounting for business combinations

"IASB and FASB Publish First Major Exposure Draft Standard," AccountingWeb, July 11, 2005 ---

The International Accounting Standards Board (IASB), based in London, and the US Financial Accounting Standards Board (FASB) have announced publication of an Exposure Draft containing joint proposals to improve and align accounting for business combinations. The proposed standard would replace IASB’s International Financial Reporting Standard (IFRS) 3, Business Combinations and the FASB’s Statement 141, Business Combinations.

Sir David Tweedie, IASB Chairman and Bob Herz, FASB Chairman, emphasized the value of a single standard to users and preparers of financial statements of companies around the world as it improves comparability of financial information. "Development of a single standard demonstrates the ability of the IASB and the FASB to work together,” Tweedie continued.

Continued in article

"Can We Go Back to the Good Old Days?" by Dennis R. Beresford, The CPA Journal --- 

Recently I visited my pharmacy to pick up eyedrops for my two golden retrievers. Before he would give me the prescription, the pharmacist insisted I sign a form on behalf of Murphy and Millie, representing that they had been apprised of their rights under the new medical privacy rules. This ludicrous situation is a good illustration of how complicated life has gotten.

I was still shaking my head later that same day when I was clicking mindlessly through the 150 or so channels that my local cable TV service makes available to me. I happened to land on The Andy Griffith Show, and the few minutes I spent with Andy, Barney, Opie, and Aunt Bea got me thinking about the Good Old Days. Wouldn’t it be nice, I thought, to go back to the Good Old Days of the profession in the early 1960s when I graduated from college?

Back then, accounting was really simple. The Accounting Principles Board hadn’t issued any standards yet, and FASB didn’t exist. So we didn’t have 880 pages listing all of the current rules and guidance on derivative financial instruments, for example. The totality of authoritative GAAP at that time fit in one softbound booklet about one-third the size of the new derivatives guidance.

In those Good Old Days, the SEC had been around for quite a while but it rarely got excited about accounting matters. Neither mandatory quarterly reporting nor management’s discussion and analysis (MD&A) had yet come into being, for example. And annual report footnotes could actually be read in an hour or so.

The country had eight major accounting firms, and becoming a partner in one was a truly big deal. Lawsuits against accounting firms were rare, and almost none of them resulted in substantial damages against the accountants.

In short, accounting seemed more like a true profession, with good judgment and experience key requirements for success.

Of course, however much we might like to return to simpler times, it’s easier said than done. And most of us would never give up the many benefits of progress, such as photocopiers, personal computers, e-mail, the Internet, and cellphones. But I think that accounting rules may have become more complicated than necessary.

Let me start with a mea culpa. You may remember the famous line from the comic strip Pogo: “We have met the enemy, and he is us!” Well, you may be tempted to rephrase that quote to “We have met the enemy, and he is … Beresford!”

I plead guilty to having led the development of 40 or so new accounting standards over my time at FASB. A number of them had pervasive effects on financial statements, and some have been costly to apply. I always tried to be as practical as possible, however, although probably few would say that I was 100% successful in meeting that objective.

In any event, more-recent accounting standards and proposals seem to be getting increasingly complicated and harder to apply. Even the best-intentioned accountants have difficulty keeping up with all of the changes from FASB, the AICPA, the SEC, the EITF, and the IASB. And some individual standards, such as those on derivatives and variable-interest entities, are almost impossible for professionals, let alone laypeople, to decipher.

Furthermore, these days, companies are subject to what I’ll call quadruple jeopardy. They have to apply GAAP as best they can, but they are then subject to as many as four levels of possible second-guessing of their judgments.

First, the external auditors must weigh in. Second, the SEC will now be reviewing all public companies’ reports at least once every three years. Third, the PCAOB will be looking at a sample of accounting firms’ audits, and that could include any given company’s reports. Finally, the plaintiff’s bar is always looking for opportunities to challenge accounting judgments and extort settlements. Broad Principles Versus Detailed Rules

I suspect that all this second-guessing is what leads many companies and auditors to ask for more-detailed accounting rules. But we may have reached the point of diminishing returns. In response to the complexity and sheer volume of many current standards, some have suggested that accounting standards should be broad principles rather than detailed rules. FASB and the SEC have expressed support for the general notion of a principles-based approach to accounting standards. (It’s kind of like apple pie and motherhood: Who can object to broad principles?) Of course, implementing such an approach is problematic.

In 2002, FASB issued a proposal on this matter. And last year the SEC reported to Congress on the same topic. Specific things that FASB suggested could happen include the following:

Standards should always state very clear objectives. Standards should have a clearly defined scope and there should be few, if any, exceptions (e.g., for certain industries). Standards should contain fewer alternative accounting treatments (e.g., unrealized gains and losses on marketable securities could all be run through income rather than the various approaches used at present). FASB also said that a principles-based approach probably would include less in the way of detailed interpretive and implementation guidance. Thus, companies and auditors would be expected to rely more on professional judgment in applying the standards.

The SEC prefers to call this approach “objectives-based” rather than “principles-based.” SEC Chief Accountant Donald Nicolaisen recently repeated the SEC’s support for such an approach, agreeing with the notion of clearly identifying and articulating the objective for each standard. Although he also suggested that objectives-based standards should avoid bright-line tests such as lease capitalization rules, he called for “sufficiently detailed” implementation guidance, including real-world examples.

Although FASB and the SEC may have reached a meeting of the minds on the overall notion of more general principles, they may disagree on the key point of how much implementation guidance to provide. FASB thinks that a principles-based approach should include less implementation guidance and rely more on judgment, while the SEC thinks that “sufficiently detailed” guidance is needed, and I suspect that would make it difficult to significantly reduce complexity in some cases.

In any event, FASB recently said that it may take “several years or more” for preparers and auditors to adjust to a change to less detail. Meantime, little has changed with respect to individual standards, which if anything are becoming even harder to understand and apply.

I’ve heard FASB board members say that FASB Interpretation (FIN) 46, on variable-interest entities (VIE), is an example of a principles-based standard. I assume they say this because FIN 46 states an objective of requiring consolidation when control over a VIE exists. But the definition of a VIE and the rules for determining when control exists are extremely difficult to understand.

FASB recently described what it meant by the operationality of an accounting standard. The first condition was that standards have to be comprehensible to readers with a reasonable level of knowledge and sophistication. This doesn’t seem to be the case for FIN 46. Many auditors and financial executives have told me that only a few individuals in the country truly know how to apply FIN 46. And those few individuals often disagree among themselves!

Such complications make it difficult to get decisions on many accounting matters from an audit engagement team. Decisions on VIEs, derivatives, and securitization transactions, to name a few, must routinely be cleared by an accounting firm’s national experts. And with section 404 of the Sarbanes-Oxley Act (SOA) and new concerns about auditor independence, getting answers is now even harder. For example, in the past, companies would commonly consult with their auditors on difficult accounting matters. But now the PCAOB may view this as a control weakness, under the assumption that the company lacks adequate internal expertise. And if auditors get too involved in technical decisions before a complex transaction is completed, the SEC or the PCAOB might decide that the auditors aren’t independent, because they’re auditing their own decisions.

When things become this complicated, I wonder whether it’s time for a new approach. Maybe we do need to go back to the Good Old Days.

Internal Controls

Today, financial executives are probably more concerned about internal controls than new accounting requirements. For the first time, all public companies must report on the adequacy of their internal controls over financial reporting, and outside auditors must express their opinion on the company’s controls. Many people have questioned whether this incredibly expensive activity is worth the presumed benefit to investors. While one might argue that the section 404 rules are a regulatory overreaction, shareholders should expect good internal controls. And audit committees, as shareholders’ representatives, must demand those good controls. So this has been by far the most time-consuming topic at all audit committee meetings I’ve attended in the past couple of years.

Companies and auditors are spending huge sums this year to ensure that transactions are properly processed and controlled. Yet the most perfect system of internal controls and the best audit of them might not catch an incorrect interpretation of GAAP. A good example of this was contained in the PCAOB’s August 2004 report on its initial reviews of the Big Four’s audit practices. The report noted that all four firms had missed the fact that some clients had misapplied EITF Issue 95-22. As the New York Times (August 27, 2004) noted, “The fact that all of the top firms had been misapplying it raised issues of just how well they know the sometimes complicated rules.”

Responding to a different criticism in that same PCAOB report, KPMG noted, “Three knowledgeable informed bodies—the firm, the PCAOB, and the SEC—had reached three different conclusions on proper accounting, illustrating the complex accounting issues registrants, auditors and regulators all face.”

Fair Value Accounting

Even those who are very confident about their understanding of the current accounting rules shouldn’t get complacent: Fair value accounting is right around the corner, making things even harder. In fact, it is already required in several recent standards.

To be clear, I’m not opposed in general to fair value accounting. It makes sense for marketable securities, derivatives, and probably many other financial instruments. But expanding the fair value concept to many other assets and liabilities is a challenge.

Consider this sentence from FASB’s recent exposure draft on fair value measurements: “The Board agreed that, conceptually, the fair value measurement objective and the approach for applying that objective should be the same for all assets and liabilities.” In that same document, FASB said, “Users of financial statements generally have agreed that fair value information is relevant.”

So the overall objective of moving toward a fair value accounting model seems clear. Of course, that doesn’t necessarily mean that we will get there soon. In fact, in the same exposure draft the board said that it would continue to use a project-by-project approach to decide on fair value or some other measure. But in reality the board has been adopting a fair value approach in most recent decisions:

SFAS 142, on goodwill, requires that impairment losses for certain intangible assets be recognized based upon a decline in the fair value of the asset. SFAS 143, on asset retirement obligations, requires that these liabilities be recorded initially at fair value rather than what the company expects to incur. SFAS 146, on exit or disposal activities, calls for the fair value of exit liabilities to be recorded, not the amount actually expected to be paid. FIN 45, on guarantees, says that a fair value must be recorded even when the company doesn’t expect to have to make good on a guarantee. A fair value approach is also integral to other pending projects, including the conditional asset retirement obligation exposure draft. Under such a standard, a company might have to record a fair value liability even when it doesn’t expect to incur an obligation. Fair value is also key to projects on business combination purchase procedures; differentiating between liabilities and equity; share-based payments (stock options); and the tremendously important revenue recognition project.

I have three major concerns about such pervasive use of fair value accounting. First, in many cases determining fair value in any kind of objective way will be difficult if not impossible. Second, the resulting accounting will produce answers that won’t benefit users of financial statements. Third, those answers will be very difficult to explain to business managers, with the result that accounting will be further discredited in their minds.

The approach that FASB is using for what I would call operating liabilities is particularly troubling. Take, for example, a company that owns and operates a facility that has some asbestos contamination. The facility is safe and can be operated indefinitely, but if the company wanted to sell the property it would have to remediate that contamination. The company has no plans to sell the property. But FASB’s exposure draft on conditional asset retirement obligations calls for the company to estimate and record a fair value liability. This would be based on what someone else would charge now to assume the obligation to clean up the problem at some unspecified future date. The board admits that it might be difficult to determine what the fair value would be in this case, and companies could omit the liability if they simply couldn’t make a reasonable estimate.

Although FASB and the SEC expect most companies to be able to make a reasonable estimate, in reality I think that will be possible only rarely. Even more important, does it really make sense to record a liability when the company might believe that there is only a 5% chance that it will have to be paid? Consider how this line of reasoning might apply to litigation. Presently, liabilities are recorded only when it’s probable that a loss has been incurred and that a reasonable estimate of the loss can be made. So if a company were sued for $1 billion but there were only a 1% chance that it would lose, nothing would be recorded. The fair value approach would seem to call for a liability of $10 million in this case, based on 1% of $1 billion.

One might think this kind of accounting will apply only in the distant future, but FASB is due to release its proposal on purchase accounting procedures in the next few months, and I understand that the proposal will require exactly this kind of accounting.

In addition to the very questionable relevance of this, I don’t know how anyone would ever be able to reasonably determine the 1% likelihood I assumed. How would an auditor attest to the reliability of financial statements whose results depend significantly on such assumptions? And where would an auditor go to obtain objective audit evidence against which to evaluate such assumptions?

Fair value definitely makes sense in certain instances, but FASB seems intent on extending the notion beyond the boundaries of common sense. FASB also seems to have an exaggerated notion of what companies and auditors are actually capable of doing. Perhaps we should consider FASB’s faith in the profession to be a compliment. Rather than feeling complimented, however, I think that this just makes many of us long for the Good Old Days.

Fair Value Accounting and Revenue Recognition

Currently, asset retirement obligations and exit costs apply to only a few companies, and even guarantees are not an everyday issue. All companies, however, have revenues—or at least they hope to have them. And for the past year or so, FASB has been engaged in a complete rethinking of revenue recognition. This, of course, was precipitated by the numerous SEC enforcement cases on improper revenue recognition. Most cases, however, involved failure to follow existing standards, and most cases also resulted in premature recognition of revenue.

Now there’s no doubt that the current revenue accounting rules are overly complicated, with many specific rules depending on the type of product or service being sold. But FASB’s current thinking would replace these rules with an asset and liability–oriented approach based on fair value accounting. This may well make revenue accounting even more complicated than the detailed rules that we are at least used to working with.

For example, assume product A is being sold to a customer. It costs $50 to produce product A and the customer has agreed to pay a nonrefundable $100 in exchange for the company’s promise to deliver this hot product next month. What should the company record at month-end?

Most accountants would probably think first of the traditional approach and conclude that the earnings process had not been completed. Because product A hasn’t been completed and shipped to the customer, the $100 credit is unearned income. Some aggressive accountants would probably say that the company should record the sale now because the $100 is nonrefundable. In that case the company would probably also record a liability for the $50 cost that will be incurred next month.

FASB has a surprise for both. The board is presently thinking about whether revenue for what it calls the “selling activity”—the difference between the $100 received and the assumed fair value of the obligation to deliver the product—should be recorded now. This assumed fair value would be the estimated amount that other companies would charge to produce product A. In other words, it’s the hypothetical amount a company would have to pay someone else to assume the obligation to produce the product. The company would have to make this assumption even though it is 100% sure that it will make the product itself rather than have someone else make it.

If one could ever determine what other companies would charge, I suspect that the amount would be higher than the $50 expected cost, because another company probably would require a risk premium to produce a product that it isn’t familiar with. It would want to earn a profit as well. Let’s assume in this case that the fair value could be determined as $80. If so, the company would record now $20 of revenue and profit for what FASB calls the selling activity. Next month it would record the $80 remaining amount of revenue, along with the $50 cost actually incurred. It’s unclear when the company would record sales commissions, delivery costs, and similar expenses, but I assume these would have to be allocated somehow.

Given that this project was added to FASB’s agenda in large part because of premature recognition of revenue in some SEC cases—Enron recognized income based on the supposed fair value of energy contracts extending 30 years into the future—it is ironic that the project may well mandate recognition earlier than most accountants would consider appropriate. That kind of premature revenue recognition is now generally prohibited, but other examples could follow, depending on the outcome of this FASB project.

Although the revenue recognition project is still in an early stage and both my understanding and the board’s positions could change, FASB seems determined to use some sort of fair value approach to revenue recognition in many cases. If this happens, we will all be wishing for the Good Old Days to return.

Is All That EITF Guidance Really Necessary?

In early 2004, FASB’s board members began reviewing all EITF consensus positions. A majority of board members now have to “not disagree” with the EITF before those positions become final and binding on companies. This gives FASB more control over the EITF process, and it should prevent the task force from developing positions that the board sees as inconsistent with existing GAAP.

Although I think the task force has done a great deal of good over its 20-year existence (I was a charter member), I think it’s time to challenge whether everything that the EITF does is necessary or even consistent with its original purpose. Too many of the task force’s topics in recent years can’t really be called “emerging issues.” Rather, the task force often takes up long-standing issues where it thinks that some limitations need to be placed on professional judgment.

For example, a couple of years ago the SEC became concerned about the accounting for certain investments in other companies. For years we’ve had standards that call for recognition of losses when market value declines are “other than temporary.” The EITF discussed this matter at eight meetings over two years and also relied on a separate working group of accounting experts. Earlier this year, a final consensus position was issued. It includes a lengthy abstract that tells companies what factors to consider, including the following matters:

Evidence to support the ability and intent to continue to hold the investment; The severity of the decline in value; How long the decline has lasted; and The evidence supporting a market price recovery. So now we have a “detailed rule” on this matter. Will this result in more consistency in practice? Will investors and other users of financial statements receive better information as a result? Is the result worth the additional effort?

Moreover, after two years of effort on this project, FASB had to reconsider the whole thing because no one had considered the effect on debt securities held as available for sale by financial institutions. So now the board is developing even more specifics to deal with the unintended consequences of the rule.

Again, I support the EITF, and I believe it has generally done a great job. The members try to develop practical ways to deal with current problems. Nonetheless, both the task force and FASB may need to more carefully challenge whether all of the EITF’s projects are really needed. If FASB actually issued relatively broad standards, there probably would be a need for the EITF to provide supplemental guidance on some issues. But we now seem to have the worst of all worlds, with quite detailed accounting standards being accompanied by even more detailed EITF guidance.

A Multitude of Challenges

I don’t intend to seem overly critical of FASB and others who are working to improve financial reporting. It’s a tough job, and the brickbats always outnumber the bouquets. If I didn’t strongly support accounting standards setting I wouldn’t have spent 10 Qs years on the inside of the process. Still, those years at FASB, as well as my time before and after, have caused me to develop strong views on these issues. And I truly do believe that standards have gotten just too complicated.

The announced move to broader principles is one I fully support. That job won’t be easy, but it has to be tried or the sea of detail will become even deeper in the near future. FASB needs to actually start doing this and not allow its actions to speak otherwise. And companies, auditors, and regulators need to support such a move and resist the temptation to seek answers to every imaginable question. Furthermore, companies and auditors may have to become more principled before a principles-based approach will work.

Part of this process could be for the EITF to be more judicious in what it takes on. Also, I urge FASB to reevaluate its attitude toward fair value accounting. I believe FASB is moving much faster in this area than preparers, auditors, and users of financial statements can accommodate. Furthermore, the SEC and other regulators may not yet be on board with this new thinking.

In the final analysis, we won’t be able to return to my so-called Good Old Days. But we have to make sure that what accounting and accountants can do is meaningful and operational. We never want to look back and ask, “Remember the Good Old Days, when accounting was important?”

CPA Journal Editorial Board member Dennis R. Beresford, CPA, was recently named the 2005 recipient of the Gold Medal for Distinguished Service from the AICPA. He received the award on October 26, during the fall meeting of the Institute’s governing council in Orlando. Beresford is the Ernst & Young Executive Professor of Accounting at the J.M. Tull School of Accounting at the University of Georgia, Terry College of Business. From 1987 to 1997, he was chairman of FASB. Prior to joining FASB, he was national director of accounting standards for Ernst & Young.ecently I visited my pharmacy to pick up eyedrops for my two golden retrievers. Before he would give me the prescription, the pharmacist insisted I sign a form on behalf of Murphy and Millie, representing that they had been apprised of their rights under the new medical privacy rules. This ludicrous situation is a good illustration of how complicated life has gotten.


From the FASB in July 2004 "FASB Response to SEC Study on the Adoption of a Principles-Based Accounting System" --- 


In July 2003, the staff of the Securities and Exchange Commission (SEC) submitted to Congress its Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System (the Study). The Study includes the following recommendations to the Financial Accounting Standards Board (FASB or Board):

1. The FASB should issue objectives-oriented standards.

2. The FASB should address deficiencies in the conceptual framework.

3. The FASB should be the only organization setting authoritative accounting

guidance in the United States.

4. The FASB should continue its convergence efforts.

5. The FASB should work to redefine the GAAP hierarchy.

6. The FASB should increase access to authoritative literature.

7. The FASB should perform a comprehensive review of its literature to identify standards that are more rules-based and adopt a transition plan to change those standards.

The Board welcomes the SEC’s Study and agrees with the recommendations. Indeed, a number of those recommendations relate to initiatives the Board had under way at the time the Study was issued.1 The Board is committed to continuously improving its standard-setting process. The Board’s specific responses to the recommendations in the Study are described in the following sections of this paper.

Objectives-Oriented Standards

In the Study, the SEC staff recommends that "those involved in the standard-setting

process more consistently develop standards on a principles-based or objectives-oriented

basis" (page 4).2 According to the Study (page 4), an objectives-oriented standard would

have the following characteristics:

Be based on an improved and consistently applied conceptual framework;

Clearly state the accounting objective of the standard;

Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;1

Minimize exceptions from the standard;

Avoid use of percentage tests ("bright-lines") that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.

The “objectives-oriented” approach to setting standards described above (and expanded
upon in the Study) is similar to the principles-based approach described in the Board’s
Proposal. After discussing the comments received on its Proposal, the Board agreed that
its conceptual framework needs to be improved. This is because an internally consistent
and complete conceptual framework is critical to a standard-setting approach that places
more emphasis on the underlying principles that are based on that framework. Pages 8
and 9 of this paper further describe the Board’s activities related to the conceptual
framework; the following sections address the other characteristics of an objectivesoriented
approach addressed in the Study.

Format and Content of Standards

The Board agrees with the Study’s recommendation to improve the format and content of its standards. In particular, The Board agrees that the objective and underlying principles  of a standard should be clearly articulated and prominently placed in FASB standards. In response to comments received on its Proposal, the Board agreed that although its existing standards are based on concepts and principles, the understandability of its standards could be improved by writing its standards in ways that (a) clearly state the accounting objective(s), (b) clearly articulate the underlying principles, and (c) improve the explanation of the rationale behind those principles and how they relate to the conceptual framework.

The Board is working on developing a format for its standards that will encompass the attributes of an objectives-oriented standard described in the Study, for example, describing the underlying objective of the standard in the introductory paragraphs, using bold type to set off the principles,3 and providing a glossary for defined terms.

In addition, the Board is working with a consultant to identify changes in the organization and exposition of its standards that will increase the understandability of those standards.  Accounting standards by their nature will include many specific technical terms; however, the Board believes it can do a better job simplifying the language used in its standards to describe how to account for complex transactions. In addition, the Board will strive to apply other effective writing techniques to enhance constituents’ understanding of FASB standards.

When discussing proposed accounting standards or specific provisions of a standard, many of the Board’s constituents comment on whether a standard is "operational."  Because that term can mean different things to different people, the Board decided to define the term operational for its purposes. The Board uses the term operational to mean the following:

A provision/standard is comprehensible by a reader who has a reasonable level of knowledge and sophistication,

The information needed to apply the provision/standard is currently available or can be created, and 

The provision/standard can be applied in the manner in which it was intended. The Board believes that if its standards are more understandable, they also will be more operational.

Implementation Guidance

As noted in the Board’s Proposal, an approach to setting standards that places more emphasis on principles will not eliminate the need to provide interpretive and implementation guidance for applying those standards. Thus, the Board agrees that some amount of implementation guidance is needed in objectives-oriented standards in order for entities to apply those standards in a consistent manner. The Board uses the term implementation guidance to refer to all of the guidance necessary to explain and operationalize the principles (that is, the explanatory text in the standards section, the definitions in the glossary, and guidance and examples included in one or more appendices that help an entity apply the provisions in the standards section). The Board believes that the amount of necessary guidance will vary depending on the nature and complexity of the arrangements that are the subject of the standard. The Board believes that there should be enough guidance such that a principle is understandable, operational, and capable of being applied consistently in similar situations. Judgment is required to decide how much guidance is needed to achieve those objectives, without providing so much guidance that the overall standard combined with its implementation guidance becomes a collection of detailed rules. Therefore, the amount and nature of implementation guidance will vary from standard to standard. 

The Board believes that its primary focus should be providing broadly applicable implementation guidance, not providing guidance on relatively narrow and less pervasive issues, including, for example, issues that are specific to certain entities or industries. When developing that implementation guidance, the Board plans to apply the same guidelines that underpin objectives-oriented standards. For example, rather than consisting of a list of rules or bright lines, the implementation guidance would explain or expand on the principle(s) or objectives in the standard. 4.

Continued in the report


From the FASB in October 2002 --- 

Results of the 2002 Annual FASAC Survey

FASAC's annual survey on the priorities of the FASB provides valuable perspectives and observations about the Board's process and direction. The 2002 survey asked Council members, Board members, and other interested constituents to provide their views about the FASB's priorities, the financial reporting issues of tomorrow, principles-based standards, and the FASB's international activities.

Key observations and conclusions from the responses to the 2002 survey are:

Twenty-two current Council members, 7 Board members, and 9 other constituents responded to the survey.

Bob Jensen's threads on accounting theory are at 

Bob Jensen's threads on accounting fraud are at 

Bob Jensen's threads on accounting for electronic commerce are at 

There is a complete saga of attempts to establish a conceptual framework of accounting.  See

Methods for setting accounting standards all have advantages and disadvantages.  It is not possible to set optimal standards for all stakeholders.  Arrow's Impossibility Theorem applies, which means that what is optimal for one constituency must be sub-optimal for other constituencies.  Accounting standards are usually expensive to implement, and the benefits of any new standard must be weighed against its costs to preparers and users of financial statements.

Deductive Accounting Theory (Mathematical Methods)

Inductive Accounting Theory (Scientific Methods)

Normative Accounting Theory

Positive Accounting Theory

April 2002 Document on SPEs and Enron from the International Accounting Standards Board (This Document is Free)


An excerpt is shown below:


Of the 16 topics on our research agenda, one warrants special mention here. For several years, there has been an international debate on the topic of consolidation policy. The failure to consolidate some entities has been identified as a significant issue in the restatement of Enron’s financial statements. Accountants use the term consolidation policy as shorthand for the principles that govern the preparation of consolidated financial statements that include the assets and liabilities of a parent company and its subsidiaries. For an example of consolidation, consider the simple example known to every accounting student. Company A operates a branch office in Edinburgh. Company B also operates a branch office in Edinburgh, but organises the branch as a corporation owned by Company B. Every accounting student knows that the financial statements of each company should report all of the assets and liabilities of their respective Edinburgh operations, without regard to the legal form surrounding those operations. 

Of course, real life is seldom as straightforward as textbook examples. Companies often own less than 100 per cent of a company that might be included in the consolidated group. Some special purpose entities (SPEs) may not be organised in traditional corporate form. The challenge for accountants is to determine which entities should be included in consolidated financial statements. 

There is a broad consensus among accounting standard-setters that the decision to consolidate should be based on whether one entity controls another. However, there is much disagreement over how control should be defined and translated into accounting guidance. In some jurisdictions accounting standards and practice seem to have gravitated toward a legal or ownership notion of control, usually based on direct or indirect ownership of over 50 per cent of the outstanding voting shares. In contrast, both international standards and the standards in some national jurisdictions are based on a broader notion of control that includes ownership, but extends to control over financial and operating policies, power to appoint or remove a majority of the board of directors, and power to cast a majority of votes at meetings of the board of directors. 

A number of commentators, including many in the USA, have questioned whether the control principle is consistently applied. The IASB and its partner standard-setters are committed to an ongoing review of the effectiveness of our standards. If they do not work as well as they should, we want to find out why and fix the problem. Last summer we asked the UK ASB to help us by researching the various national standards on consolidation and identifying any inconsistencies or implementation problems. It has completed the first stage of that effort and is moving now to more difficult questions. 

The particular consolidation problems posed by SPEs were addressed by the IASB’s former Standing Interpretations Committee in SIC-12. There are some kinds of SPE that pose particular problems for both an ownership approach and a control-based approach to consolidations. It is not uncommon for SPEs to have minimal capital, held by a third party, that bears little if any of the risks and rewards usually associated with share ownership. The activities of some SPEs are

so precisely prescribed in the documents that establish them that no active exercise of day-to-day control is needed or allowed. These kinds of SPEs are commonly referred to as running on ‘auto-pilot’. In these cases, control is exercised in a passive way. To discover who has control it is necessary to look at which party receives the benefits and risks of the SPE. 

SIC-12 sets out four particular circumstances that may indicate that an SPE should be consolidated:

(a) in substance, the activities of the SPE are being conducted on behalf of the enterprise according to its specific business needs so that the enterprise obtains benefits from the SPE’s operation. 

(b) in substance, the enterprise has the decision-making powers to obtain the majority of the benefits of the activities of the SPE or, by setting up an ‘autopilot’ mechanism, the enterprise has delegated these decision-making powers. 

(c) in substance, the enterprise has rights to obtain the majority of the benefits of the SPE and therefore may be exposed to risks incidental to the activities of the SPE. 

(d) in substance, the enterprise retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.

The IASB recognises that we may be able to improve our approach to SPEs. With this in mind, we have already asked our interpretations committee if there are any ways in which the rules need to be strengthened or clarified.

Current criticisms and concerns about financial reporting 

There some common threads that pass through most of the topics on our active and research agendas. Each represents a broad topic that has occupied the best accounting minds for several years. It is time to bring many of these issues to a conclusion. 

Off balance sheet items 

When a manufacturer sells a car or a dishwasher, the inventory is removed from the balance sheet (a process that accountants refer to as derecognition) because the manufacturer no longerowns the item. Similarly, when a company repays a loan, it no longer reports that loan as a liability. However, the last 20 years have seen a number of attempts by companies to remove assets and liabilities from balance sheets through transactions that may obscure the economic substance of the company’s financial position. There are four areas that warrant mention here, each of which has the potential to obscure the extent of a company’s assets and liabilities. 

Leasing transactions

A company that owns an asset, say an aircraft, and finances that asset with debt reports an asset (the aircraft) and a liability (the debt). Under existing accounting standards in most jurisdictions (including ASB and IASB standards), a company that operates the same asset under a lease structured as an operating lease reports neither the asset nor the liability. It is possible to operate a company, say an airline, without reporting any of the company’s principal assets (aircraft) on the balance sheet. A balance sheet that presents an airline without any aircraft is clearly not a faithful representation of economic reality.

Our predecessor body, working in conjunction with our partners in Australia, Canada, New Zealand, the UK and the USA, published a research paper that invited comments on accounting for leases. The UK ASB is continuing work on this topic and we are monitoring its work carefully. As noted above, we expect to move accounting for leases to our active agenda at some point in the future. There is a distinct possibility that such a project would lead us to propose that companies recognise assets and related lease obligations for all leases.

 Securitisation transactions

Under existing accounting standards in many jurisdictions, a company that transfers assets (like loans or credit-card balances) through a securitisation transaction recognises the transaction as a sale and removes the amounts from its balance sheet. Some securitisations are appropriately accounted for as sales, but many continue to expose the transferor to many of the significant risks and rewards inherent in the transferred assets. In our project on improvements to IAS 39 (page 5), we plan to propose an approach that will clarify international standards governing a company’s ability to derecognise assets in a securitisation. Our approach, which will not allow sale treatment when the ‘seller’ has a continuing involvement with the assets, will be significantly different from the one found in the existing standards of most jurisdictions.

Creation of unconsolidated entities 

Under existing accounting standards in many jurisdictions, a company that transfers assets and liabilities to a subsidiary company must consolidate that subsidiary in the parent company’s financial statements (see page 6). However, in some cases (often involving the use of an SPE), the transferor may be able (in some jurisdictions) to escape the requirement to consolidate. Standards governing the consolidation of SPEs are described on page 7. 

Pension obligations

Under existing standards in many jurisdictions (including existing international standards) a company’s obligation to a defined benefit pension plan is reported on the company’s balance sheet. However, the amount reported is not the current obligation, based on current information and assumptions, but instead represents the result of a series of devices designed to spread changes over several years. In contrast, the UK standard (FRS 17) has attracted significant recent attention because it does not include a smoothing mechanism. The IASB plans to examine the differences among the various national accounting standards for pensions (in particular, the smoothing mechanism), as part of our ongoing work on convergence.

Items not included in the profit and loss account 

Under existing accounting standards in some jurisdictions, a company that pays for goods and services through the use of its own shares, options on its shares, or instruments tied to the value of its shares may not record any cost for those goods and services. The most common form of this share-based transaction is the employee share option. In 1995, after what it called an “extraordinarily controversial” debate, the FASB issued a standard that, in most cases in the USA, requires disclosure of the effect of employee share options but does not require recognition in the financial statements. In its Basis for Conclusions, the FASB observed:

The Board chose a disclosure-based solution for stock-based employee compensation to bring closure to the divisive debate on this issue—not because it believes that solution is the best way to improve financial accounting and reporting.

Most jurisdictions, including the UK, do not have any standard on accounting for share-based payment, and the use of this technique is growing outside of the USA. There is a clear need for international accounting guidance. Last autumn, the IASB reopened the comment period on a discussion document Accounting for Share-based Payment. This document was initially published by our predecessor, in concert with standard-setters from Australia, Canada, New Zealand, the UK and the USA. We have now considered the comments received and have begun active deliberation of this project. Accounting measurement

Under existing accounting standards in most jurisdictions, assets and liabilities are reported at amounts based on a mixture of accounting measurements. Some measurements are based on historical transaction prices, perhaps adjusted for depreciation, amortisation, or impairment. Others are based on fair values, using either amounts observed in the marketplace or estimates of fair value. Accountants refer to this as the mixed attribute model. It is increasingly clear that a mixed attribute system creates complexity and opportunities for accounting arbitrage, especially for derivatives and financial instruments. Some have suggested that financial reporting should move to a system that measures all financial instruments at fair value.

Our predecessor body participated in a group of ten accounting standard-setters (the Joint Working Group or JWG) to study the problem of accounting for financial instruments. The JWG proposal (which recommended a change to measuring all financial assets and liabilities at fair value) was published at the end of 2000. Earlier this year the Canadian Accounting Standards Board presented an analysis of comments on that proposal. The IASB has just begun to consider how this effort should move forward. 

Intangible assets

Under existing accounting standards in most jurisdictions, the cost of an intangible asset (a patent, copyright, or the like) purchased from a third party is capitalised as an asset. This is the same as the accounting for acquired tangible assets (buildings and machines) and financial assets (loans and accounts receivable). Existing accounting standards extend this approach to self-constructed tangible assets, so a company that builds its own building capitalises the costs incurred and reports that as the cost of its self-constructed asset. However, a company that develops its own patent for a new drug or process is prohibited from capitalising much (sometimes all) of the costs of creating that intangible asset. Many have criticised this inconsistency, especially at a time when many view intangible assets as significant drivers of company performance.

The accounting recognition and measurement of internally generated intangibles challenges many long-cherished accounting conventions. Applying the discipline of accounting concepts challenges many of the popular conceptions of intangible assets and ‘intellectual capital’. We have this topic on our research agenda. We also note the significant work that the FASB has done on this topic and its recent decision to add a project to develop proposed disclosures about internally generated intangible assets. We plan to monitor those efforts closely.

Bob Jensen's threads on the Enron/Andersen scandals are at 

Bob Jensen's SPE threads are at 

Bob Jensen's threads on accounting theory are at 


Underlying Bases of Balance Sheet Valuation

Levels of "Value" of an Entire Company
General Theory Days Inns of America
(As Reported September 30, 1987)
Market Value of the Entire Block of Common Shares at Today's Price Per Share
(Ignoring Blockage Factors)
Not Available 
Day Inns of America
Was Privately Owned
Exit Value of Firm if Sold As a Firm
(Includes synergy factors and unbooked intangibles)
Not Available for
Days Inns of America
Sum of Exit Values of Booked Assets Minus Liabilities & Pref. Stock
(includes unbooked and unrealized gains and losses)
as Reported by Days Inns
Book Value of the Firm as Reported in Financial Statements  $87,356,000 as Reported
Book Value of the Firm as Reported in the Financial Statements  After General Price Level Adjustments Not Available for Days Inns


Analysts often examine the market to book ratios which is the green value above divided by the book value.  Usually the book value is not adjusted for general price levels in calculating this ratio, but there is not reason why it could not be PLA book value.  But the green value often widely misses the mark in measuring the value of the firm as a whole (the blue value above).  The green value is based upon marginal trades of the day that do not adjust for blockage factors (large purchases that give total ownership or effective ownership control of the company).  Usually it is impossible to know whether the green value above is higher or lower than the blue value.  In addition to the blockage factor, there is the huge problem that the stock market prices have transitory movements up and down due to changing moods of speculators that create short-term bubbles and bursts.  Buyers and sellers of an entire firm are looking at the long term and generally ignore transitory price fluctuations of daily trades of relatively small numbers of shares.  For example, daily transaction prices on 100,000 shares in a bubble or burst market are hardly indicative of the long term value of 100 million shares of a corporation.

Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, Price Level Adjusted (PLA) Historical Cost, and Current Cost Entry Value (adjusted for depreciation and amortization).  Companies complained heavily that users did not obtain value that justified the cost of implementing FAS 33.  Analysts complained that the FASB allowed such crude estimates that the FAS 33 schedules were virtually useless, especially the Current Cost estimates.  The FASB rescinded FAS 33 when it issued FAS 89 in 1986.  

FAS 33 had a significant impact on some companies.  For example the the earnings reported by United States Steel in the 1981 Annual Report as required under FAS 33 were as follows:

1981 United States Steel Income Before Extraordinary items and Changes in Acctg. Principles
Historical Cost (Non-PLA Adjusted) Historical Cost (PLA Adjusted) Market Value (Current Cost)
$1,077,000,000 Income $475,300,000 Income 
Plus $164,500,000 PLA gain due to decline in purchasing power of debt
$446,400,000 Income
Plus $164,500,000 PLA Gain

Less $168,000,000 Current cost increase less effect of increase in the general price level

Companies are no longer required to generate FAS 33-type comparisons.  The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances.  For example, price-level adjustments may be required for for operations in hyperinflation nations.  Exit value accounting is required for firms deemed highly likely to become non-going concerns.  Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people).  Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities.  

Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting.  Beginning in January 2005, all nations in the Eurpean Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

Historical Cost Accounting:  Unadjusted for General Price-Level Changes

Advantages of Historical Cost

Nobody I know holds the mathematical wonderment of double entry and historical cost accounting more in awe than Yuji Ijiri.  For example, see Theory of Accounting Measurement, by Yuji Ijiri (Sarasota:  American Accounting Association Studies in Accounting Research No. 10, 1975) --- 

Disadvantages of Historical Cost

Historical Cost Accounting:  Price-Level Adjusted (PLA) Historical Cost Accounting

The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances.  For example, price-level adjustments may be required for for operations in hyperinflation nations.  The international IASB standards require PLA accounting in hyperinflation nations.

The SEC issued ASR 190 requiring PLA supplemental reports.  This was followed by the FASB's 1979 FAS 33.  However, follow-up studies did not point to investor enthusiasm over such supplemental reports.  Eventually, both ASR 190 and FAS 33 were rescinded, largely from lack of interest on the part of financial analysts and investors due to relatively low inflation rates in the United States.

Advantages of PLA Accounting

Disadvantages of PLA Accounting

Market Value Accounting:  Entry Value (Current Cost, Replacement Cost) Accounting

Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, Price Level Adjusted (PLA) Historical Cost, and Current Cost Entry Value (adjusted for depreciation and amortization).  Companies complained heavily that users did not obtain value that justified the cost of implementing FAS 33.  Analysts complained that the FASB allowed such crude estimates that the FAS 33 schedules were virtually useless, especially the Current Cost estimates.  The FASB rescinded FAS 33 when it issued FAS 89 in 1986.  

Current cost accounting by whatever name (e.g., current or replacement cost) entails the historical cost of balance sheet items with current (replacement) costs.  Depreciation rates can be re-set based upon current costs rather than historical costs. 

Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, PLA-Adjusted historical cost, and Current Cost Entry Value (adjusted for depreciation and amortization).  Companies complained heavily that users did not obtain value that justified the cost of implementing FAS 33.  Analysts complained that the FASB allowed such crude estimates that the FAS 33 schedules were virtually useless, especially the Current Cost estimates.  The FASB rescinded FAS 33 when it issued FAS 89 in 1986.  Companies are no longer required to generate FAS 33-type comparisons.  The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances.  For example, price-level adjustments may be required for for operations in hyperinflation nations.  Exit value accounting is required for firms deemed highly likely to become non-going concerns.  Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people).  Economic (discounted cash flow) valuations are required for certain types of assets and liabilites such as pension liabilities.  Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting.  Beginning in January 2005, all nations in the Eurpean Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

Advantages of Entry Value (Current Cost, Replacement Cost) Accounting

Disadvantages of Entry Value (Current Cost, Replacement Cost) Accounting

Market Value Accounting:  Exit Value (Liquidation, Fair Value) Accounting

Exit value accounting is required under GAAP for personal financial statements (individuals and married couples) and companies that are deemed likely to become non-going concerns.  Some theorists advocate exit value accounting for going concerns as well as non-going concerns.  Both nationally (particularly under FAS 115 and FAS 133) and internationally (under IAS 32 and 39 for),  exit value accounting is presently required in some instances for financial instrument assets and liabilities.  Both the FASB and the IASB have exposure drafts advocating fair value accounting for all financial instruments.

FASB's Exposure Draft for Fair Value Adjustments to all Financial Instruments
On December 14, 1999 the FASB issued Exposure Draft 204-B entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value.  This document can be downloaded from 
(Trinity University students can find the document at J:\courses\acct5341\fasb\pvfvalu1.doc ).

If an item is viewed as a financial instrument rather than inventory, the accounting becomes more complicated under SFAS 115.  Traders in financial instruments adjust such instruments to fair value with all changes in value passing through current earnings.  Business firms who are not deemed to be traders must designate the instrument as either available-for-sale (AFS) or hold-to-maturity (HTM).  A HTM instrument is maintained at original cost.  An AFS financial instrument must be marked-to-market, but the changes in value pass through OCI rather than current earnings until the instrument is actually sold or otherwise expires.   Under international standards, the IASB requires fair value adjustments for most financial instruments.  This has led to strong reaction from businesses around the world, especially banks.  There are now two major working group debates.  In 1999 the Joint Working Group of the Banking Associations sharply rebuffed the IAS 39 fair value accounting in two white papers that can be downloaded from

Advantages of Exit Value (Liquidation, Fair Value) Accounting

Exit value reporting is not deemed desirable or practical for going concern businesses for a number of reasons that I will not go into in great depth here.  

Disadvantages of Exit Value (Liquidation, Fair Value) Accounting

·         Operating assets are bought to use rather than sell.  For example, as long as no consideration is being given to selling or abandoning a manufacturing plant, recording the fluctuating values of the land and buildings creates a misleading fluctuation in earnings and balance sheet volatility.  Who cares if the value of the land went up by $1 million in 1994 and down by $2 million in 1998 if the plant that sits on the land has been in operation for 60 years and no consideration is being given to leaving this plant?

·         Some assets like software, knowledge databases, and Web servers for e-Commerce cost millions of dollars to develop for the benefit of future revenue growth and future expense savings.  These assets may have immense value if the entire firm is sold, but they may have no market as unbundled assets.  In fact it may be impossible to unbundle such assets from the firm as a whole.  Examples include the Enterprise Planning Model SAP system in firms such as Union Carbide.  These systems costing millions of dollars have no exit value in the context of exit value accounting even though they are designed to benefit the companies for many years into the future.

·         Exit value accounting records anticipated profits well in advance of transactions.  For example, a large home building company with 200 completed houses in inventory would record the profits of these homes long before the company even had any buyers for those homes.  Even though exit value accounting is billed as a conservative approach, there are instances where it is far from conservative.

·         The value of a subsystem of items differs from the sum of the value of its parts.  Investors may be lulled into thinking that the sum of all subsystem net assets valued at liquidation prices is the value of the system of these net assets.  Values may differ depending upon how the subsystems are diced and sliced in a sale.

·         Appraisals of exit values are both to expensive to obtain for each accounting report date and are highly subjective and subject to enormous variations of opinion.  The U.S. Savings and Loan scandals of the 1980s demonstrated how reliance upon appraisals is an invitation for massive frauds.  Experiments by some, mostly real estate companies, to use exit value-based accounting died on the vine, including well-known attempts decades ago by TRC, Rouse, and Days Inn.

·         Exit values are affected by how something is sold.  If quick cash is needed, the best price may only be half of what the price can be by waiting for the right time and the right buyer.

·         Financial securities that for one reason or another are deemed as to be "held-to-maturity" items may cause misleading increases and decreases in reported values that will never be realized.   A good example is the market value of a fixed-rate bond that may go up and down with interest rates but will always pay its face value at maturity no matter what happens to interest rates.

Hi Rick,

GAAP requires that individual's use exit (liquidation) value accounting. See "Personal Financial Statements," by Anthony Mancuso, The CPA Journal, September 1992 --- 

Bob Jensen

-----Original Message----- 
From: Richard Newmark [mailto:richard.newmark@PHDUH.COM]  
Sent: Tuesday, February 12, 2002 2:40 AM 
Subject: Re: Tax Base

How would you measure an individual's GAAP income? Should individuals report their income using accrual accounting?


Economic Value (Discounted Cash Flow, Present Value) Accounting

There are over 100 instances where present GAAP requires that historical cost accounting be abandoned in favor of discounted cash flow accounting (e.g., when valuing pension liabilities and computing fair values of derivative financial instruments).  These apply in situations where future cash inflows and outflows can be reliably estimated and are attributable to the particular asset or liability being valued on a discounted cash flow basis.

Advantages of Economic Value (Discounted Cash Flow, Present Value) Accounting

Disadvantages of Economic Value (Discounted Cash Flow, Present Value) Accounting


Theory Disputes Focus Mainly on the Tip of the Iceberg
(Intangibles and Other Assets and Liabilities Beneath the Surface)

The big stuff lies below the surface where it is powerful and invisible.

Pictures Source: 

What is important to ship navigators is the giant mass that lies below the icebergs.  If we make an analogy that the financial statements contain only what appears above the surface, over 99% of the accounting theory disputes have centered on the top of the icebergs.  We endlessly debate how to value what is seen above the surface and provide investors virtually nothing about the really big stuff beneath the surface.

For example, what difference does it make how Microsoft Corporation values its tangible assets if 98% of its value lies in intangible assets such as intellectual property, human resources, market share, and other items of value that accountants do not know how to value?  One can argue that the difference between the capitalized value of Microsoft's outstanding shares and the reported value of Shareholders' Equity is mostly due to intangibles that accountants have no idea how to detect and value.  If the goal of accounting is to help investors value a company, it is backwards to value intangibles from market prices.  Our job is to help investors set those prices.

What we teach just won't float?

Quite a few of you out there, like me, are trying to teach analysis of financial statements and business analysis and valuation from books like Penman or Palepu, Healy, and Bernard.   The current task of valuing MCI illustrates how frustrating this can be in the real world and how financial statement analysis that we teach, along with the revered Residual Income and Free Cash Flow Models, are often Titanic tasks in rearranging the deck chairs on sinking models.  If you've not attempted valuations with these models I suggest that you begin with my favorite case study:

"Questrom vs. Federated Department Stores, Inc.:  A Question of Equity Value," May 2001 edition of Issues in Accounting Education, by University of Alabama faculty members Gary Taylor, William Sampson, and Benton Gup, pp. 223-256.

In spite of all the sophistication in models, it is ever so common for intangibles and forecasting problems to sink the valuation models we teach.  
My threads on valuation are at 

A question I always ask my students is:  What is the major thing that has to be factored in when valuing Microsoft Corporation?

The answer I'm looking for is certainly not product innovation or something similar to that.  The answer is also not customer loyalty, although that probably is a huge factor.  The big factor is the massive cost of retraining the entire working world in something that replaces MS Office products (Excel, Word, PowerPoint, Outlook, etc.).  It simply costs too much to retrain workers in MS Office substitues even if we are so sick of security problems in Micosoft's systems.   How do you factor this "customer lock-in" into a Residual Income or FCF Model?  Our models are torpedoed by intangibles in the real world.

MCI's customer base is another torpedo for valuation models.  Here the value seems to lie in a "web of corporate customers."  And nobody seems to be able to value that.

"Valuing MCI in an Industry Awash in Questions," by Matt Richtel, The New York Times, February 9, 2005 ---

Industry bankers and accountants are trying to answer just that: What is the value of MCI, a company for which Qwest Communications has already made a tentative offer of about $6.3 billion, and on which Verizon Communications has been running the numbers. Conversations between MCI and Qwest have been suspended since late last week, and Verizon has yet to make a formal offer, people close to the negotiations say.

Most analysts say MCI's extensive network assets in this country and Europe may have diminishing value because of the industry's continued capacity glut. Instead, they say, MCI's worth lies more in its web of corporate customers.

But as MCI's revenue continues to tumble, the real trick for the accountants is trying to forecast the future. Can the company meet its stated goal of achieving profitable growth as a telecommunications company emphasizing Internet technology before the bottom falls out of its traditional voice and data business?

Continued in article

What we teach just won't float?

Quite a few of you out there, like me, are trying to teach analysis of financial statements and business analysis and valuation from books like Penman or Palepu, Healy, and Bernard.   The current task of valuing Amazon illustrates how frustrating this can be in the real world and how financial statement analysis that we teach, along with the revered Residual Income and Free Cash Flow Models, are often Titanic tasks in rearranging the deck chairs on sinking models.  

From The Wall Street Journal Accounting Weekly Review on February 11, 2005

TITLE: Amazon's Net Is Curtailed by Costs 
REPORTER: Mylene Mangalindan 
DATE: Feb 03, 2005 
TOPICS: Financial Accounting, Financial Statement Analysis, Income Taxes, Managerial Accounting, Net Operating Losses

SUMMARY: Amazon "...had forecast that profit margins would rise in the fourth quarter, while Wall Street analysts had expected margins to remain about the same." The company's operating profits fell in the fourth quarter from 7.9% of revenue to 7%. The company's stock price plunged "14% in after-hours trading."

1.) "Amazon said net income rose nearly fivefold, to $346.7 million, or 82 cents a share, from $73.2 million, or 17 cents a share a year earlier." Why then did their stock price drop 14% after this announcement?

2.) Refer to the related article. How were some analysts' projections borne out by the earnings Amazon announced?

3.) One analyst discussed in the related article, Ken Smith, disagrees with the majority of analysts' views as discussed under #2 above. Do you think that his viewpoint is supported by these results? Explain.

4.) Summarize the assessments made in answers to questions 2 and 3 with the way in which Amazon's operating profits as a percentage of sales turned out this quarter.

5.) Amazon's results "included a $244 million gain from tax benefits, stemming from Amazon's heavy losses earlier in the decade." What does that statement say about the accounting treatment of the deferred tax benefit for operating loss carryforwards when those losses were experienced? Be specific in describing exactly how these tax benefits were accounted for.

6.) Why does Amazon adjust out certain items, including the tax gain described above, in assessing their earnings? In your answer, specifically state which items are adjusted out of earnings and why that adjustment might be made. What is a general term for announcing earnings in this fashion?

Reviewed By: Judy Beckman, University of Rhode Island

TITLE: Web Sales' Boom Could Leave Amazon Behind 
REPORTER: Mylene Mangalindan 
ISSUE: Jan 21, 2005 

Bob Jensen's  threads on valuation are at 

What lies below the surface of the financial reporting icebergs?  

The knowledge capital estimates that Lev and Bothwell came up with during their run last fall of some 90 leading companies (see accompanying table) were absolutely huge. Microsoft, for example, boasted a number of $211 billion, while Intel, General Electric and Merck weighed in with $170 billion, $112 billion and $110 billion, respectively.

Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 ---
Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm

.In October 1996, AMR Corp. sold 18% of its computer-reservations system, called SABRE, to the public. It held on to the remaining 82%. That one transaction provides a beautiful way of evaluating tangible and intangible assets. When I recently checked the market, SABRE constituted 50% of AMR's value. This is mind-boggling! You have one of the largest airlines in the world, with roughly 700 jets in its fleet, nearly 100,000 employees, and exclusive and valuable landing rights in the world's most heavily trafficked airports. On the other hand, you have a computer-reservation system. It's a good system that's used by a lot of people, but it's just a computer system nonetheless. And this system is valued as much as the entire airline. Now, what makes this asset -- the computer system -- so valuable?

One big difference is that when you're dealing with tangible assets, your ability to leverage them -- to get additional business or value out of them -- is limited. You can't use the same airplane on five different routes at the same time. You can't put the same crew on five different routes at the same time. And the same goes for the financial investment that you've made in the airplane.

But there's no limit to the number of people who can use AMR Corp.'s SABRE system at once: It works as well with 5 million people as it does with 1 million people. The only limit to your ability to leverage a knowledge asset is the size of the market.

Economists call physical assets "rival assets" -- meaning that users act as rivals for the specific use of an asset. With an airplane, you've got to decide which route it's going to take. But knowledge assets aren't rivals. Choosing isn't necessary. You can apply them in more than one place at the same time. In fact, with many knowledge assets, the more places in which you apply them, the larger the return. With many knowledge assets, you get what economists call "increasing returns to scale." That's one key to intangible assets: The larger the network of users, the greater the benefit to everyone.

Source: "New Math for the New Economy," by Alan M. Webber, Fast Company, January/February, 2000 ---
Trinity students may go to J:\courses\acct5341\readings\levJan2000.htm

On August 28, 2002, the FASB met with representatives from the Financial Valuation Group and the Phillips-Hitchner firm to discuss valuation of intangible assets. See our news item for access to their presentation. More details in our full news item at 

Companies will have to place intangible assets, such as customer lists and customer back orders, in their financial statements, under proposals released last week by the International Accounting Standards Board --- 

Controversy Over FAS 2 on Research and Development (R&D)

From The Wall Street Journal Accounting Educators' Review on April 23, 2004

TITLE: Brothers of Invention
REPORTER: Timothy Aeppel
DATE: Apr 19, 2004
PAGE: B1,3
TOPICS: Research & Development, Intangible Assets

SUMMARY: Lahart reports on the growing instances of designing variations of new
patent-protected products in an attempt to skirt the patent laws and offer
virtual clones of those products at lower prices.

1.) What is a patent? How does one appropriately account for a patent that has
been granted to a firm? How does a patent differ from other intangible assets?
How is it similar? How does a patent give a firm a competitive advantage? In
the Aeppel article, what happens to this advantage when a design-around is

2.) Explain impairment of an intangible asset. How do the "design arounds"
described in the Aeppel article impair the value of the patent? How do you
account for such an impairment?

3.) What effect is this issue having on research & development (R&D)
expenditures for firms developing new patented products? Are R&D costs expensed
or capitalized? What about R&D costs that result in the granting of a patent?

4.) Why are valid patent-holders designing around their own products?

Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"Brothers of Invention:  'Design-Arounds' Surge As More Companies Imitate Rivals' Patented Products," by Timothy Aeppel, The Wall Street Journal, April 19, 2004, Page B1 ---,,SB108233054158486127,00.html 

Nebraska rancher Gerald Gohl had a bright idea: Create a remote-controlled spotlight, so he wouldn't have to roll down the window of his pickup truck and stick out a hand-held beacon to look for his cattle on cold nights.

By 1997, Mr. Gohl held a patent on the RadioRay, a wireless version of his spotlight that could rotate 360 degrees and was mounted using suction cups or brackets. Retail price: more than $200. RadioRay started to catch on with ranchers, boaters, hunters and even police.

Wal-Mart Stores Inc. liked it, too. Mr. Gohl says a buyer for Wal-Mart's Sam's Club stores called to discuss carrying the RadioRay as a "wow" item, an unusual product that might attract lots of attention and sales. Mr. Gohl said no, worrying that selling to Sam's Club could drive the spotlight's price lower and poison his relationships with distributors.

Before long, though, Sam's Club was selling its own wireless, remote-controlled searchlight -- for about $60. It looked nearly identical to the RadioRay, except for a small, plastic part restricting the light's rotation to slightly less than 360 degrees. Golight Inc., Mr. Gohl's McCook, Neb., company, sued Wal-Mart in 2000, alleging patent infringement. The retailer countered that Mr. Gohl's invention was obvious and that its light wasn't an exact copy of the RadioRay's design.

The legal battle between Mr. Gohl and the world's largest retailer -- which Wal-Mart lost in a federal district court and on appeal and is now considering taking to the Supreme Court -- reflects a growing trend in the high-stakes, persnickety world of patents and product design. Patent attorneys say that companies increasingly are imitating rivals' inventions, while trying to make their own versions just different enough to avoid infringing on a patent. The near-copycat procedure, which among other things helps companies avoid paying royalties to patent holders, is called a "design-around."

"The thinking in engineering offices more and more boils down to, 'Let's see what the patent says and see if we can get around it and get something as good -- or almost as good -- without violating the patent,' " says Ken Kuffner, a patent attorney in Houston who represents a U.S. maker of retail-display stands that designed around the patent on plastic displays it used to buy from another company. He declines to identify his client.

Design-arounds are nearly as old as the patent system itself, underscoring the pressure that companies feel to keep pace with the innovations of competitors. And U.S. courts have repeatedly concluded that designing around -- and even copying products left unprotected -- can be good for consumers by lowering prices and encouraging innovation.

The practice appears to be surging as companies shift more manufacturing outside the U.S. in an effort to drive costs lower. No one tracks overall design-around numbers, but "there's really been a spike in this sort of activity in the last few years," says Jack Barufka, a patent-attorney specializing in design-arounds at Pillsbury Winthrop LLP in McLean, Va.

Mr. Barufka, a former physicist, has handled design-arounds on exercise equipment, industrial parts, and factory machinery. A client recently brought him a household appliance, which he won't identify, to be dissected part-by-part so that his client can try to make a similar product at a cheaper price, probably by using foreign suppliers.

"We design around competitor patents on a regular basis," says James O'Shaughnessy, vice president and chief intellectual property counsel at Rockwell Automation Inc. in Milwaukee, a maker of industrial automation equipment. "Anybody who is really paying attention to the patent system, who respects it, will still nevertheless try to find ways -- either offshore production or a design-around -- to produce an equivalent product that doesn't infringe."

Design-arounds are particularly common in auto parts, semiconductors and other industries with enormous markets that are attractive to newcomers looking for a way to break in. The practice also happens in mature industries, where there are few big breakthroughs and competitors rely on relatively small changes to gain a competitive advantage. Patented products are attractive targets for an attempted end run because they command premium prices, making them irresistible amid razor-thin profit margins and expanding global competition.

Few companies will talk about their design-around efforts, since the results often look like little more than clones of someone else's idea. Even companies with patented products that are designed-around usually keep quiet, sometimes because their own engineers are looking for ways to make an end run on rivals.

The surge in design-arounds is pushing research-and-development costs higher, since some companies feel forced to protect their inventions from being copied by coming up with as many alternative ways to achieve the same result -- and patenting those, too.

"A patent is basically worthless if someone else can design around it easily and make a high-performing component for less," says Morgan Chu, a patent attorney at Irell & Manella LLP in Los Angeles.

Because successful design-arounds also force prices lower, they make it harder for companies to recover their investment in new products. Danfoss AS, a Danish maker of air conditioning, heating and other industrial equipment, discovered in the late 1990s that a customer in England had switched to buying a designed-around part for a Danfoss agricultural machine at a lower price from an English supplier. Danfoss eventually won back the customer, but only after agreeing to a price concession, says Georg Nissen, the Danish company's intellectual property manager, who notes they lowered their price about 5%.

The main way for companies to fight design-arounds is in court -- or the threat of it. Dutton-Lainson Co., a Hastings, Neb., maker of marine, agricultural, and industrial products, recently discovered that a rival was selling a tool used by ranchers to tighten the barbed wire on fences that was identical to its own patented tool, with an ergonomic handle shaped to fit the palm of a hand.

Continued in the article

This is a good slide show!
"The Truth Behind the Earnings Illusion:  The profit picture has never been so distorted. The surprise? Things aren't as ugly as they look" by Justin Fox, Fortune, July 22, 2002 --- 

Where are the major differences between book income and taxable income that favor booked income reported to the investing public?

Answer according to Justin Fox:

What the heck happened? The most obvious explanations for the disconnect are disparities in accounting for stock options and pension funds. When a company's employees exercise stock options, the gains are treated for tax purposes as an expense to the company but are completely ignored in reported earnings. And while investment gains made by a company's employee pension fund are counted in reported earnings, they don't show up in tax profits.

Analysts at Standard & Poor's are working to remove those two distortions by calculating a new "core earnings" measure for S&P 500 companies that includes options costs and excludes pension fund gains. When that exercise is completed in the coming weeks, most of the profit disconnect may disappear. Then again, maybe not. In struggling to deliver the outsized profits to which they and their investors had become accustomed in the mid-1990s, a lot more CEOs and CFOs may have bent the rules than we know about. "There was some cheating around the edges," says S&P chief economist David Wyss. "It's just not clear how big the edges are."

While conservative accounting is now back in vogue, it's impossible to say with certainty that reported earnings have returned to reality: Comparing the earnings per share of the S&P 500 with the tax profits of all American corporations, both public and private (which is what the Commerce Department reports), is too much of an apples and oranges exercise. But over the long run reported earnings and tax earnings do grow at about the same rate--just over 7% a year since 1960, according to Prudential Securities chief economist Richard Rippe, Wall Street's most devoted student of the Commerce Department profit numbers. So the fact that Commerce says after-tax profits came in at an annualized rate of $615 billion in the first quarter--a record-setting pace if it holds up for the full year--ought to be at least a little reassuring to investors. "I do believe the hints of recovery that we're seeing in tax profits will continue," Rippe says.

That does not mean we're due for another profit boom. Declining interest rates were the biggest reason profits rose so fast in the 1990s, says S&P's Wyss. Rates simply don't have that far to fall now. So even when investors start believing again what companies say about their earnings, they may still be shocked at how slowly those earnings are growing.

Continued at 

Reply by Bob Jensen:

For a technical explanation of the stock option accounting alluded to in the above quotation, go to one of my student examinations at 

The exam02.xls Excel workbook answers can be downloaded from 

The S&P revised GAAP core earnings model alluded to in the above quotation can be examined in greater detail at 

The pause that refreshes just got a bit more refreshing - Coca-Cola Co. announced Sunday it will lead the corporate pack by treating future stock option grants as employee compensation.

Where are the major differences between book income and economic income that understate book income reported to the investing public?

This question is too complex to even scratch the surface in a short paragraph.  One of the main bones of contention between the FASB and technology companies is FAS 2 that requires the expensing of both research and development (R&D)  even though it is virtually certain that a great deal of the outlays for these items will have economic benefit in future years.  The FASB contends that the identification of which projects, what future periods, and the amount of the estimated benefits per period are too uncertain and subject to a high degree of accounting manipulation (book cooking) if such current expenditures are allowed to be capitalized rather than expensed.  Other bones of contention concern expenditures for building up the goodwill, reputation, and training "assets" of companies.  The FASB requires that these be expensed rather than capitalized except in the case of an acquisition of an entire company at a price that exceeds the value of tangible assets less current market value of debt.  In summary, many firms have argued for "pro forma" earnings reporting such that companies can make a case that huge expense reporting required by the FASB and GAAP can be adjusted for better matching of future revenues with past expenditures.

You can read more about these problems in the following two documents:

Accounting Theory --- 

State of the Profession of Accountancy --- 

Hard Assets Versus Intangible Assets

Intangible assets are difficult to define because there are so many types and circumstances.  For example some have contractual or statutory lives (e.g., copyrights, patents and human resources) whereas others have indefinite lives (e.g., goodwill and intellectual capital).  Baruch Lev classifies intangibles as follows in "Accounting for Intangibles:  The New Frontier" --- :

He does not flesh in these groupings.  I flesh in some examples below of unbooked (unrecorded) intangible assets that may have value far in excess of all the booked assets of a company.

Baruch Lev's Value Chain Scorecard


  • Internal Renewal

· Research and Development
· IT Development
· Employee Training
· Communities of Practice
· Customer Acquisition Costs

  • Acquired Knowledge

· Technology Purchase
· Reverse Engineering
· IT Acquisition

  • Networking

· R&D Alliances/Joint Ventures
· Supplier/Customer Integration


  • Intellectual Property

    · Patents, Trademarks, Copyrights
    · Cross-licensing
    · Patent/Know-how Royalties

  • Technological Feasibility

· Clinical Tests, FDA Approvals
· Beta Tests
· Unique Visitors

  • Customers

· Marketing Alliances
· Brand Support
· Stickiness and Loyalty Traffic Measures

  • Employees

· Work Practices
· Retention
· Hot Skills (Knowledge Workers


  • Top Line

· Innovation Revenues
· Market Share/Growth
· Online Revenues
· Revenues from Alliances
· Revenue Growth by Segments

  • Bottom Line

· Productivity Gains
· Online Supply Channels
· Earnings/Cash Flows
· Value Added
· Cash Burn Rate

  • Growth Options

· Product Pipeline
· Expected Restructuring Impact
· Market Potential/Growth
· Expected Capital Spending


The knowledge capital estimates that Lev and Bothwell came up with during their run last fall of some 90 leading companies (see accompanying table) were absolutely huge. Microsoft, for example, boasted a number of $211 billion, while Intel, General Electric and Merck weighed in with $170 billion, $112 billion and $110 billion, respectively.

Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 ---
Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm

  • It is seldom, if ever mentioned, but Microsoft's overwhelming huge asset is its customer lock-in to the Windows Operating System combined with the enormous dominance of MS Office (Word, Excel, Outlook, etc) and MS Access.  The cost of shifting most any organization over to some other operating system and suite software comparable to MS Office is virtually prohibitive.  This is the main asset of Microsoft, but measuring its value and variability is virtually impossible.
    • Intellectual property
    • Trademarks, patents, copyrights
    • In-process R&D
    • Unrecorded goodwill
    • Ways of doing business and adapting to technology changes and shifts in consumer tastes
For example, my (Baruch Lev's) recent computations show that Microsoft has knowledge assets worth $211 billion -- by far the most of any company. Intel has knowledge assets worth $170 billion, and Merck has knowledge assets worth $110 billion. Now, compare those figures with DuPont's assets. DuPont has more employees than all of those companies combined. And yet, DuPont's knowledge assets total only $41 billion -- there isn't much extra profitability there.

Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 ---
Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm


University logos of prestigious universities (Stanford, Columbia, Carnegie-Mellon, Duke, etc.) are worth billions when discounting their value in distance education of the future--- 



Leases:  A Scheme for Hiding Debt

Accounting rules still allow companies to classify lease obligations differently than debt, leaving billions of dollars off corporate balance sheets and relegating a big slice of corporate financing to the shadows.
Jonathan Weil, "How Leases Play A Shadowy Role In Accounting" (See below)

At the FASB (Financial Accounting Standards Board), Bob Herz says he thinks "lease accounting is probably an area where people had good intentions way back when, but it evolved into a set of rules that can result in form-over substance accounting."  He cautions that an overhaul wouldn't be easy:  "Any attempts to change the current accounting in an area where people have built their business models around it become extremely controversial --- just like you see with stock options."
Jonathan Weil, "How Leases Play A Shadowy Role In Accounting" (See below)  
By the phrase form over substance, Bob Herz is referring to the four bright line tests of requiring leases to be booked on the balance sheet.  Over the past two decades corporations have been using these tests to skate on the edge with leasing contracts that result in hundreds of billions of dollars of debt being off balance sheets.  The leasing industry has built an enormously profitable business around financing contracts that just fall under the wire of each bright line test, particularly the 90% rule that was far too lenient in the first place.  One might read Bob's statement that after the political fight in the U.S. legislature over expensing of stock options, the FASB is a bit weary and reluctant to take on the leasing industry.  I hope he did not mean this.

Let me close by citing Harry S. Truman who said, "I never give them hell; I just tell them the truth and they think its hell!"
Great Speeches About the State of Accountancy

"20th Century Myths," by Lynn Turner when he was still Chief Accountant at the SEC in 1999 ---

It is interesting to listen to people ask for simple, less complex standards like in "the good old days." But I never hear them ask for business to be like "the good old days," with smokestacks rather than high technology, Glass-Steagall rather than Gramm-Leach, and plain vanilla interest rate deals rather than swaps, collars, and Tigers!! The bottom line is—things have changed. And so have people.

Today, we have enormous pressure on CEO’s and CFO’s. It used to be that CEO’s would be in their positions for an average of more than ten years. Today, the average is 3 to 4 years. And Financial Executive Institute surveys show that the CEO and CFO changes are often linked.

In such an environment, we in the auditing and preparer community have created what I consider to be a two-headed monster. The first head of this monster is what I call the "show me" face. First, it is not uncommon to hear one say, "show me where it says in an accounting book that I can’t do this?" This approach to financial reporting unfortunately necessitates the level of detail currently being developed by the Financial Accounting Standards Board ("FASB"), the Emerging Issues Task Force, and the AICPA’s Accounting Standards Executive Committee. Maybe this isn’t a recent phenomenon. In 1961, Leonard Spacek, then managing partner at Arthur Andersen, explained the motivation for less specificity in accounting standards when he stated that "most industry representatives and public accountants want what they call ‘flexibility’ in accounting principles. That term is never clearly defined; but what is wanted is ‘flexibility’ that permits greater latitude to both industry and accountants to do as they please." But Mr. Spacek was not a defender of those who wanted to "do as they please." He went on to say, "Public accountants are constantly required to make a choice between obtaining or retaining a client and standing firm for accounting principles. Where the choice requires accepting a practice which will produce results that are erroneous by a relatively material amount, we must decline the engagement even though there is precedent for the practice desired by the client."

We create the second head of our monster when we ask for standards that absolutely do not reflect the underlying economics of transactions. I offer two prime examples. Leasing is first. We have accounting literature put out by the FASB with follow-on interpretative guidance by the accounting firms—hundreds of pages of lease accounting guidance that, I will be the first to admit, is complex and difficult to decipher. But it is due principally to people not being willing to call a horse a horse, and a lease what it really is—a financing. The second example is Statement 133 on derivatives. Some people absolutely howl about its complexity. And yet we know that: (1) people were not complying with the intent of the simpler Statements 52 and 80, and (2) despite the fact that we manage risk in business by managing values rather than notional amounts, people want to account only for notional amounts. As a result, we ended up with a compromise position in Statement 133. To its credit, Statement 133 does advance the quality of financial reporting. For that, I commend the FASB. But I believe that we could have possibly achieved more, in a less complex fashion, if people would have agreed to a standard that truly reflects the underlying economics of the transactions in an unbiased and representationally faithful fashion.

I certainly hope that we can find a way to do just that with standards we develop in the future, both in the U.S. and internationally. It will require a change in how we approach standard setting and in how we apply those standards. It will require a mantra based on the fact that transparent, high quality financial reporting is what makes our capital markets the most efficient, liquid, and deep in the world.

From The Wall Street Journal Accounting Weekly Review on April 22, 2005

TITLE: Lease Restatements Are Surging
REPORTER: Eiya Gullapalli
DATE: Apr 20, 2005
TOPICS: Accounting, Advanced Financial Accounting, Lease Accounting, Restatement, Sarbanes-Oxley Act

SUMMARY: Last winter, "the Big Four accounting firms...banded together to ask the Security and Exchange Commission's chief accountant to clarify rules on lease accounting...Now about 250 companies have announced restatements for lease accounting issues..."

1.) Why is it curious that so many companies are now restating previous financial statements due to lease accounting problems? What does the fact that companies must restate previous results imply about previous accounting for these lease transactions?

2.) What industries in particular are cited for these issues in the article? How do you think this industry uses leases?

3.) While one company, Emeritus Corp., disclosed significant impacts on previously reported income amounts, companies are "...for the most part, not materially affecting their earnings, analysts say..." Are you surprised by this fact? What is the most significant impact of capitalizing a lease on a corporation's financial statements?  In your answer, define the terms operating lease and capitalized lease.

4.) How do points made in the article show that the Sarbanes-Oxley Act is accomplishing its intended effect?

Reviewed By: Judy Beckman, University of Rhode Island

"Lease Restatements Are Surging:  Number Increases Daily; Accounting Experts Say GAAP Violations Are Rife," by Diya Gullapalli, The Wall Street Journal, April 20, 2005; Page C4 ---,,SB111396285894611651,00.html

When it comes to bookkeeping snafus, lease accounting may be the new revenue recognition.

It all started in November, when KPMG LLP told fast-food chain CKE Restaurants Inc. that it had problems with the way CKE recognized rent expenses and depreciated buildings. That led CKE to restate its financials for 2002 as well as some prior years. CKE will also take a charge in its upcoming annual filing for 2003 through its just-ended 2005 fiscal year.

By winter, the Big Four accounting firms had banded together to ask the Securities and Exchange Commission's chief accountant to clarify rules on lease accounting. Retail and restaurant trade groups began battling rule makers about the merits of issuing such guidance.

Now, about 250 companies have announced restatements for lease-accounting issues similar to CKE's, and the number continues to rise daily.

"We'd be shocked if this isn't the biggest category of restatements we've ever seen," says Jeff Szafran of Huron Consulting Group LLC, which tracks restatements.

Given that so many publicly traded companies, especially retailers and restaurant chains, hold leases, it perhaps isn't surprising that lease restatements are snowballing. Accounting experts say the restatements also demonstrate that violations of generally accepted accounting principles still are widespread.

"The whole subject has been a curiosity to me," says Jack Ciesielski, editor of the Analyst's Accounting Observer newsletter in Baltimore. "This was existing GAAP that hasn't changed, but I don't think we've seen the end of these restatements."

Since many of the companies announcing restatements so far report on a January-ending fiscal year, Mr. Ciesielski and other accounting-industry watchers anticipate a slew of additional restatements in coming weeks as more companies prepare their books.

Corporate-governance advocates say the volume of lease-problem restatements shows the Sarbanes-Oxley Act is doing its job. That 2002 law laid down guidelines for ensuring that companies had proper internal controls, systems to prevent accounting mistakes and improprieties. Indeed, many of the companies that have had to restate due to lease problems also have reported weakness in their internal controls.

While Ernst & Young LLP clients Friendly Ice Cream Corp., Whole Foods Market Inc. and Cingular Wireless, a joint venture between SBC Communications Inc. and BellSouth Corp., all reported material weaknesses in internal controls in their latest annual reports due partly to lease issues, PricewaterhouseCoopers LLP client J. Jill Group Inc. says its lease-driven restatement didn't signal such significant internal-control problems.

The main rule on lease accounting hasn't changed much. Issued in 1976, Statement of Financial Accounting Standards No. 13 is, in fact, one of the oldest rules written by the Financial Accounting Standards Board, which sets guidelines for publicly traded companies. While some parts of FAS 13 have been reinterpreted since then, auditors for the most part hadn't raised any concerns about clients' lease accounting -- until now.

"Our industry has been accounting for leases using the same methodology for 20 years at least and had gotten clean opinions," says Carleen Kohut, chief financial officer of the National Retail Federation.

The changes in lease accounting are "not the result of the discovery of new facts or information," reads a statement from Emeritus Corp., an assisted-living company that announced a restatement for lease accounting within a week of CKE.

Had Emeritus correctly applied lease-accounting rules in 2003, it could have almost wiped out its profit. In a restated annual report released in January, the company said lease expenses and other adjustments lowered earnings to $204,000 for 2003 from the originally reported $4.5 million -- and such adjustments widened past years' losses even further.

Emeritus didn't return calls for comment.

Others companies such as home-furnishing store Bombay Co. announced a lease restatement in March and then withdrew the decision a week later, demonstrating lingering confusion over the matter.

The SEC's letter released in February clarified three specific areas of lease accounting, focusing on leasehold improvement amortization, rent-expense recognition and tenant incentives.

The bright side is that companies coming to grips with faulty lease accounting are, for the most part, not materially affecting their earnings, analysts say -- companies such as Emeritus being an exception. Rather, they say, the change is just a reshuffling of dollars across various line items.

 TITLE: FOOTNOTES: Recent US Earnings Restatements
REPORTER: Dow Jones Newswires
ISSUE: Apr 19, 2005

A concise summary of the February 7, 2005 letter is provided at

The complete February 7, 2005 letter from the SEC's Chief Accountant to Robert J. Kueppers is located at

In recent weeks, a number of public companies have issued press releases announcing restatements of their financial statements relating to lease accounting. You requested that the Office of the Chief Accountant clarify the staff's interpretation of certain accounting issues and their application under generally accepted accounting principles relating to operating leases. Of specific concern is the appropriate accounting for: (1) the amortization of leasehold improvements by a lessee in an operating lease with lease renewals, (2) the pattern of recognition of rent when the lease term in an operating lease contains a period where there are free or reduced rents (commonly referred to as "rent holidays"), and (3) incentives related to leasehold improvements provided by a landlord/lessor to a tenant/lessee in an operating lease. It should be noted that the Commission has neither reviewed this letter nor approved the staff's positions expressed herein. In addition, the staff's positions may be affected or changed by particular facts or conditions. Finally, this letter does not purport to express any legal conclusion on the questions presented.

The staff's views on these issues are as follows:

  1. Amortization of Leasehold Improvements - The staff believes that leasehold improvements in an operating lease should be amortized by the lessee over the shorter of their economic lives or the lease term, as defined in paragraph 5(f) of FASB Statement 13 ("SFAS 13"), Accounting for Leases, as amended. The staff believes amortizing leasehold improvements over a term that includes assumption of lease renewals is appropriate only when the renewals have been determined to be "reasonably assured," as that term is contemplated by SFAS 13.
  2. Rent Holidays - The staff believes that pursuant to the response in paragraph 2 of FASB Technical Bulletin 85-3 ("FTB 85-3"), Accounting for Operating Leases with Scheduled Rent Increases, rent holidays in an operating lease should be recognized by the lessee on a straight-line basis over the lease term (including any rent holiday period) unless another systematic and rational allocation is more representative of the time pattern in which leased property is physically employed.
  3. Landlord/Tenant Incentives - The staff believes that: (a) leasehold improvements made by a lessee that are funded by landlord incentives or allowances under an operating lease should be recorded by the lessee as leasehold improvement assets and amortized over a term consistent with the guidance in item 1 above; (b) the incentives should be recorded as deferred rent and amortized as reductions to lease expense over the lease term in accordance with paragraph 15 of SFAS 13 and the response to Question 2 of FASB Technical Bulletin 88-1 ("FTB 88-1"), Issues Relating to Accounting for Leases, and therefore, the staff believes it is inappropriate to net the deferred rent against the leasehold improvements; and (c) a registrant's statement of cash flows should reflect cash received from the lessor that is accounted for as a lease incentive within operating activities and the acquisition of leasehold improvements for cash within investing activities. The staff recognizes that evaluating when improvements should be recorded as assets of the lessor or assets of the lessee may require significant judgment and factors in making that evaluation are not the subject of this letter.

To the extent that SEC registrants have deviated from the lease accounting standards and related interpretations set forth by the FASB, those registrants, in consultation with their independent auditors, should assess the impact of the resulting errors on their financial statements to determine whether restatement is required. The SEC staff believes that the positions noted above are based upon existing accounting literature and registrants who determine their prior accounting to be in error should state that the restatement results from the correction of errors or, if restatement was determined by management to be unnecessary, state that the errors were immaterial to prior periods.

Registrants should ensure that the disclosures regarding both operating and capital leases clearly and concisely address the material terms of and accounting for leases. Registrants should provide basic descriptive information about material leases, usual contract terms, and specific provisions in leases relating to rent increases, rent holidays, contingent rents, and leasehold incentives. The accounting for leases should be clearly described in the notes to the financial statements and in the discussion of critical accounting policies in MD&A if appropriate. Known likely trends or uncertainties in future rent or amortization expense that could materially affect operating results or cash flows should be addressed in MD&A. The disclosures should address the following:

  1. Material lease agreements or arrangements.
  2. The essential provisions of material leases, including the original term, renewal periods, reasonably assured rent escalations, rent holidays, contingent rent, rent concessions, leasehold improvement incentives, and unusual provisions or conditions.
  3. The accounting policies for leases, including the treatment of each of the above components of lease agreements.
  4. The basis on which contingent rental payments are determined with specificity, not generality.
  5. The amortization period of material leasehold improvements made either at the inception of the lease or during the lease term, and how the amortization period relates to the initial lease term.

As you know, the SEC staff is continuing to consider these and related matters and may have further discussions on lease accounting with registrants and their independent auditors.

We appreciate your inquiry and further questions about these matters can be directed to Tony Lopez, Associate Chief Accountant in the Office of the Chief Accountant (202-942-7104) or Louise Dorsey, Associate Chief Accountant in the Division of Corporation Finance (202-942-2960).


Despite a Post-Enron Push, Companies Can Still Keep Big Debts Off Balance Sheets.
"How Leases Play A Shadowy Role In Accounting," by Jonathan Weil, The Wall Street Journal, September 22, 2004, Page A1 ---,,SB109580870299124246,00.html?mod=home%5Fpage%5Fone%5Fus 

Despite the post-Enron drive to improve accounting standards, U.S. companies are still allowed to keep off their balance sheets billions of dollars of lease obligations that are just as real as financial commitments originating from bank loans and other borrowings.

The practice spans the entire spectrum of American business and industry, relegating a key gauge of corporate health to obscure financial-statement footnotes, and leaving investors and analysts to do the math themselves. The scale of these off-balance-sheet obligations -- stemming from leases on everything from aircraft to retail stores to factory equipment -- can be huge:

• US Airways Group Inc., which recently filed for Chapter 11 bankruptcy protection, showed only $3.15 billion in long-term debt on its most recently audited balance sheet, for 2003, and didn't include the $7.39 billion in operating-lease commitments it had on its fleet of passenger jets.

• Drugstore chain Walgreen Co. shows no debt on its balance sheet, but it is responsible for $19.3 billion of operating-lease payments mainly on stores over the next 25 years.

• For the companies in the Standard & Poor's 500-stock index, off-balance-sheet operating-lease commitments, as revealed in the footnotes to their financial statements, total $482 billion.

Debt levels are among the most important measures of a company's financial health. But the special accounting treatment for many leases means that a big slice of corporate financing remains in the shadows. For all the tough laws and regulations set up since Enron Corp.'s 2001 collapse, regulators have left lease accounting largely untouched. Members of the Financial Accounting Standards Board say they are considering adding the issue to their agenda next year.

"Leasing is one of the areas of accounting standards that clearly merits review," says Donald Nicolaisen, the Securities and Exchange Commission's chief accountant. The current guidance, he says, depends on rigidly defined categories in which a slight variation has a major effect and relies too much on "on-off switches for determining whether a leased asset and the related payment obligations are reflected on the balance sheet."

A case in point is the "90% test," part of the FASB's 28-year-old rules for lease accounting. If the present value of a company's minimum lease payments equals 90% or more of a property's value, the transaction must be treated as a "capital lease," with accounting treatment akin to that of debt. If the figure is slightly less, say 89%, the deal is treated as an "operating lease," subject to certain other conditions, meaning the lease doesn't count as debt. The lease commitment appears not in the main body of the financial statements but in footnotes, often obscurely written and of limited usefulness.

The $482 billion figure for the S&P 500 was determined through a Wall Street Journal review of the companies' annual reports. That's equivalent to 8% of the $6.25 trillion reported as debt on the 500 companies' balance sheets, according to data provided by Reuters Research. For many companies, off-balance-sheet lease obligations are many times higher than their reported debt.

Given the choice between leasing and owning real estate or equipment, many companies pick operating leases. Besides lowering reported debt, operating leases boost returns on assets and often plump up earnings through, among other things, lower depreciation expenses.

"It's nonsense," Trevor Harris, an accounting analyst and managing director at Morgan Stanley, says of the 90% rule. "What's the difference between 89.9% and 90%, and 85% and 90%, or even 70% and 90%? It's the wrong starting point. You've purchased the right to some resources as an asset. The essence of accounting is supposed to be economic substance over legal form."

This summer, Union Pacific Corp. opened its new 19-story, $260 million headquarters in Omaha, Neb. The railroad operator is the owner of the city's largest building, the Union Pacific Center, in virtually every respect except its accounting.

Under an initial operating lease, Union Pacific guaranteed 89.9% of all construction costs through the building's completion date. After completing the building, the company signed a new operating lease, which guarantees 85% of the building's costs. Unlike most operating leases, both were "synthetic" leases, which allow the company to take income-tax deductions for interest and depreciation while maintaining complete operational control. A Union Pacific spokesman declined to comment.

Neither lease has appeared on the balance sheet. Instead, they have stayed in the footnotes, resulting in lower reported assets and liabilities. On its balance sheet, Union Pacific shows about $8 billion of debt, while its footnotes show about $3 billion of operating-lease commitments, including for railroad engines and other equipment.

The 90% test goes to the crux of investor complaints that U.S. accounting standards remain driven by arbitrary rules, around which companies can easily structure transactions to achieve desired outcomes.

It means different companies entering nearly identical transactions can account for them in very different ways, depending on which side of the 90% test they reside. Meanwhile, as with disclosures showing employee stock-option compensation expenses, most investors and stock analysts tend to ignore the footnotes disclosing lease obligations.

Three years ago, Enron's collapse revealed how easily a company could hide debt. A big part of the energy company's scandal centered on off-balance-sheet "special purpose entities." These obscure partnerships could be kept off the books -- with no footnote disclosures -- if an independent investor owned 3% of an entity's equity. Responding to public outcry, FASB members eliminated that rule and promised more "principles-based" standards, which spell out concise objectives and emphasize economic substance over form, rather than a "check the box" approach with rigid tests and exceptions that can be exploited.

The accounting literature on leasing covers hundreds of pages. The FASB's original 1976 pronouncement, called Financial Accounting Standard No. 13, does state a broad principle: A lease that transfers substantially all the benefits and risks of ownership should be accounted for as such. But in practice, critics say, FAS 13 amounts to all rules and no principles, making it easy to manipulate its strict exceptions and criteria as needed. One key rule says a lease is a "capital lease" if it covers 75% or more of the property's estimated useful life. One day less, and it can stay off-balance-sheet, subject to other tests.

Continued in the article

"Group (the IASB) to Alter Rules On Lease Accounting," The Wall Street Journal, September 23, 2004, Page C4

BRUSSELS -- The International Accounting Standards Board next week will unveil plans to overhaul the rules on accounting for leased assets, the board's chairman said yesterday.

Critics long have contended that the rules for determining whether leases should be included as assets and liabilities on a company's balance sheet are easy to evade and encourage form-over-substance accounting. "It's going to be a very big deal," Chairman Sir David Tweedie told Dow Jones Newswires after testifying to the European Parliament. International accounting rules on leasing exist already, but they are useless, Mr. Tweedie said.

Airlines that lease their aircraft, for instance, rarely include their planes on their balance sheets, he said. "So the aircraft is just a figment of your imagination," Mr. Tweedie said. The board will convene a meeting next week to discuss changes to current rules, he said.

The Wall Street Journal yesterday reported (see the above article) that the U.S. Financial Accounting Standards Board is considering adding lease accounting to its agenda of items for overhaul.

From The Wall Street Journal's The Weekly Review: Accounting on September 24, 2004

TITLE: Lease Accounting Still Has an Impact 
REPORTER: Jonathan Weil 
DATE: Sep 22, 2004 
TOPICS: Financial Accounting, Financial Accounting Standards Board, Financial Statement Analysis, Lease Accounting, off balance sheet financing

SUMMARY: The on-line version of this article is entitled "How Leases Play a Shadowy Role in Accounting." The article highlights the typical practical ways in which entities avoid capitalizing leases; reports on a WSJ analysis of footnote disclosures to assess levels of off-balance sheet debt; and comments on the difficulties the FASB may face in trying to amend Statement of Financial Accounting Standards No. 13.


1.) What accounting standard governs the accounting for lease transactions under U.S. GAAP? When was that accounting standard written and first put into effect?

2.) When is the Financial Accounting Standards Board (FASB) considering working on improvements to the accounting for lease transactions? Why is the FASB likely to face challenges in any attempt to change accounting for leasing transactions?

3.) What are the names of the two basic methods of accounting for leases by lessees under current U.S. standards? Which of these methods is he referring to when the author writes, "U.S. companies are...allowed to keep off their balance sheets billions of dollars of lease obligations..."

4.) What are the required disclosures under each of the two methods of accounting for leases? What are the problems with financial statement users relying on footnote disclosures as opposed to including a caption and a numerical amount on the face of the balance sheet?

5.) How do you think the Wall Street Journal identified the amounts of lease commitments that are kept off of corporate balance sheets? Specifically identify the steps you think would be required to measure obligations under operating leases in a way that is comparable to the amounts shown for capital leases recognized on the face of the balance sheet.

6.) What four tests must be made in determining the accounting for any lease? Why do you think the author focuses on only one of these tests, the "90% test"?

7.) What financial ratios are impacted by accounting for leases? List all that you can identify in the article, and that you can think of, and explain how they are affected by different accounting treatments for leases.

8.) What is a "special purpose entity"? When are these entities used in leasing transactions?

9.) What is a "synthetic lease"? When are these leases constructed?

Reviewed By: Judy Beckman, University of Rhode Island

This is Auditing 101:  Where were the auditors?

"SEC Uncovers Wide-Scale Lease Accounting Errors," AccountingWeb, March 1, 2005 ---

Where were the auditors? That is the question being asked as more than 60 companies face the prospect of restating their earnings after apparently incorrectly dealing with their lease accounting, Dow Jones reported.

Companies in the retail, restaurant and wireless-tower industries are among those affected in what is being called the most sweeping bookkeeping correction in such a short time period since the late 1990s.

Among the companies on the list are Ann Taylor, Target and Domino's Pizza. You can view a full listing of the affected companies.

"It's always disturbing when our accounting is not followed," Don Nicolaisen, chief accountant at the Securities and Exchange Commission, said last week during an interview. He published a letter on Feb. 7 urging companies to follow accounting standards that have been on the books for many years, Dow Jones reported.

Based on the charges and restatement announcements that have come in the wake of the SEC letter it seems companies have failed for years to follow what regulators see as cut-and-dried lease-accounting rules. The SEC has yet to go so far as to accuse companies of wrongdoing, but it has led people to wonder why auditors hired to keep company books clean could have missed so many instances of failure to comply with the rule.

"Where were the auditors?" J. Edward Ketz, an accounting professor at Pennsylvania State University, said to Dow Jones. "Where were the people approving these things? This doesn't seem like something that really requires new discussion. If we have to go back and revisit every single rule because companies and their professional advisers aren't going to follow the rules, then I think we're in very serious trouble in this country."

Tom Fitzgerald, a spokesman for auditing firm KPMG, declined to comment. Representatives for Deloitte & Touche LLP, PricewaterhouseCoopers LLC, and Ernst & Young LLP, didn't return several phone calls, Dow Jones reported.

The crux of the issue is that companies are supposed to book these "leasehold improvements" as assets on their balance sheets and then depreciate those assets, incurring an expense on their income statements, over the duration of the lease. Instead, companies such as Pep Boys-Manny Moe & Jack had been spreading those expenses out over the projected useful life of the property, which is usually a longer time period, Dow Jones reported.

As a result, expenses were deferred and income was added to the current period. McDonald's Corp. took a charge of $139.1 million, or 8 cents a share, in its fourth quarter to correct a lease-accounting strategy that it says had been in place for 25 years, Dow Jones reported, adding that Pep Boys said it would book a charge of 80 cents a share, or $52 million, for the nine months through Oct. 30, 2004.

Insurance:  A Scheme for Hiding Debt That Won't Go Away

The SEC and Eliot Spitzer have launched probes into sales by insurance firms of products that help customers burnish results.  Industry executives say companies can reap distinct accounting benefits by obtaining loans dressed up as insurance products. Under U.S. generally accepted accounting principles, companies are allowed to use insurance recoveries to offset losses on their income statements -- often without disclosing them. To qualify as insurance under the accounting rules, financial contracts must involve a significant transfer of risk from one party to another.

"Fresh Probes Target Insurers' Earnings Role," by Theo Francis and Jonathan Weil, The Wall Street Journal, November 8, 2004, Page C1 ---,,SB109988032427267296,00.html?mod=home_whats_news_us 

The Securities and Exchange Commission and New York Attorney General Eliot Spitzer each have launched investigations into sales by insurance companies of questionable financial products that help customers burnish their financial statements, according to people familiar with the matter.

The SEC's enforcement division is conducting an industrywide investigation into whether a variety of insurance companies may have helped customers improperly smooth their earnings by selling them financial-engineering products that were designed to look like insurance but in some cases were little more than loans in disguise, people familiar with the matter say. The agency is focusing on a universe of products that are intended to achieve desired accounting results for customers' financial statements, as opposed to traditional insurance, whose primary goal is transferring risk of losses from a policyholder to the insurer selling the coverage.

Meanwhile, New York state investigators are preparing to issue subpoenas as soon as this week to several large insurance companies. After months of combing through industry documents in its continuing probe of insurance-broker compensation, Mr. Spitzer's office has grown increasingly concerned about insurance-industry products, detailed in The Wall Street Journal last month, that customers can use to manipulate their income statements and balance sheets.

Although Mr. Spitzer's office and the SEC began looking into the issue separately, they have discussed sharing information and resources, according to a person familiar with the probes.

Normally, an insurer is paid a specific amount of premiums to take on a risk of uncertain size and timing. In the "insurance" at issue, the risk of loss to the insurer selling the policy is limited and sometimes even eliminated -- partly because, in these policies' simplest form, the premiums are so high; other times, the loss already has occurred.

Industry executives say companies can reap distinct accounting benefits by obtaining loans dressed up as insurance products. Under U.S. generally accepted accounting principles, companies are allowed to use insurance recoveries to offset losses on their income statements -- often without disclosing them. To qualify as insurance under the accounting rules, financial contracts must involve a significant transfer of risk from one party to another.

Continued in the article

Insurance companies historically have been rancid with white collar crime and consumer rip offs.  Bob Jensen's threads on insurance company scandals are at


Debt Versus Equity

From The Wall Street Journal Accounting Educators' Review on July 16, 2004

TITLE: Possible Accounting Change May Hurt Convertible Bonds 
REPORTER: Aaron Lucchetti 
DATE: Jul 08, 2004 
TOPICS: Bonds, Convertible bonds, Earnings per share, Emerging Issues Task Force, Financial Accounting, Financial Accounting Standards Board

SUMMARY: The Emerging Issues Task Force is considering changing the requirements for including in the EPS calculation the potentially dilutive shares issuable from so-called CoCo bonds. These bonds have an interest-payment coupon and are contingently convertible, typically depending upon a specified percentage increase in the stock price.


1.) Describe the terms of CoCo Bonds. What do you think the term "CoCo" means? How do they differ from typical convertible bonds? Why do investors find typical convertible bonds attractive? Why do companies find it attractive to offer typical convertible bonds?

2.) What is the Emerging Issues Task Force (EITF)? How can the organization of that task force help to resolve issues, such as the questions surrounding CoCo bonds, more rapidly than the issues can be addressed by the FASB itself?

3.) In general, what is the accounting issue being addressed by the EITF? What is the proposed change in accounting? Does any of this have to do with the actual accounting for the bonds and their associated interest expense?

4.) Explain in detail the effect of these bonds on companies' earnings per share (EPS) calculations. Will the amount of companies' net income change under the proposed EITF resolution of this accounting issue? What will change? Is it certain that the change in treatment of these bonds will have a dilutive effect on EPS? Explain.

5.) Why might an EITF ruling require retroactive restatement of earnings by companies issuing these bonds? How else could any change in treatment of these bonds be presented in the financial statements?

6.) One investment analyst states that "the new accounting doesn't change economics, but investors [are] still likely to care." Why is this the case?

7.) Why does one analyst describe CoCo bonds as a gimmick? Why then would we "probably be better off without it"?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Coke:  Gone Flat at the Bright Lines of Accounting Rules and Marketing Ethics
The king of carbonated beverages is still a moneymaker, but its growth has stalled and the stock has been backsliding since the late '90s.  Now it turns out that the company's glory days were as much a matter of accounting maneuvers as of marketing magic. 
Guizuenta's most ingenious contribution to Coke, the ingredient that added rocket fuel to the stock price, was a bit of creative though perfectly legal balance-sheet rejeiggering that in some ways prefigured the Enron Corp. machinations.  Known inside the company as the "49% solution," it was the brain child of then-Chief Financial Officer M. Douglas Ivester.  It worked like this:  Coke spun off its U.S. bottling operations in late 1986 into a new company known as Coca-Cola Enterprises Inc., retaining a 49% state for itself.  That was enough to exert de facto control but a hair below the 50% threshold that requires companies to consolidate results of subsidiaries in their financials.  At a stroke, Coke erased $2.4 billion of debt from its balance sheet.
Dean Foust, "Gone Flat," Business Week, December 20, 2004, Page 77.  
This is a Business Week cover story.
Coca Cola's outside independent auditor is Ernst & Young

There were other problems, some of which did not do the famed Warren Buffet's reputation any good.  See "Fizzy Math and Fishy Marketing Lawsuit, Probes Prove Damaging to Coke," by Margaret Webb Pressler, Washington Post, June 20, 2003 --- 

Coca Cola's marketing tactics were unethical and unhealthy for kids --- 

Also see "The Ten Habits of Highly Defective Corporations," From The Nation --- 


Contingent convertible bonds get a tax-treatment boost from a new IRS revenue ruling. But the window of opportunity may slam shut.
"Cuckoo for Coco Puffs?" Robert Willens, Lehman Brothers,, May 22, 2002
Now the FASB intends to shut the loop-hole.  If the proposed rule (Section 404)  goes into effect, companies will have to record an increase in shares outstanding on the day they issue a Co-Co (Contingent Convertible Bond that can be converted only at threshold share prices), thus reducing EPS.  And the change would be retroactive, a step the board generally reserves for particularly egregious accounting practices, says Dennis Beresord, professor of accounting at the University of Georgia and FASB's former chief.
"Too Much of a Good Thing," CFO Magazine, September 4, 2004, Page 21.

From The Wall Street Journal Accounting Weekly Review on October 29, 2004

TITLE: First Marblehead: Brilliance or Grade Inflation?
REPORTER: Karen Richardson
DATE: Oct 25, 2004
TOPICS: Advanced Financial Accounting, Allowance For Doubtful Accounts, Financial Statement Analysis, Securitization, Valuations

SUMMARY: First Marblehead securitizes student loans and records assets based on significant estimates. Investors have significantly increased short selling on the stock because of concern over when the receivables recorded through securitization will ultimately be collected.

1.) Define the term securitization. What purpose does securitization serve?

2.) What does the author mean by "gain-on-sale" accounting? When are gains recognized in securitization transactions?

3.) What standard governs the accounting requirements for securitization transactions? Why does that standard focus on a question of discerning liabilities from sales? Is that accounting question a point of difficulty in the case described in this article? Explain.

4.) Why are critics arguing that "it will be at least five years before any significant cash starts rolling in" on First Marblehead's assets?

5.) According to what is listed in the article, how many factors must be estimated to record the assets and revenues under First Marblehead's business model? How uncertain do you think the company may be in its estimates of these of these items?

6.) Why will it take time until "the company's massive earnings growth can be verified"? What evidence will help to evaluate the validity of the estimates made in First Marblehead's revenue recognition process?

7.) What is the process of short selling? Why is it telling that there has been a significant increase in the number of short-sellers on First Marblehead's stock?

Reviewed By: Judy Beckman, University of Rhode Island

FERF Newsletter, April 20, 2004

Update on SFAS 150

Halsey Bullen, Senior Project Manager at the Financial Accounting Standards Board (FASB), gave an update on SFAS 150.

Private Net last discussed SFAS 150 and FASB Staff Position (FSP) 150-3 in the February issue: 

Bullen said that SFAS 150 was originally designed to account for "ambiguous" instruments, such as convertible bonds, puttable stock, Co-Co No-Nos (conditionally convertible, no coupon, no interest instruments), and variable share forward sales contracts. Mandatorily redeemable shares of ownership issued by private companies were then included in the accounting for this class of instruments.

Bullen said that FSP 150-3 allowed private companies to defer implementation of SFAS 150 until 2005 with respect to shares that were redeemable on fixed dates for fixed or externally indexed amounts, and indefinitely for other mandatorily redeemable shares. (We will assume indefinite deferral for mandatorily redeemable ownership shares issued by private companies.)

As an update, Bullen said that in Phase 2, the FASB was considering several alternatives for "bifurcating" the ambiguous instruments into equity and liability components: * Fundamental components approach, * Narrow view of equity as common stock, * IASB 32 approach: bifurcate convertibles and treat any other obligation that might require transfer of assets as a liability for the full amount, * Minimum obligation approach, and * Reassessed expected outcomes approach.

Bullen said that the FASB has encountered a number of challenges in trying to account for these ambiguous instruments, not the least of which are just basic conceptual definitions of shareholder equity and liability. For example, should equity be defined as assets minus liabilities, or should liabilities be first defined as assets minus shareholder equity?

One FEI member asked Bullen, "Where is the concept of simplicity?" Bullen responded, "Simplicity is as simplicity does." In other words, if the financial instrument is not simple, how can its accounting be simple?

Bullen told the participants to expect an exposure draft in late 2004 or early 2005.

Accrual Accounting and Estimation

From The Wall Street Journal Accounting Educators' Review on July 9, 2004

TITLE: Accrual Accounting Can Be Costly 
REPORTER: Gene Colter 
DATE: Jul 02, 2004 
TOPICS: Earnings Management, Earnings Quality, Financial Accounting, Financial Analysis, Financial Statement Analysis, Restatement, Revenue Recognition

SUMMARY: The article discusses a research study relating the extent of accrual accounting estimates to subsequent firm performance and incidence of shareholder litigation. The study was conducted by Criterion Research Group, LLC, and the article notes that the research is of interest to insurers that offer directors and officers policies.

1.) Summarize the research study described in the article. Who performed the research? What can you understand about the relationships examined in the project? What was the motivation for the research?

2.) Define the term accrual accounting. Is it accurately compared to cash basis accounting by the description given in the article? Why must accrual accounting always involve estimates?

3.) What is the overall impression of accrual accounting that is created in the article? In your answer, comment on the statement, "Accrual accounting is common and kosher."

4.) Describe weaknesses of cash basis accounting as compared to the issues with accrual basis accounting that are presented in the article. Which basis do you think better presents information that is useful to financial statement readers? Support your answer; you may cite relevant accounting literature to do so.

5.) What basis of accounting is being described using the computer network example in the article? What accounting standards prescribe this treatment? Name at least one other industry besides computer software sales in which this accounting treatment is required.

6.) Refer again to question #5 and your answer. What alternative method must be used in this area if accrual accounting were to be avoided entirely? What are the disadvantages of this approach?

7.) Why do you think some companies must record more extensive accruals and estimates than other companies must? Do these factors themselves lead to greater likelihood of shareholder litigation as is found in the article?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"Accrual Accounting Can Be Costly," by Gene Colter, The Wall Street Journal, July 2, 2004, Page C1 ---,,SB108871005216853178,00.html 

Firms Booking Aggressively Are More Likely to Be Sued By Shareholders, Study Says

Book now. Pay later.

Pay the lawyers, maybe. A study to be released today suggests that companies that are most aggressive when booking noncash earnings are four times as likely to be sued by shareholders as less-aggressive peers.

At issue is so-called accrual accounting, in which companies book revenue when they earn it and expenses when they incur them rather than when they actually receive the cash or pay out the expenses. Accrual accounting is common and kosher. Problems arise, however, when companies miscalculate how much revenue they've really earned in a given period or how much in related expenses it cost to get that money.

For example, say Company A agrees to build a computer network for Company B over four years for $4 million, a job that Company A estimates it'll have to spend $1 million to complete. Company A works hard and estimates it ended up building half the computer network in the first year on the job, so it books $2 million of revenue that year. By accounting rules, it must accrue related costs in the same proportion as revenues, so it also books $500,000 of expenses in the same first year. But say it then turns out that Company A's costs to finish the network actually run to $2 million. Company A has to address that by booking $1.5 million of expenses in future years. In other words, Company A would end up increasing earnings in the first year, but at a cost to future earnings.

Getting the numbers wrong isn't a violation of generally accepted accounting principles (though intentionally misestimating is). But companies have a lot of leeway, and those that make the most aggressive assumptions when booking what the green-visor guys call accruals can end up creating a misleading picture of their financial health in any given year. When skeptics refer to a company's "revenue recognition problems," this is often what they're talking about.

The new study, based on six years of data, was conducted by Criterion Research Group LLC, an independent research firm in New York that caters primarily to institutional investors. It shows that companies that fall into what Criterion calls the highest accrual category are more likely to end up getting sued by shareholders.

The study builds on earlier research by Criterion that showed companies that use more accruals underperform companies with fewer accruals. In that report, Criterion screened 3,500 nonfinancial companies over 40 years and found that those using the most accruals had poorer forward earnings and stock returns and also had more earnings restatements and Securities and Exchange Commission enforcement actions.

None of this is to say that companies that end up in shareholder litigation set out to mislead shareholders. Rather, says Criterion Chairman Neil Baron, these companies simply run a higher risk of making mistakes with their books.

"Accruals are estimates," Mr. Baron says. "If you're a company and a much higher percentage of your earnings come from accruals or estimates, it's much more likely that you're going to be wrong more often."

Criterion screened companies involved in class-action suits from 1996 to 2003 for its new study. In each case it looked at a company's earnings for the year of the class start date, which is the year in which the alleged misbehavior began. Criterion then assigned these companies into one of 10 ranks, with those in the 10th group using the most accruals and those in 1st using the fewest. There were four times as many shareholder class-action suits among 10th group companies as there were among 1st group firms.

A number of companies in the two highest accrual categories recently settled shareholder class actions related to accounting issues, including Rite Aid Corp., Waste Management Inc., MicroStrategy Inc. and Gateway Inc. Other companies still involved in ongoing shareholder class actions involving accounting issues also turned up in the aggressive-accruals group.

Companies currently in Criterion's highest-accrual category include Chiron Corp., eBay Inc., General Motors Corp., Halliburton Co. and Yahoo Inc. -- none of which now face shareholder suits related to accounting -- among others.

EBay spokesman Hani Durzy says he doesn't think his company belongs in the high-accruals gang, noting that the company's profit-and-loss statement "closely mirrors our cash flow." He adds: "We are essentially a cash business."

A GM spokesman says, "All of GM's accounting policies and procedures are in full compliance with U.S. GAAP and are reviewed by our outside auditor and the audit committee, and we have, to the best of our knowledge, never had to restate earnings because of an accounting issue."

An e-mail from Halliburton's public-relations office notes that Halliburton follows GAAP and adds that accruals "are universally required by GAAP."

Representatives from Chiron and Yahoo said the companies had no comment.

A Criterion analyst pointed out that accruals don't necessarily relate to everyday operations. For example, a company estimating and booking tax benefits from employee stock options is also using accruals. Estimates related to pension accounting are also accruals.

Mr. Baron stresses that the vast majority of companies that book a lot of accruals are unlikely to face shareholder suits, restatements or SEC actions. Many may even outperform low-accrual companies. But he says investors should be "more scrutinizing" of financial statements from companies that make liberal use of accruals, because, statistically, they are most likely to run into these problems.

Sophisticated investors, such as fund managers, might reckon they can spot bookkeeping alarms before the broad investing public and get out of a stock before the lawyers start filing briefs. But it's possible that companies with a lot of accruals can suffer even without litigation: Mr. Baron says his firm has been contacted by insurers that offer directors and officers policies, which large companies buy to protect executives and directors against lawsuits. The insurers are asking about Criterion's research as they weigh whether to charge D&O customers higher premiums, he says.

Bob Jensen's threads on revenue accounting are at 

From The Wall Street Journal Accounting Weekly Review on January 28, 2005

TITLE: Quirk Could Hurt Mortgage Insurers  (Quirk = FAS 70)
REPORTER: Karen Richardson 
DATE: Jan 21, 2005 
TOPICS: Financial Accounting, Financial Accounting Standards Board, Insurance Industry, Loan Loss Allowance, loan guarantees, Contingent Liabilities

SUMMARY: "Millions of people who can't afford to put down 10% or 20% of a home's price are required by their mortgage lenders to buy policies from mortgage insurers, which, by agreeing to shoulder some risk of missed loan payments, can lower the buyer's down payment to as little as 3%." However, as a result of a "quirk" in establishing Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises" in 1982, the FASB allowed an exclusion for mortgage insurers from requirements to reserve for future losses. This exclusion may lead to to delayed reporting of costs associated with the mortgage lending and of exacerbation of losses if default rates increase due to the type of borrowers taking advantage of this insurance in the hot real estate market.

1.) What is the purpose of mortgage insurance for a home buyer?

2.) How do mortgage insurance providers, and insurance providers in general, earn profits on their activities? How are insurance rates determined? In general what costs are deducted against revenues determined from those insurance rates?

3.) Access Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises," via the FASB's web site, located at From the discussion in the summary of the standard, state the general accounting requirements contained in this statement.

4.) Based on the discussion in the article, what is the exemption allowed for mortgage insurers from Statement No. 60's requirements? What is the reasoning for that exemption? What is your opinion about this reason?

5.) Refer again to the FASB Statement No. 60 on the FASB's web site. Locate the exemption described in question 4 and give its citation.

6.) Given this accounting requirement exemption, what are the concerns with measuring profit in the mortgage insurance industry in general (regardless of the issues with the current real estate market)? What is the technique used to handle that issue in financial reports? In your answer, specifically refer to, and define, the matching concept in accounting.

7.) How does the potential caliber of the real estate buyers using mortgage insurance exacerbate the concerns raised in question 6?

Reviewed By: Judy Beckman, University of Rhode Island


Earnings Management
The Controversy Over Earnings Smoothing and Other Manipulations

Probably the best illustration of earnings management (both legitimate and fraudulent) is the saga of Enron --- 

Earnings Management Deception
The 1999 bulletin also said that if accounting practices were intentionally misleading "to impart a sense of increased earnings power, a form of earnings management, then by definition amounts involved would be considered material." AIG hinted some errors may have been intentional, saying that certain transactions "appear to have been structured for the sole or primary purpose of accomplishing a desired accounting result."
Jonathan Weil, "AIG's Admission Puts the Spotlight On Auditor PWC," The Wall Street Journal, April 1, 2005 ---,,SB111231915138095083,00.html?mod=home_whats_news_us
Bob Jensen's threads on the AIG mess are at

It's not clear who got the earnings game going (meeting earnings forecasts by one penny): executives or investors. But it's past time for it to stop. As the Progressive example shows, those companies that continue the charade do it by choice.
Gretchen Morgenson, "Pennies That Aren't From Heaven," The New York Times, November 7, 2004 --- 

Ask any chief executive officer if he or she practices the art of earnings management and you will undoubtedly hear an emphatic "Of course not!" But ask those same executives about their company's recent results, and you may very well hear a proud "we beat the analysts' estimate by a penny."

While almost no one wants to admit to managing company earnings, the fact is, almost everybody does it. How else to explain the miraculous manner in which so many companies meet or beat, by the preposterous penny, the consensus earnings estimates of Wall Street analysts?

After years of such miracles, investors finally seem to be wising up to the fact that an extra penny of profit is not only meaningless but may also be evidence of earnings management and, therefore, bad news. After all, the practice can hide 

what's genuinely going on in a company's books.

A study by Thomson Financial examined how many of the 30 companies in the Dow Jones industrial average missed, met or beat analysts' consensus earnings estimates during each quarter over the last five years. It also looked at how the companies' shares responded to the results.

Over the period, on average, almost half of the companies - 46.1 percent - met consensus estimates or beat them by a penny.

Pulling off such a feat in an uncertain world smacks of earnings management. "It is not possible for this percentage of reporting companies to hit the bull's-eye," said Bill Fleckenstein, principal at Fleckenstein Capital in Seattle. "Business is too complicated; there are too many moving parts."

The precision has a purpose, of course: to keep stock prices aloft. According to Thomson's five-year analysis, companies whose results came in below analysts' estimates lost 1.08 percent of their value, on average, the day of the announcement. The loss averaged 1.59 percent over five days.

Executives have lots of levers to pull to make their numbers. Lowering the company's tax rate is a favorite, as is recognizing revenues before they actually come in or monkeying with reserves set aside to cover future liabilities.

If all else fails and a company faces the nightmare of an earnings miss, its spinmeisters can always begin a whispering campaign to persuade Wall Street analysts to trim their estimates, making them more attainable. Their stock might drift downward as a result, but the damage is not usually as horrific as it is when earnings miss the target unexpectedly.

So it is not surprising that the strategy has become so widespread and that fewer companies in the Thomson study are coming in below their target these days. For the first three quarters of 2004, 10.9 percent missed their expected results, down from 11.7 percent in 2003 and 25 percent in 2002.

At the heart of earnings management is - what else? - executive compensation. The greater the percentage of pay an executive receives in stock, the bigger the incentive to produce results that propel share prices.

Continued in the article

Coke:  Gone Flat at the Bright Lines of Accounting Rules and Marketing Ethics
The king of carbonated beverages is still a moneymaker, but its growth has stalled and the stock has been backsliding since the late '90s.  Now it turns out that the company's glory days were as much a matter of accounting maneuvers as of marketing magic. 
Guizuenta's most ingenious contribution to Coke, the ingredient that added rocket fuel to the stock price, was a bit of creative though perfectly legal balance-sheet rejeiggering that in some ways prefigured the Enron Corp. machinations.  Known inside the company as the "49% solution," it was the brain child of then-Chief Financial Officer M. Douglas Ivester.  It worked like this:  Coke spun off its U.S. bottling operations in late 1986 into a new company known as Coca-Cola Enterprises Inc., retaining a 49% state for itself.  That was enough to exert de facto control but a hair below the 50% threshold that requires companies to consolidate results of subsidiaries in their financials.  At a stroke, Coke erased $2.4 billion of debt from its balance sheet.
Dean Foust, "Gone Flat," Business Week, December 20, 2004, Page 77.  
This is a Business Week cover story.
Coca Cola's outside independent auditor is Ernst & Young

There were other problems, some of which did not do the famed Warren Buffet's reputation any good.  See "Fizzy Math and Fishy Marketing Lawsuit, Probes Prove Damaging to Coke," by Margaret Webb Pressler, Washington Post, June 20, 2003 --- 

Coca Cola's marketing tactics were unethical and unhealthy for kids --- 

Also see "The Ten Habits of Highly Defective Corporations," From The Nation --- 


Goodwill and Other Asset Impairment


"MCI Inc. Posts $3.4 Billion Loss For 3rd Quarter," by Shawn Young, The Wall Street Journal, November 5, 2004, Page B2 ---,,SB109956924948864745,00.html?mod=technology_main_whats_news 

Results Reflect Write-Off Of $3.5 Billion on Assets; Revenue in 2004 to Drop 

Results Reflect Write-Off Of $3.5 Billion on Assets; Revenue in 2004 to Drop By SHAWN YOUNG Staff Reporter of THE WALL STREET JOURNAL November 5, 2004; Page B2

MCI Inc. reported a $3.4 billion third-quarter loss, reflecting a $3.5 billion write-off the phone giant has said it is taking on assets that have lost value.

The company also cautioned that 2004 revenue will be slightly below the $21 billion to $22 billion it had projected early in the year.

"Slightly means slightly," said Chief Executive Michael Capellas. He noted that the company hadn't changed its projections since a regulatory setback led MCI and larger rival AT&T Corp. to virtually abandon marketing of home phone service to consumers. Both companies are now focused almost exclusively on business customers.

Despite the revenue decline, MCI projects a fourth-quarter profit, the result of improving margins, lower costs and a little stabilization in the price wars that have wracked the long-distance industry. The profit would be the first for the former WorldCom Inc. in years. The company filed for Chapter 11 bankruptcy protection in 2002 in the wake of a massive accounting fraud. It emerged under the name MCI in April.

The improving trends that could produce a fourth-quarter profit were also evident in operating results for the third quarter, which largely met investor expectations.

Continued in the article

Bob Jensen's threads on the Worldcom and MCI scandals are at 

"How to Avoid the Goodwill Asteroid," by Jon D. Markman,, May 24, 2002 --- 

One of the gravest fears of investors today is being totaled by an "asteroid" event -- moments when a stock gets pushed to the edge of extinction by a bolt from the blue, such as a drug application rejection, a securities probe revelation or a surprise earnings restatement.

Yet many shareholders seem blithely unaware that at least one asteroid speeding toward their companies is entirely foreseeable: the likelihood that management will have to write down a decent-sized chunk of their net worth sometime this year and perhaps rather soon.

This unfortunate prospect is faced, potentially, by companies such as AOL Time Warner (AOL:NYSE - news - commentary - research - analysis), Allied Waste Industries (AW:NYSE - news - commentary - research - analysis), Georgia-Pacific (GP:NYSE - news - commentary - research - analysis) and Cendant (CD:NYSE - news - commentary - research - analysis) that have accumulated a great deal of goodwill on their balance sheets over the past few years. That's accountant-speak for the amount a company pays for another company over its book value because of expectations that some of its intangible assets -- such as patented technology, a prized brand name or desirable executives -- will prove valuable in a concrete, earnings-enhancing sort of way.

New Accounting Rules

Companies carry goodwill on their balance sheets as if it were an asset as solid as a piece of machinery, and therefore it is one of many items balanced against liabilities, such as long-term debt, to measure shareholder equity or book value. Just as hard assets are depreciated, or expensed, by a certain amount each year to account for their diminished value as they age, intangibles have long been amortized by a certain amount annually to account for their waning value.

The value of machinery rarely dissipates quickly, but the value of goodwill can evaporate in a flash if a company determines that it paid too much for intangible assets -- e.g., if a patent or brand turns out not to be as defensible as originally believed, or demand for a new technology falters. As you can imagine, companies typically don't want to admit they overpaid. But once they do, they must write down the vanished value so that the "intangibles" lines on their balance sheets reflect fair-market pricing. If the writedown leaves a company's assets at a level lower than liabilities, the company is left with a negative net worth, which, as you would expect, is frowned upon, and often results in a dramatically lower stock price.

Until last year, companies tried to avoid recording goodwill after acquisitions by using a method of accounting called "pooling of interests." In these stock-for-stock deals, companies were allowed to record the acquiree's assets at book value even though the value of the stock it had given up was greater than the amount of real stuff its shareholders received. The advantage: No need to drag down earnings each quarter by amortizing, or expensing, goodwill.

The rulebook changed this year, however, and pooling went the way of the dodo; now companies are forced to record goodwill on their books. As a compromise to serial acquirers, who have a powerful lobby, the Financial Accounting Standards Board (FASB) decided that companies would no longer have to amortize goodwill regularly against earnings. Instead, a new standard -- encompassed in Rule 142 -- requires companies to test goodwill for "impairment" periodically.

Essentially, this means that while the diminished value of goodwill won't count against a company's earnings annually anymore, companies might need to write down huge gobs of it from time to time when accountants decide they can't ignore the fact that an acquisition didn't turn out as planned. It also means that because FASB 142 does not dictate a set of strictly objective rules for calculating impairment, writedowns will be somewhat subjective in both timing and amount.

Don't Fall for These Three Ploys

As a result, many market skeptics believe that FASB 142, which was intended to improve earnings transparency, may in some cases actually result in more egregious earnings manipulation than ever. Donn Vickrey, vice president at Camelback Research Alliance, a provider of analytical tools and consulting services for financial information, says he sees three ways that companies interested in managing their earnings could end-run shareholders using the new rule.

The big bath. In this approach, companies will write off a big portion of the goodwill on their books, telling investors it is an insignificant "paper loss" that should have no impact on the firm's share price. The benefit: Future write-offs would be unnecessary, and the company's earnings stream could be more effectively smoothed out in future periods. This approach would work only if it does not put the company at risk of violating debt covenants that require it to maintain a certain ratio of assets vs. liabilities.

Cosmetic earnings boost. Under FASB 142, many companies will record earnings that appear higher than last year's because of the elimination of goodwill amortization. However, the increase will be purely cosmetic, as the company's underlying cash flow and profitability would remain unchanged. Investors should thus ensure they are comparing prior periods with the current period on an apples-to-apples basis by eliminating goodwill amortization from comparable year-earlier financial statements. The amount might be buried in footnotes to the balance sheet, though Kellogg (K:NYSE - news - commentary - research - analysis) explains the issue clearly in its latest 10-k in the section devoted to its acquisition of cookie maker Keebler in March 2001. Kellogg says it recorded $90.4 million in intangible amortization expense during 2001 and would have recorded $121 million in 2002 had it not adopted FASB 142 at the start of the year.

Avoid-a-write-off. Some companies might take advantage of the new rule by avoiding a goodwill write-off as long as possible to prevent the big charge to earnings. Since the tests for impairment are subjective, Camelback believes it will not be hard for firms to avoid write-offs in the short run -- a strategy that could both help them avoid violations in debt covenants and potentially provide a boost in executive compensation formulas.

While any public company that does acquisitions will find itself facing decisions about how to account for goodwill impairment, companies with the greatest absolute levels of goodwill -- as well as ones with the greatest amount of goodwill relative to their market capitalization -- will be the most vulnerable in the future to having their earnings blasted by the FASB 142 asteroid.

Continued at 

From The Wall Street Journal Accounting Educators' Review on Junly 30, 2004

TITLE: FASB May Bite Into Overseas Profits 
REPORTER: Lingling Wei 
DATE: Jul 28, 2004 
LINK: Print Only 
TOPICS: Financial Accounting, Financial Accounting Standards Board, International Accounting Standards Board

SUMMARY: The FASB has voted 4-3 to instruct the staff to examine "whether it is practical to require companies to book a liability for taxes they potentially owe on profits earned and held overseas."

1.) What was the vote undertaken at the Financial Accounting Standards Board (FASB)? Did this vote actually establish a new accounting requirement? Explain, commenting on the FASB's process for establishing a new accounting standard.

2.) Why did the FASB undertake this step with respect to deferred taxes? How does it fit in with other work being undertaken in concert with the International Accounting Standards Board?

3.) FASB member Michael Crooch comments that "there is a fair amount of opposition to the change" proposed by the FASB. Do you think such opposition is unusual or common for FASB proposals? Support your answer.

4.) Define the term "deferred taxes". When must deferred taxes be recorded? Why do we bother to record them? That is, how does the process of reporting deferred taxes help to improve reporting in the balance sheet and income statement?

5.) What taxes currently are recorded on foreign earnings? Why do companies currently not calculate deferred taxes for profits on foreign earnings? Why then would any change in this area result in "a major hit to earnings"?

6.) Why do you think that companies might reconsider repatriating foreign earnings if they must begin to record deferred taxes on those amounts? What does your answer imply in regards to the economic consequences of accounting policies?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

From The Wall Street Journal Accounting Educators' Review on December 13, 2002

TITLE: International Body to Suggest Tighter Merger Accounting 
REPORTER: Silvia Ascarelli and Cassell Bryan-Low 
DATE: Dec 05, 2002 
TOPICS: Advanced Financial Accounting, Financial Accounting, Financial Statement Analysis, Goodwill, International Accounting, International Accounting Standards Board, Restructuring

SUMMARY: The International Accounting Standards Board (IASB) is proposing a new standard for business combination accounting. The proposal prescribes accounting treatment that is more stringent than U.S. standards. For example, it disallows recording restructuring charges at the outset of a business combination; such charges must simply be recorded as incurred.

1.) Compare and contrast the standard for business combinations proposed by the IASB to the current U.S. standard. To investigate these differences directly from the source, access the IASB's web site at

2.) Why are U.S. companies expected to be concerned about recording restructuring charges as they are incurred in the process of implementing a business combination, rather than when these anticipated costs are identified at the outset of a business combination? Do these two accounting treatments result in differing amounts of expense being recorded for these restructuring charges? Will such U.S. companies be required to report according to this IAS, assuming it is implemented?

3.) How are the goodwill disclosures proposed in the IAS expected to help financial statement analysis?

4.) How are European companies expected to be impacted by this proposed IAS and future proposals currently planned in this area of accounting for business combinations? Provide your answer by considering not only the article under this review, but also by again accessing the IASB's web site referenced above.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Program professors can search past editions of Educators' Reviews at  
Go to the Educators' Review section and click on "Search the Database." You can also change your discipline selection or remove yourself from the mailing list.


Some intangible assets are booked and amortized.  Accounting guidance in this area dates back to APB 17.  Usually these are contractual or legal rights (patents, copyrights, etc.) and amortizations and write downs are to be based on the following provisions in Paragraph 27 of APB 17:

The Board believes that the value of intangible assets at any one date eventually disappears and that the recorded costs of intangible assets should be amortized by systematic charges to income over the periods estimated to be benefited. Factors which should be considered in estimating the useful lives of intangible assets include:

  • Legal, regulatory, or contractual provisions may limit the maximum useful life.
  • Provisions for renewal or extension may alter a specified limit on useful life.
  • Effects of obsolescence, demand, competition, and other economic factors may reduce a useful life.
  • A useful life may parallel the service life expectancies of individuals or groups of employees.
  • Expected actions of competitors and others may restrict present competitive advantages.
  • An apparently unlimited useful life may in fact be indefinite and benefits cannot be reasonably projected.
  • An intangible asset may be a composite of many individual factors with varying effective lives.

When a company purchases another company, the purchase price may soar way above the book value of the acquired firm.  The reason for the unbooked excess is the unbooked market values of booked and unbooked assets plus synergy increments  less negative value of unbooked liabilities. Paragraph 39 of FAS 141 requires the partitioning of the unbooked excess value into (1) separable versus (2) inseparable components of unbooked excess purchase value.  The inseparable portion is then booked as "goodwill."  This portion is then booked as goodwill and is carried forward as an asset subject to impairment tests of FAS 142.  Paragraph 39 of FAS 141 requires an intangible asset to be recognized as an asset apart from goodwill if it arises from:

· contractual or other legal rights, regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations; or

· separable, that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged regardless of whether there is an intent to do so. An intangible asset is still considered separable if it can be sold transferred, licensed, rented, or exchanged in combination with a related contract, asset or liability.

Paragraphs 10-28 of FAS 141 provides examples of intangible assets that are considered "separable" and are not to be confounded in the goodwill account. But the majority of the unbooked excess value is usually the inseparable goodwill arising from "knowledge capital" arising from the following components:

Knowledge Capital Components

  • Spillover Knowledge (see above)
  • Human Resources (see above)
  • Structural Capital (see above)

Knowledge capital arises generally from the conservatism concept that guides the FASB and other standard setters around the world.  For example, human resources are not owned, controlled, bought, and sold like tangible assets.  As a result, investment in training are expensed rather than capitalized.  Research and development expenditures are expensed rather than booked under the highly conservatism rulings in FAS 2.  This includes most R&D in database and software development except when impacted by FAS 86.

Knowledge capital is often the major component of goodwill.  But "goodwill" as defined in FAS 141 and 142 is a hodgepodge of other positive and negative components that comprise the net excess value difference between the market value of total owners' equity and the value of the firm as a whole.  This is summarized below:

Goodwill Components

+ Market value of Owners' Equity  ($10 billion)
-     Book value of Owners' Equity  ($01 billion)
= Market to book difference in value    ($09 billion)
- Adjustment of booked items to fair value  ($04 billion)
= Goodwill that includes the following components ($5 billion)
  • Unbooked synergy value of booked items (+$1 billion)
  • Unbooked knowledge capital value (+$04 billion)
  • Other unbooked  items (-$01 billion)
  • Joint effects, including other synergies (+$01 billion)

The components of goodwill are not generally additive.  For example, a firm has just been purchased for $10 billion and has a book equity value of $1 billion.  The market to book ratio is therefore 10=$10/$1.  Suppose the value of the individual booked assets and liabilities sums to $5 billion even though the booked value on a historical cost basis is only $1 billion.  However, when combined as a bundle of booked items, assume there is a combined value of $6 billion, because the value of the combined booked items is worth more than the $5 billion sum of the parts.  For example, if an airline sells its booked airplanes and airport facilities, these many be worth more as a bundle than the sum of the values of all the pieces.  If there were no unbooked items, the value of the firm would be $6 billion, thereby, resulting in $1 billion in goodwill arising entirely from synergy of booked items. 

However, the value of the equity is $10 billion rather than $6 billion.  This difference is due to the net value of the unbooked asset and liability items and the synergies they create in combination with one another.  For example, if an airline sells the entire business in addition to its airplanes and airport facilities, there is added value due to the intellectual capital components such as experienced mechanics, flight crews, computer systems, and ground crews.  There are also negative components such as unbooked operating lease obligations on airplanes not booked on the balance sheet.  

The components of goodwill are not additve in value, but in combination they sum to the $5 billion in goodwill equal to the market value of the combined equity minus the sum of the market values of the booked items (without the $1 billion in unbooked synergy value).  When combined with the booked items, the unbooked knowledge capital takes on more value than $4 billion it can be sold for individually.  For example, if American Airlines sold its entire SABRE reservations system in one sale and the remainder of the company in another sale, the sum would probably be less than the combined value of the unbooked SABRE system plus all of the booked items belonging to American Airlines.  This is because there is synergy value between the booked and unbooked items.  One of the synergy items is leverage.  Values of booked debt and assets may be more additive in firms having low debt/equity ratios than in high leverage firms where there investors adjust added values for higher risk.

If investors seek to extrapolate firm value from balance sheet value, they will discover that historical costs are useless and that adustments of booked items to fair value falls way short of total value.  The problem is that major components of value never appear on the balance sheets.  The unbooked knowledge capital components of firm value have become so enormous that it is not uncommon to find market to book values of equity way in excess of the ten to one ratio illustrated above. 

Goodwill cannot be booked in the United States except when there is a combining of two companies that must now be accounted for as a purchase under FAS 141.  Goodwill is the purchase price less the current fair values of the booked items (not adjusted for synergy value).  No formal attempt is made to report the portion that is knowledge capital, although management may justify the business combination on some identified knowledge capital items.  For example, if Microsoft purchased PeopleSoft, Bill Gates would make a public explanation of why the value of PeopleSoft is almost entirely due to unbooked items relative to booked items in PeopleSoft's balance sheet.

The main reason why goodwill cannot be booked, unless there is a business combination transaction, is that estimation of the value of the firm on an ongoing basis is too expensive and subject to enormous measurement error.  One common approach is to multiply the market price per share times the number of shares outstanding.  But this is usually far different from the price buyers are willing to pay for all of the shares outstanding.  This difference arises in part because acquiring control usually is far more valueable than the sum of the shares at current trading values.  This difference arises in part because current share prices are subject to transient market price movements of shares of all traded companies, whereas the value of the firm in a business combination deal is much more stable.

From The Wall Street Journal Accounting Educators' Review on April 4, 2002

TITLE: Why High-Fliers Built on Big Ideas, Are Such Fast Fallers 
DATE: Apr 04, 2002 
TOPICS: Intangible Assets, Electricity Markets, Goodwill, Managerial Accounting, Pharmaceutical Industry, Research & Development

SUMMARY: Greg Ip reports on the perils of life-cycle differences based on products and services that are reliant on intangible rather than tangible assets. That value is created with either is undeniable, but significantly riskier when that value is supported by something intangible that may disappear entirely.

1.) What is a product life cycle? How many of the 5 basic stages of a product's life can you name? What has happened to the product life cycle that is heavily dependent on technological changes? What part does intangible assets have in this change? How could the $5 billion in assets of a firm sell for $42 million?

2.) What does the author mean when he says "value today is increasingly derived from intangible assets - intellectual property, innovative technology, financial services or reputation"? Explain in terms of Alan Greenspan's statement "a firm is inherently fragile if its value-added emanates more from conceptual as distinct from physical assets."

3.) The article relates the story of Polaroid, once a pioneer noted for its technological prowess. Its "technology" asset formed the basis of its early success. How did technology and innovation finally slay it?

4.) Other industries are exposed to the same sorts of forces, including the pharmaceutical and fiber-optic industries. How have they fared?

5.) Why have companies tried to cast off hard assets in favor of intangible assets? In 2000, Jeffrey Skilling said, " What's becoming clear is that there's nothing magic about hard assets. They don't generate cash. What does is a better solution for your customer. And increasingly that's intellectual, not physical assets, driven." Do you suppose he's changed his mind?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

A common mistake is to assume that "goodwill" is comprised only of unbooked assets such as knowledge capital.  Nothing could be further from the truth in terms of how goodwill is calculated under FAS 141 rules.  Goodwill also includes downward value adjustments for unbooked risk items such as off-balance sheet financing, pending and potential litigation losses, pending and possible adverse legislative and taxation actions, estimated environmental protection expenses, and various industry-specific liabilities such as unbooked frequent flyer certificate obligations.

From The Wall Street Journal Accounting Educators' Reviews on June 20, 2002

TITLE: Frequent-Flier Programs Get an Overhaul 
REPORTER: Ron Lieber 
DATE: Jun 18, 2002 
PAGE: D1 LINK:,,SB1024344325710894400.djm,00.html  
TOPICS: Frequent-flier programs, Accounting

SUMMARY: Many frequent-flier programs are offering alternative rewards in exchange for frequent-flier miles. Questions focus on accounting for frequent-flier programs and redemption of miles.

1.) What is a frequent-flier program? List three possible ways to account for frequent-flier miles awarded to customers in exchange for purchases. Discuss the advantages and disadvantages of each accounting method.

2.) Why are companies offering alternative rewards in exchange for frequent-flier miles? How is the redemption of miles reported in the financial statements? Discuss accounting issues that arise if the miles are redeemed for awards that are less costly than originally anticipated.

3.) The article states that the 'surge in unredeemed points is causing bookkeeping headaches.' Why would unredeemed points cause bookkeeping headaches? Would companies be better off if the points were never redeemed? If a company created a liability for awarded points, in what circumstances could the liability be removed from the balance sheet?

4.) Refer to the related article. Describe Jet Blue's frequent-flier program. How does stipulating a one-year expiration on frequent-flier points change accounting for a frequent-flier program?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

TITLE: JetBlue Joins the Fray But With Big Caveat: Miles Expire in a Year 
REPORTER: Ron Lieber 
ISSUE: Jun 18, 2002 


Liabilities and Equity of Microsoft Corporation

The off-balance sheet liabilities of Microsoft dwarf the recorded liabilities.

  • The major risk of Microsoft is the ease with which its products can be duplicated elsewhere such as in China.  From a global perspective this gives rise to perhaps billions in lost revenues and enormous expenditures to protect copyrights.

  • There are enormous contingency risks and pending lawsuits, particularly government lawsuits alleging abuse of monopoly powers and civil lawsuits from companies claiming unfair marketing practices and copyright infringements.



Entrenched Assets and Market Dominance

  • Microsoft Windows and MS Office
  • AMR Sabre
  • Oracle Databases
  • AOL 

Market-to-Book (ratio of market value of net assets/book value of net assets) > 6.0

Conservatism is Largely to Blame

  • R&D expensed under FASB, but only R expensed by IAS
  •'s tremendous investment in systems, marketing, and distribution software
  • AOL's customer acquisition costs
  • Distrust of valuations that are highly subjective and subject to extreme volatility
Managers and auditors "don't want to put anything on the balance sheet that may turn out to be worthless.  If they don't have to value intangible assets, such as AOL's customer acquisition costs, their legal liability is reduced."  Baruch Lev
Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 ---
Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm

Institutional Investors and Security Analysts Are Also At Fault

Institutional investors and financial analysts are also quite happy with the current system because they think that they've go inside networks and proprietary information."  Baruch Lev
Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 ---
Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm



Wages of factory workers are traced directly into finished goods inventories and are "capitalized" costs rather than expenses.  They are carried in the balance sheet as "tangible assets" until the the inventory items are sold or perish.  Then these costs become "expenses" in the income statement and are written off to the Retained Earnings account.  Similarly, wages of construction workers on a building are capitalized into the Buildings asset account rather than expensed in the income statement.  These wages become expensed over time in periodic depreciation charges. Costs of labor and direct materials that can be traced to construction of tangible assets thereby become assets and are written off across future periods.  Even indirect labor and material charges may be capitalized as overhead applied to tangible assets.  Tangible assets depict "touchable" items that can be purchased and sold in established markets such as commodity markets, real estate markets, and equipment markets.  

Wages and salaries of research workers can be traced to particular projects.  However, under most accounting standards worldwide, research costs, including all direct material, labor,  and overhead costs are expensed immediately rather than capitalized as assets even though the revenues from the projects may not commence until many years into the future.  Research projects are typically too unique and too uncertain to be traded in markets.  Accounting standard setters recognize that there are many "intangible" items having future benefits or losses that are not booked as assets or liabilities.  Outlays for development of intangibles are expensed rather than capitalized until they can be better matched with the revenues they generate.  Examples in include research for new or improved products.  Intangibles also include contractual items such as copyrights, advertising, product promotions, and public relations outlays.  When intangibles such as patents and copyrights are purchased, the outlays can be booked as intangible assets.  Costs are then amortized over time.  However, resources devoted to discovery and development of intangibles are generally not booked as assets.  They are expensed when incurred rather than capitalized.  Typical examples of intangible expenses include the following:

  • Research (including development of patent and copyright items)
  • Long-term development of patents, products, and copyrights
  • Advertising and trademarks
  • Employee training and development
  • Public relations

When an entire firm is purchased, the difference between the total price and the current value of all intangibles is typically booked to a "Goodwill" asset account.  When purchased as a lump sum, goodwill can be carried as an asset until its value is deemed to be "impaired."  However, when developed internally, goodwill is not booked as an asset.  This creates all sorts of problems when comparing similar companies where one company purchased its goodwill and the other company developed it internally.  In the U.S., goodwill accounting must be treated under purchase rather than pooling methods that, in turn, result in booking of "purchased goodwill."  FAS 141 spells out the accounting standards for Goodwill.   

One requirement under FAS 141 is that contractual items such as patents and copyrights that can be separated from goodwill must be valued separately and be immediately expensed.  This is an attempt in FAS 141 to make it easier to compare a firm that acquires R&D in a business combination with a firm that develops its own R&D.  However, implementation of FAS 141 rules in this regard becomes very murky.

FAS 142 dictates that firms are no longer required to amortize capitalized goodwill costs.  Instead firms are required to run impairment tests and expense portions of goodwill that has been deemed "impaired."  FAS 142 does not alter standards for intangibles that are not acquired in a business combination.  Hence, standards such as FAS 2 (R&D), FAS 19 (Oil and Gas), FAS 50 (Recording Industry), and FAS 86 (Computer Software) remain intact in situations apart from business combinations.  Paragraph 39(b) of FAS 142 admits to the following:

In some cases, the cost of generating an intangible asset internally 
cannot be distinguished from the cost of maintaining or 
enhancing ... internally generated goodwill.

There is nothing new about the sad state of accounting for intangibles.   In a working paper entitled "The Measurement and Recognition of Intangible Assets:  Then and Now," Claire Eckstein from Fairleigh Dickinson University quotes the following footnote from 1928:

The Gold Dust Corporation
August 31, 1928

In view of the available surplus, and in the fact that the corporation carries its most valuable asset, viz, its goodwill at $1, and also because of the uncertain market value of industrial plants, it was concluded that it would be entirely approprate for the corporation to carry its plants in a similar manner as its goodwill, viz, at the nominal value of $1.

The FASB admits that accounting for intangibles is in a sad state in terms of providing relevant information to investors.  An agenda project has been created that is titled "Disclosure of Information about Intangible Assets not Recognized in Financial Statements."  Analysts bemoan the state of accounting for intangibles.  In April 2001, Fortune stated the following:

In the Fortune 500 there are thousands upon thousands of statistics that reveal very little
that's meaningful about the corporations they purportedly describe.  At least that's the
verdict of a growing number of forward-thinking market watchdogs, academics, accountants,
and others.  Convinced that accounting gives rotten information about the value of performance
in modern knowledge-intensive companies, they are proposing changes that would be
earthshaking to the profession.

Because so much of the problem rests in "knowledge intensive companies," Baruch Lev and others have come to view unrecognized intangibles as being synonymous with unrecognized "knowledge capital."

Measuring the Value of Intangibles and Valuation of the Firm

Knowledge Capital Valuation Factors (terminology adapted from Baruch Lev's writings)
Value Creators
  • Scalability
         Nonrivalry (e.g., the SABRE airline reservations system)
         Increasing Returns (due to initial fixed cost followed by low marginal cost)
  • Network Effects
         Positive Feedback ¨(customer discussion boards)
         Network Externalities (fast word of mouth)
         Industry Standard (Microsoft Windows)

Value Destroyers

  • Partial Excludability (training of employees who cannot be indentured servants)
         Fuzzy Property Rights
         Private vs. Social Returns (training that creates immense competition other nations)
  • Inherent Risk
         Sunk Cost
         Creative Destruction (Relational database and ERP destruction of COBOL systems)
         Volatility of value due to competition and technological change
         Risk Sharing (only a few products emerge as winners amidst a trail of road kill)
  • Non-tradability
         Contracting Problems
         Negligible Marginal Cost

A few years ago a hardback set of the thirty-two volumes of the Britannica cost $1,600…In 1992 Microsoft decided to get into the encyclopedia business…[creating] a CD with some multimedia bells and whistles and a user friendly front end and sold it to end users for $49.95…Britannica started to see its market erode…The company's first move was to offer on-line access to libraries at a subscription rate of $2,000 per year…Britannica continued to lose market share…In 1996 the company offered a CD version for $200…Britannica now sells a CD for $89.99 that has the same content as the thirty-two volume print version that recently sold for $1,600.
Shapiro and Varian (1999, pp. 19–20)

On November 14, 2002 the following links were provided at 

1. Announcement: Lev's Book: Intangibles-Management, Measurement and Reporting has been published by the Brookings Institution Press. Get your copy now at book stores and retailers.
2. Paper with Feng Gu: Intangible Assets, discussing Lev's methodology for measuring intangible assets.
- intangible-assets.doc
- intangibles-tables.ppt (Accompany Tables in Microsoft Powerpoint)

Paper with Feng Gu: Markets in Intangibles: Patent Licensing,
- patent-licensing.doc (Microsoft Word)
- patent-licensing-tables.doc (Microsoft Word)

4. April 16, 2001 - "Accounting Gets Radical" - Fortune
5. April 2001 - "Knowledge Capital Scoreboard: Treasures Revealed" - CFO online
6. May 10, 2001 - Interview with Baruch Lev - (in spanish)
7. May 14, 2001 - "How Do We Guage Value of New Web Technologies?" - Wall Street Journal
8. May 14, 2001 - "How do you value intangible assets?" - National Law Journal (No Online Version Available)
9. June 18, 2001 - "Taking Stock of a Company's Most Valuable Assets" - Business Week


There are all sorts of models for valuing an entire firm such that estimates of the value of unbooked items (goodwill) can be derived as the difference between the sum of the values of booked items and the entire value of the firm.  However, derivation of values of knowledge capital becomes confounded by the synergy effects. 

The major problem is all valuation models is that they entail forecasting into the future based upon extrapolations from past history.  This is not always a bad thing when forecasting in relatively stable industries and economic conditions.  The problem in modern times is that there are very few stable industries and economic conditions.  Equity values and underlying values of intangibles are impacted by highly unstable shifts in investor confidence in equity markets, manipulations of accounting reports, terrorism, global crises such as the Asian debt crises, emergence of China in the world economy, and massive litigation unknowns such as lawsuits regarding mold in buildings.  Forecasting the future from the past is easy in most steady-state systems.  It is subject to enormous error in forecasting in systems that are far from being in steady states.

The popular models for valuing entire firms include the following:

  • Valuation based upon analyst forecasts.  These alternatives have the advantages of being rooted in data outside what is reported under GAAP in financial statements.  Analysts may meet with top management and consider intangibles.  But there are also drawbacks such as the following:
  • The cart is in front of the horse.  When the purpose of accounting data is to help help investors and analysts set stock prices in securities markets, the forecasts of users (especially leading multiples) for valuation entails circular reasoning.
  • The recent scandals involving security analysts of virtually all major investment firms and brokerages makes us tend to doubt the objectivity and ability of analysts to make forecasts that are not self-serving.  See 
  • Analyst forecasts tend to be highly subjective.  Comparing them may be like finding the mean between a banana and a lemon.
  • Valuation using stock price multiples (usually limited to comparing firms in a given industry and adjusted for leverage).  Multiples can be based upon price forecasts (leading multiples) or past price trends (trailing multiples).  In either case, the valuations are suspect for the following reasons:
  • The cart is in front of the horse.  When the purpose of the valuation exercise is to help help investors set stock prices in securities markets, the use of stock prices (especially leading multiples) for valuation entails circular reasoning.
  • Use of the current prices of small numbers of shares traded is not the same as the per-share value of all the shares acquired in a single transaction.  This difference arises in part because acquiring control usually i
  • s far more valuable than the sum of the shares at current trading values.  This difference arises in part because current share prices are subject to transient market price movements of shares of all traded companies, whereas the value of the firm in a business combination deal is much more stable.  For example, Microsoft share prices have declined about 40% between Year 2000 and Year 2002, but it is not at all clear that the value of the firm and/or its knowledge capital value has declined so steeply in the bear market of securities pricing in Year 2002.
  • Present value valuation based upon forecasted dividends (usually including a forecasted dividend growth rate). 
    The problem with forecasted dividends is that firms have dividend policies that do not reflect future value.  For example, many firms do not pay dividends at all or their payout ratios are too small to be reflective of firm value.  There may be enormous dividends decades into the future, but these are too uncertain to be realistic for valuation purposes.  Another problem is that forecasted dividend models generally require the estimation of a "terminal value" of the firm, and this usually entails grasping for straws.
  • Discounted abnormal earnings and returns valuation (including Edwards-Bell-Ohlson (EBO) and Steward's EVA Models)
    Abnormal earnings  and returns valuation models generally use forcasted after-tax operating profits discounted at the firm's current weighted average cost of capital.   There are variations of methods such as the abnormal returns method, the abnormal earnings method, and the free cash flow method of valuing returns to debt and equity.   

    One of the nicer summaries of the EBO versus EVA models can be found in "Measuring Wealth," by Charles Lee, CA Magazine, April 1996, pp. 32-37 --- 

    The value of the firm depends on its ability to generate "abnormal earnings" above what can be earned in riskless or near-riskless investment alternatives.  There are immense problems in this valuation approach for the following reasons:
  • Empirical studies both before and after the Enron scandal indicate that earnings management is systemic and pervasive such that managers can manipulate abnormal earnings valuations with their earnings management policies (that are generally secret).
  • Earnings measures are subject to all the limitations of GAAP including the failure to expense employee stock options, inclusion of income on pension funds, write-off of R&D under FAS 2, and the expensing of expenditures for knowledge capital intended to benefit the future.  Actually, this problem is not as serious as it might seem at first blush since many of the accounting distortions wash themselves out over time if they are do to timing.  However, when the timing is long-term such as in the case of long-term R&D projects, distortions persist due to discounting.  For example, if a firm deducts $1 billion per year on a research project that may only start to pay off 15 or more years into the future, the conservatism badly distorts the discounted abnormal earnings and return valuation methods.
  • Abnormal earnings and returns valuation models implicitly assume firms that carry massive amounts of excess cash, beyond what is needed for year-to-year operations, distribute the excess cash as dividends to owners.  This just is not the case in some firms like Microsoft that carry huge cash reserves.  As a result, abnormal earnings and returns valuation methods must take this into account since abnormal earnings do not accrue to free cash reserves.
MicrosoftAssets00.jpg (18291 bytes)
  • Real Options
    There are various valuation methods that are less widely used.  One of these is the Real Options approach that shows some promise even though it is still quite impractical.  See 

  • Market Transaction
    On rare occasion, a portion of a company's knowledge capital is sold in market transactions that give clues about total value.  The sale of a portion of the SABRE system by American Airlines is an excellent example of a clue to the immense value of this   unbooked asset on the balance sheet..  The problem with this is that market price of a portion of the SABRE system ignores the synergy values of the remaining portion still owned by AMR.

In the final analysis, the most practical approach to date is to attempt to forecast the revenues and/or cost savings attributable to major components of intellectual capital.   This is much easier in the case of software and systems such as the SABRE system than it is in components like human resources where total future benefits are virtually impossible to drill down to present values at particular points in time.

The valuation of intangibles will probably always be subject to enormous margins of error and risk.

One way to help financial statement users analyze intangibles would be to expand upon the interactive spreadsheet/database approach currently used by Microsoft Corporation for making forecasts.  Although this approach is not currently used by Microsoft for detailed analysis of intangibles, we can envision how knowledge capital components might be expanded upon in a way that financial statement users themselves can make assumptions and then analyze the aggregative impacts of those assumptions.  Click on the Following from 

FY 2003 Microsoft "What-if?" (193 KB) Do your own forecasting for Microsoft’s FY 2003 income statements based on your assumptions with this Excel projection tool --- 

Pivot tables might also be useful for slicing and dicing information about intangibles.  Although Microsoft does not employ this specifically for analysis of intangibles, the approach used at the following link might be extended for such purposes:

Financial History PivotTable (122 KB) Allows you to view and analyze historical Microsoft financial data.  For example, you can look at income statement line items dating back to 1985 --- 

Click here to view references on intangibles 

FAS 141 and the Question of Value By PricewaterhouseCoopers CFOdirect Network Newsdesk, January 16, 2003 --- 

Just as early reactions to FAS 142 seemed to have overlooked the complexities in reviewing and testing goodwill for impairment, so too have reactions to complying with the Financial Accounting Standards Board's Statement No. 141 – Business Combinations.

Adopted and issued at the same time as Statement No. 142 in the summer of 2001, the headline news about FAS 141 was the elimination of the Pooling-of-Interest accounting method in mergers and acquisitions. Going forward from June 30, 2001, all acquisitions are to be accounted for using one method only – Purchase Accounting.

This change is significant and one particular aspect of it – the identification and measurement of intangible assets outside of goodwill – seems to be somewhat under-appreciated.

Stephen C. Gerard, Managing Director at Standard & Poor's Corporate Value Consulting, says that there is "general conceptual understanding of Statement 141 by corporate management and finance teams. But the real impact will not be felt until the next deal is done." And that deal in FAS 141 parlance will be a "purchase" since "poolings" are no longer recognized.

Consistent M&A Accounting

The FASB, in issuing Statement No. 141, concluded that "virtually all business combinations are acquisitions and, thus, all business combinations should be accounted for in the same way that other asset acquisitions are accounted for – based on the values exchanged."

In defining how business combinations are to be accounted for, FAS 141 supersedes parts of APB Opinion No. 16. That Opinion allowed companies involved in a merger or acquisition to use either pooling-of-interest or purchase accounting. The choice hinged on whether the deal met 12 specified criteria. If so, pooling-of-interest was required.

Over time, "pooling" became the accounting method of choice, especially in "mega-deal" transactions. That, in the words of the FASB, resulted in "…similar business combinations being accounted for using different methods that produced dramatically different financial statement results."

FAS 141 seeks to level that playing field and improve M&A financial reporting by:
    • Better reflecting the investment made in an acquired entity based on the values exchanged.
    • Improving the comparability of reported financial information on an apples-to-apples basis.
    • Providing more complete financial information about the assets acquired and liabilities assumed in business combinations.
    • Requiring disclosure of information on the business strategy and reasons for the acquisition.

When announcing FAS 141, the FASB wrote: "This Statement requires those (intangible assets) be recognized as assets apart from goodwill if they meet one of two criteria – the contractual-legal criterion or the separability criterion."

Unchanged by the new rule are the fundamentals of purchase accounting and the purchase price allocation methodology for measuring goodwill: that is, goodwill represents the amount remaining after allocating the purchase price to the fair market values of the acquired assets, including recognized intangibles, and assumed liabilities at the date of the acquisition.

"What has changed," says Steve Gerard, "is the rigor companies must apply in determining what assets to break out of goodwill and separately recognize and amortize."

Thus, in an unheralded way, FAS 141 introduces a process of identifying and placing value on intangible assets that could prove to be a new experience for many in corporate finance, as well as a costly and time-consuming exercise. Nonetheless, an exercise critical to compliance with the new rule.

Continued at  


Intangibles:  An Accounting Paradox

An Accounting Paradox

If you are following the accounting saga following the implosion of Enron and Andersen, I strongly recommend the Summer 2002, Volume 21, Number 2 of the Journal of Accounting and Public Policy --- 

Enron:  An Accounting Perspective

  • Reforming corporate governance post Enron: Shareholders' Board of Trustees and the auditor 97 -- 103 
    A.R. Abdel-khalik
  • Enron: what happened and what we can learn from it pp. 105 -- 127 
    G.J. Benston, A.L. Hartgraves
  • Enron et al.--a comment pp.129 -- 130 
    J.S. Demski
  • Where have all of Enron's intangibles gone? pp.131 -- 135 
    Baruch Lev
  • Enron: sad but inevitable pp.137 -- 145 
    L. Revsine
  • Regulatory competition for low cost-of-capital accounting rules pp.147 -- 149 
    S. Sunder

Regular Paper

  • How are loss contingency accruals affected by alternative reporting criteria and incentives? pp. 151 -- 167 
    V.B. Hoffman, J.M. Patton

Where were Enron's intangible assets?  In particular, what was its main intangible asset that has been overlooked in terms of accounting for intangibles?


Answer by Baruch Lev:

Baruch Lev Quote from Page 131 (from the reference above)

On December 31, 2000, Enron's market value was $75.2 billion, while its book value (balance sheet equity) was $11.5 billion.  The market-to-book gap of almost $64 billion, while not equal to the value of intangibles (it reflects, among other things, differences between current and historical-cost values of physical assets), appears to indicate that Enron had substantial intangibles just half a year before it started its quick slide to extinction.  This naturally raises the questions: Where are Enron's intangibles now?  And even more troubling: Why did not those intangibles--a hallmark of modern corporations--prevent the firm's implosion?  In intangibles are "so good", as many believe, why is Enron's situation "so bad"?

Baruch Lev Quite beginning on Page 133 (from the reference above)

So the answer to the question posed at the opening of this note--where have Enron's intangible gone?--is a simple one: Nowhere.  Enron did not have substantial intangibles, that is, if hype, glib, and earnings manipulation did not count as intangibles.  Which, of course, also answers the second question--why did not the intangibles prevent Enron's implosion.

Back to Greenspan's comment about the fragility of intangibles: "A physical asset, whether an office building or an automotive assembly plant, has the capability of producing goods even if the reputation of the managers of such facilities falls under a cloud.  The rapidity of Enron's decline is an effective illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation."  Intangibles are indeed fragile, more on this later, but "true" intangibles are not totally dependent on managers' reputation.  IBMs management during the 1980s and early 1990s drove the company close to bankruptcy, and was completely discredited (though not ethically, as Enron's).  But IBMs intangibles--innovation capabilities and outstanding services personnel--were not seriously harmed.  Indeed, under Lou Gerster's management (commencing in 1993), IBM made an astounding comeback.  Hypothetically, would a tarnished reputation of Microsoft, Pfizer, or DuPont's management destroy the ability of these similarly innovative companies to continuously introduce new products and services and maintain dominant competitive positions?  Of course not.  Even when companies collapse, valuable patents, brands, R&D laboratories, trained employees, and unique information systems will find eager buyers.  Once more, Enron imploded, and its trading activities "acquired" for change not because its intangibles were tied to management's reputation, but partly, because it did not have any valuable intangibles--unique factors of production--that could be used by successor managers to resuscitate the company and create value.

Finally, to the fragility of intangibles.  As I elaborate elsewhere,3 along with the ability of intangible assets to create value and growth, comes vulnerability, which emanates from the unique attributes of these factors of production:

Partial excludability (spillover): The inability of owners of intangible assets to completely appropriate (prevent non-owners from enjoying) the benefits of the assets.  Patents can be "invented around", and ultimately expire; trained employees often move to competitors, and unique organizational structures (e.g., just-in-time production) are imitated by competitors.

Inherently high risk: Certain intangible investments (e.g., basic research, franchise building for new products) are riskier than most physical and financial assets.  The majority of drugs under development do not make it to the market, and most of the billions of dollars spent by the dotcoms in the late 1990s to build franchise (customer base) were essentially lost.

Nonmarketability: Market in intangibles are in infancy, and lack transparency (there are lots of patent licensing deals, for example, but no details released to the public).  Consequently, the valuation of intangible-intensive enterprises is very difficult (no "comparables"), and their management challenging.

Intangibles are indeed different than tangible assets, and in some sense more vulnerable, due to their unique attributes.  Their unusual ability to create value and growth comes at a cost, at both the corporate and macroeconomy level, as stated by Chairman Greenspan: "The difficulty of valuing firms that deal primarily with concepts and the growing size and importance of these firms may make our economy more susceptible to this type of contagion".  Indeed, intangible-intensive firms are "growing in size and importance", a fact that makes the study of the measurement, management, and reporting of intangible assets so relevant and exciting, irrespective of Enron the intangibles-challenged sorry affair.


Answer by Bob Jensen

I have to disagree with Professor Lev with respect his statement:  " Enron did not have substantial intangibles."  I think Enron, like many other large multinational corporations, invested in a type of intangible asset that has never been mentioned to my knowledge in the accounting literature.  Enron invested enormously in the intangible asset of political power and favors.  There are really two types of investments of this nature for U.S. based corporations:

  1. Investments in bribes and political contributions allowed under U.S. law, including the Foreign Corrupt Practices Act (FCPA)

  2. Investments in bribes and political contributions not allowed under U.S. law, including the Foreign Corrupt Practices Act (FCPA)

I contend that large corporate investment in political power is sometimes the main intangible asset of the company.  This varies by industry, but political favors are essential in agribusiness, pharmaceuticals, energy, and various other industries subject to government regulation and subsidies.  Enron took this type of investment to an extreme in both the U.S. and in many foreign nations.  Many of Enron's investments in political favors appear to violate the FCPA, but the FCPA is so poorly enforced that it seldom prevents huge bribes and other types of investments in political intangibles.

I provide you with several examples below.

Two Examples of Enron's Lost Millions in Political Intangibles
India and Mozambique:  Enron Invests in U.S. Government Threats to Cut Off  Foreign Aid

1995'S 10 WORST

by Russell Mokhiber and Andrew Wheat 


The module about Enron in 1995 reads as follows:

Enron's Political Profit Pipeline

In early 1995, the world's biggest natural gas company began clearing ground 100 miles south of Bombay, India for a $2.8 billion, gas-fired power plant -- the largest single foreign investment in India.

Villagers claimed that the power plant was overpriced and that its effluent would destroy their fisheries and coconut and mango trees. One villager opposing Enron put it succinctly, "Why not remove them before they remove us?"

As Pratap Chatterjee reported ["Enron Deal Blows a Fuse," Multinational Monitor, July/August 1995], hundreds of villagers stormed the site that was being prepared for Enron's 2,015-megawatt plant in May 1995, injuring numerous construction workers and three foreign advisers.

After winning Maharashtra state elections, the conservative nationalistic Bharatiya Janata Party canceled the deal, sending shock waves through Western businesses with investments in India.

Maharashtra officials said they acted to prevent the Houston, Texas-based company from making huge profits off "the backs of India's poor." New Delhi's Hindustan Times editorialized in June 1995, "It is time the West realized that India is not a banana republic which has to dance to the tune of multinationals."

Enron officials are not so sure. Hoping to convert the cancellation into a temporary setback, the company launched an all-out campaign to get the deal back on track. In late November 1995, the campaign was showing signs of success, although progress was taking a toll on the handsome rate of return that Enron landed in the first deal. In India, Enron is now being scrutinized by the public, which is demanding contracts reflecting market rates. But it's a big world.

In November 1995, the company announced that it has signed a $700 million deal to build a gas pipeline from Mozambique to South Africa. The pipeline will service Mozambique's Pande gas field, which will produce an estimated two trillion cubic feet of gas.

The deal, in which Enron beat out South Africa's state petroleum company Sasol, sparked controversy in Africa following reports that the Clinton administration, including the U.S. Agency for International Development, the U.S. Embassy and even National Security adviser Anthony Lake, lobbied Mozambique on behalf of Enron.

"There were outright threats to withhold development funds if we didn't sign, and sign soon," John Kachamila, Mozambique's natural resources minister, told the Houston Chronicle. Enron spokesperson Diane Bazelides declined to comment on the these allegations, but said that the U.S. government had been "helpful as it always is with American companies." Spokesperson Carol Hensley declined to respond to a hypothetical question about whether or not Enron would approve of U.S. government threats to cut off aid to a developing nation if the country did not sign an Enron deal.

Enron has been repeatedly criticized for relying on political clout rather than low bids to win contracts. Political heavyweights that Enron has engaged on its behalf include former U.S. Secretary of State James Baker, former U.S. Commerce Secretary Robert Mosbacher and retired General Thomas Kelly, U.S. chief of operations in the 1990 Gulf War. Enron's Board includes former Commodities Futures Trading Commission Chair Wendy Gramm (wife of presidential hopeful Senator Phil Gramm, R-Texas), former U.S. Deputy Treasury Secretary Charles Walker and John Wakeham, leader of the House of Lords and former U.K. Energy Secretary.


United States Deregulation of Energy That Needed a Change in the Law:  Enron's Investment in Wendy Gramm

Forwarded by Dick Haar on February 11, 2002

Senator Joseph Leiberman 
706 Hart Senate Office Building 
Washington, D.C. 20510

RE: Enron Investigation

Dear Senator Leiberman,

I watched your Sunday morning appearance on Face the Nation with intense interest. Inasmuch as I own a fair amount of Enron stock in my SEP/IRA, I'm sure you can understand my curiosity relative to your investigation.

Knowing you to be an honorable man, I feel secure that you will diligently pursue the below listed matters in an effort to determine what part, if any, these matters contributed to the collapse of Enron.

1. Government records reveal the awarding of seats to Enron executives and Ken Lay on four Energy Department trade missions and seven Commerce Department trade trips during the Clinton administration's eight years.

a. From January 13, 1995 through June 1996, Clinton Commerce Secretary Ron Brown and White House Counsel Mack McLarty assisted Ken Lay in closing a $3 billion dollar power plant deal with India. Four days before India gave final approval to the deal, Enron gave $100,000 to the DNC. Any quid pro quo?

b. Clinton National Security Advisor, Anthony Lake, threatened to withhold aid to Mozambique if it didn't approve an Enron pipeline project. Subsequent to Mr. Lake's threats, Mozambique approved the project, which resulted in a further $770 million dollar electric power contract with Enron. Perhaps, if NSA Advisor Lake had not been so busy strong-arming for Enron, he might have been focused on something obliquely related to national security like, say, Mr. Bin Laden? Could it be that a different, somewhat related, investigation is warranted?

c. In 1999, Clinton Energy Secretary Bill Richardson traveled to Nigeria and helped arrange a joint, varied, energy development program which resulted in $882 million in power contracts for Enron from Nigeria. Perhaps if Energy Scretary Richardson had been more focused on domestic energy, we might have avoided:

i. The severe loss of nuclear secrets to China and concurrently ii. developed more domestic sources of energy.

d. Subsequent to leaving Clinton White House employ, Enron hired Mack McLarty (White House Counsel), Betsy Moler (Deputy Energy Secretary) and Linda Robertson (Treasury Official). Even a person without a high school diploma (no disrespect to airline security screeners) can see that this looks like Enron paying off political favors with fat-cat corporate jobs, at the expense of stockholders and Enron pension employees.

e. Democratic Mayor Lee P. Brown of Houston (Enron headquarter city), received $250,000 just before Enron filed Chapter 11 bankruptcy. Isn't that an awful lot of money to throw away right before bankruptcy?

The Democratic National Committee was the recipient of hundreds of thousands of dollars from 1990 through 2000. The above matters appear to be very troubling and look like, smack of, reek of, political favors for campaign payoffs. I know you will find out.

2. Recently, former Clinton Treasury Secretary Robert Rubin called a top U. S. Treasury official, asking on Enron's behalf, for government help with credit agencies. As you well know, Rubin is the chairman of executive committee at Citigroup, which just coincidentally, is Enron's largest unsecured creditor at an estimated $3 billion dollars.

3. As you well know, Mr. Leiberman, Citigroup is Senator Tom Daschle's largest contributor ($50,000) in addition to being your single largest contributor ($112,546). This fact brings to mind some disturbing questions I feel you must answer.

a. Have you, any member of your staff, any Senate or House colleagues, any relatives or any friends of yours, been asked by Citigroup to intercede on their behalf, in an effort to recover part or all of Citigroup's $3 billion, at the expense of Enron's shareholders, employees and or Enron pensioners?

b. Did your largest contributor, Citigroup, have anything to do with the collapse of Enron?

c. Enron has tens of thousands of employees, stockholders and pensioners who have lost their life savings. How will you answer their most obvious question? Do you represent Citigroup, your largest contributor, or do you represent the Enron employees, et al, who stand to lose if Citigroup recovers any of its $3 billion?

During Sunday's Face the Nation, both you and Senator McCain praised Attorney General Ashcroft for recusing himself from the Justice Department investigation because he had once received a contribution from Enron. I know in my heart, that, being the honest gentleman you are, you will now recuse yourself because of the glaring conflict of interest described above. I also know that you will pass this letter to your successor for his or her attention.

Very truly yours,

Robert Theodore Knalur

Also see:  "Where Was Enron Getting a Return for Its Political Bribes?" at 

The extent to which Enron's investments and alleged investments in current and future political favors actually resulted in political favors will never be known.  Clearly, Enron invested in some enormous projects such as the $3 billion power plant in India knowing full well that the investment would be a total loss without Indian taxpayer subsidies.  Industry in India just could not pay the forward contract gas rates needed to run the plant.  

Enron executives intended that purchased political influence would make it one of the largest and most profitable companies in the world.  In the case of India, the power plant became a total loss, because the tragedy of the September 11 terror made the U.S. dependent upon India in its war against the Taliban.  Even if the White House leaders had been inclined to muscle the Indian government to subsidize power generated from the new Enron plant in India, the September 11 tragedy destroyed  Enron's investment in political intangibles and its hopes to fire up its $3 billion gas-fired power plant in India.  The White House had greater immediate need for India's full support in the war against the Taliban.

The point here is not whether Enron money spent for political favors did or did not actually result in favors.  The point is that to the extent that any company or wealthy employees invest heavily for future political favors, they have invested in an intangible asset and have taken on the intangible risk of loss of reputation and money if some of these investments become discovered and publicized in the media.  In fact, discovery and disclosure will set government officials scurrying to avoid being linked to political payoffs.

Enron is a prime example of a major corporation focused almost entirely upon turning political favors into revenues, especially in the areas of energy trading and foreign power plant construction.  As such, these investments are extremely high risk.  

It is doubtful that political intangibles will ever be disclosed or accounted for except in the case of bankruptcy or other media frenzies like the Enron media frenzies.  

Accountants and auditors face an enormous task of disclosing and accounting for political intangibles.

Because disclosures and accounting of political intangibles will likely destroy their value.  Generally, accounting for assets does not destroy those assets.  This is not the case for many types of political intangibles that cost millions upon millions of dollars in corporations.

August 28, 2002 reply from Craig Polhemus [Joedpo@AOL.COM

-----Original Message----- 
From: Craig Polhemus [mailto:Joedpo@AOL.COM]  
Sent: Wednesday, August 28, 2002 1:55 AM 
Subject: Re: An Accounting Paradox: When will accounting for an asset destroy the asset?

Bob Jensen writes:

<<Question: Accountants and auditors face an enormous task of disclosing and accounting for political intangibles.

Answer: Because disclosures and accounting of political intangibles will likely destroy their value. Generally, accounting for assets does not destroy those assets. This is not the case for many types of political intangibles that cost millions upon millions of dollars in corporations.>>

Interesting. There are many instances where the reverse is true -- the marketing value to a lobbying firm of having made large contributions to the winning candidates (of whatever party) is greatest where it is well known. This applies regardless whether the contributions came from individual partners or (at least in those states where it's legal for state and local elections) from the firm itself.

Even on a local level, if you're in a jurisdiction where judges are elected, would you prefer to go to a lawyer who contributed to the successful judge or to one who did not? I have a friend who asks this question directly whenever he's seeking local counsel. And if you're that lawyer, do you want that contribution to be secret or as public as possible? Maybe even exaggerated?

Dita Beard is a classic example -- her initial "puffery" [whether truthful, partially truthful, or entirely false] about getting the IT&T antitrust case dropped based on a pledge of IT&T funding to support moving the 1972 Republican National Convention to Miami was a marketing aid to her ONLY if she let it be known, at least to her clients and potential clients.

Similarly, Ed Rollins writes of a foreign "contributor" who apparently passed a million in cash to a middleman and thought it made it to the Reagan re-election campaign. Rollins believes the middleman (an unnamed Washington lawyer, by the way) held on to it all but the "contributor" felt he'd purchased access, and certainly the middleman benefited not just financially but also from the contributor's belief that the middleman had provided direct access to the campaign and hence the Administration.

I express no opinion on how such things should be recorded in financial statements -- I'm just pointing out that publicity about large political contributions to successful candidates (whether within or exceeding legal limits) can be positive for some businesses, such as lobbying firms.

Craig [Craig Polhemus, 
Association Vitality International]

August 28, 2002 reply from Bob Jensen

Great to hear from you Craig.

I agree that sometimes the accounting and/or media disclosure of investments in political favors may increase the value of those investments. Or it may have a neutral effect in some industries like agribusiness and oil where the public has come to expect that members of Congress and/or the Senate are heavily dependent upon those industries for election to office and maintenance of their power.

On the other hand, it is unlikely that accounting and media disclosure of the Enron investments in political favors, including the favors of linking foreign aid payments to Enron's business deals, would have either a positive or neutral impact upon the expected value of those political favors to Enron.

It is most certain that accounting and media disclosure political investments that are likely to violate the Foreign Corrupt Practices Act would deal a severe blow to the value of those intangible assets.


Bob Jensen

August 28 reply from 

I think companies have invested a great deal in political intangibles outside the arena of government. Consider the current discussions on the importance of expensing stock option expensing as an example. Views are strong and vary widely on the issue but clearly, these positions exist only to gain visibility and increase political pressure.

On the side that believes CPA stands for 'can't prove anything' we find the speech to the Stanford Director's College on June 3, 2002 by T. J. Rodgers, CEO of Cypress. Mr. Rodgers refers to expensing options as "...the next mistake..." and refers to "...accounting theology vs. business reality...." He opposes the Levin- McCain proposal and recounts the story you have on your website of the 1994 political storm in Silicon Valley when the FASB proposed expensing options. He believes that the free market will eliminate any abuse of option accounting. Contrast that with the opposition represented in the July 24, 2002 letter to CEOs from John Biggs at TIAA-CREF. Mr. Biggs also derides the profession by labeling APB 25 as an "...archaic method..." and that its use has the effect of “…eroding the quality of earnings…” by encouraging “…the use of one form of compensation.” Mr. Biggs completes his letter by equating option expensing to management credibility. Both of these men have made political investments with their comments, drawing lines in the sand. While the remarks were not made directly to any political body, and there is no tangible cost involved, this is still political pressure. It is also interesting both men focus on the accounting profession as the root cause rather than the value of the political intangibles that exist only in market capitalization.

Consider how companies build political intangibles with analysts, institutional shareholders and others. ADP had an extended string of increased quarterly earnings – over 100 consecutive quarters. The PE multiple for the stock has been high for some time, due in no small part to the consistency of this trend. ADP management reminded shareholders with every quarter how long they had provided shareholders with higher earnings. When that streak recently ended, the stock dropped like a stone. Closing price moved down from $41.35 on July 17, 2002 to $31.60 the next day. The volume associated with that change was almost nine times the July 16 trading volume. How would anyone explain this event other than a reversal of political intangibles that did not exist on the financial statements?

Power and politics are always with us. We just have to be smart enough to know which is for show and which is for $$$. (By the way, if you have a way to tell them apart, let me know.)

August 28 reply from E. Scribner [escribne@NMSU.EDU

Hi, Bob and Craig! 
You've discovered an accounting application of Heisenberg's uncertainty principle, which originated with the notion that to "see" an electron's position we have to "illuminate" it, which causes it to shift its position so it's not "there" any more. To quote from the American Insitutute of Physics ( ), "At the moment the light is diffracted by the electron into the microscope lens, the electron is thrust to the right."

When we "illuminate" political intangibles by disclosing them, they are not "there" any more.

Ed Scribner 
New Mexico State University
 Las Cruces, NM, USA ---

August 28, 2002 Reply from Bob Jensen
Heisenberg's Theory Song
"My get up and go got up an went."  

 August 28, 2002 reply from Richard C. Sansing [Richard.C.Sansing@DARTMOUTH.EDU

There is an extensive literature on the economics of information. The Analytics of Uncertainty and Information by Jack Hirshleifer and John Riley is a good survey. Chapters 6 (The economics of emergent public information) and 7 (Research and invention) address the issues of the value of private information and the effects of disclosure on its value.

Heisenberg's uncertainty principle both "originated" and (for practical purposes) terminated with the behavior of electrons and other sub-atomic particles. It applies to the joint indeterminacy of the position and momentum of electrons. It is only significant at the atomic level because Planck's constant is so small.

Richard C. Sansing 
Associate Professor of Business Administration 
Tuck School of Business at Dartmouth 



The Controversy over Accounting for Securitizations and Loan Guarantees

Accounting for Loan Guarantees

FASB Issues Accounting Guidance to Improve Disclosure Requirements for Guarantees --- 

Accounting and Auditing Policy Committee Credit Reform Task Force --- 

The new FAS 146 Interpretation 46 deals with loan guarantees of Variable Interest (Special Purpose) Entities --- at:

From The Wall Street Journal Accounting Educators' Review on November 15, 2002

TITLE: H&R Block's Mortgage-Lending Business Could Be Taxing 
REPORTER: Joseph T. Hallinan 
DATE: Nov 12, 2002 
TOPICS: Accounting, Bad Debts, Cash Flow, Debt, Loan Loss Allowance, Securitization, Valuations

SUMMARY: H&R Block's pretax income from mortgage operations grew by 146% during the fiscal year ending April 30, 2002. However, the accounting treatment for the securitization of these mortgages is being questioned.

1.) Describe the accounting treatment used by H&R Block for the sale of mortgages. Why is this accounting treatment controversial?

2.) What alternative accounting methods are available to record H&R Block's sale of mortgages? Discuss the advantages and disadvantages of each accounting treatment. Which accounting method is most conservative?

3.) Why do companies, such as H&R Block, sell mortgages? Why does H&R Block retain the risks of non-payment? How could the sale be structured to transfer the risks of non-payment to the purchaser of the mortgages? How would this change the selling price of the mortgages? Support your answer.

4.) How do economic conditions change the expected losses that will result from non-payment? How does the credit worthiness of borrowers change the expected losses that will result from non-payment? Support your answers.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"H&R Block Faces Issues With Mortgage Business," by Joseph T. Hallinan, The Wall Street Journal,  November 12, 2002, Page C1 ----,,SB103706997739674188.djm,00.html

Famous for its tax-preparation service, H&R Block Inc. last year prepared 16.9 million individual income-tax returns, or about 14% of all individual returns filed with the Internal Revenue Service.

But the fastest-growing money maker for the Kansas City, Mo., company these days is its mortgage business, which last year originated nearly $11.5 billion in loans. The business, which caters to poor credit risks, has been growing much faster than its U.S. tax business. In the fiscal year ended April 30, Block's pretax income from mortgage operations grew 146% over the year before. The tax business, while still the largest in the U.S., grew just 23%.

If those rates remain unchanged, the mortgage business will this year for the first time provide most of Block's pretax income. In the most-recent fiscal year, mortgage operations accounted for 47.3% of Block's pretax income.

As Block's mortgage business has soared, so has its stock price, topping $53 a share earlier this year from less than $15 two years ago, though it has dropped in recent months as investors have fretted about the cost of lawsuits in federal court in Chicago and state court in Texas on behalf of tax clients who received refund-anticipation loans. But now, some investors and analysts are raising questions about the foundation beneath Block's mortgage earnings. "The game is up if interest rates rise and shut off the refinancing boom," says Avalon Research Group Inc., of Boca Raton, Fla., which has a "sell" rating on Block's shares.

On Monday, the shares were up $1.53, or 4.8%, to $33.63 in 4 p.m. New York Stock Exchange composite trading -- a partial snapback from a $3.25, or 11%, drop on Friday in reaction to the litigation in Texas over fees H&R Block collected from customers in that state.

The company dismisses concerns about its mortgage results. "We think it's a great time for our business right now," says Robert Dubrish, president and CEO of Block's mortgage unit, Option One Mortgage Corp.

Much of Block's mortgage growth has come because the company uses a fairly common but controversial accounting treatment that allows it to accelerate revenue, and thus income. This treatment, known as gain-on-sale accounting, has come back to haunt other lenders, including Conseco Inc. and AmeriCredit Corp. At Block, gains from sales of mortgage loans accounted for 62% of revenue at the mortgage unit last year.

In essence, under gain-on-sale accounting, lenders post upfront the estimated profit from a securitization transaction, which is the sale to investors of a pool of loans. Specifically, the company selling the loans records profit for the excess of the sales price and the present value of the estimated interest income that is expected to be received on the loans above the amounts funded on the loans and the present value of the interest agreed to be paid to the buyers of the loan-backed securities.

But if the expected income stream is cut short -- say, because more borrowers refinance their loans than expected when the profit was calculated -- the company essentially has to reverse some of the gain, taking a charge.

That is what happened at Conseco. The Carmel, Ind., mobile-home lender was forced to take a $350 million charge in 1998 after many of its loans were paid off early. It stopped using gain-on-sale accounting the following year, saying that the "clear preference" of investors was traditional loan accounting. AmeriCredit in Fort Worth, Texas, which lends money to car buyers with poor credit histories, abandoned the practice in September in the midst of a meltdown of its stock price.

But Block says it faces nowhere near the downside faced by AmeriCredit and Conseco, which it says had different business models. Big Block holders seem to agree. "Block doesn't have anywhere near the scale of exposure [to gain on sale] that the other companies had," says Henry Berghoef, co-manager of the Oakmark Select mutual fund, which owns 7.7 million, or about 4.3%, of Block's shares.

Another potential problem for Block is the way it treats what is left after it sells its loans. The bits and pieces that it keeps are known as residual interests. Block securitizes most of these residual interests, allowing it to accelerate a significant portion of the cash flow it expects to receive rather than taking it over the life of the underlying loans. The fair value of these interests is calculated by Block considering a number of factors, such as expected losses on its loans. If Block guesses wrong, it could be forced to take a charge down the road.

Block says its assumptions underlying the valuation of these interests are appropriately conservative. It estimates lifetime losses on its loan pools at roughly 5%, which it says is one percentage point higher than the 4% turned in by its worst-performing pool of loans. (Comparable industry figures aren't available.) So Block says the odds of a write-up are much greater than those of a write-down and would, in a worst-case scenario that it terms "remote," probably not exceed $500 million. Block's net income for the fiscal year ended April 30 was $434.4 million, or $2.31 a share, on revenue of $3.32 billion.

Block spokeswoman Linda McDougall says gain-on-sale provides an "insignificant" part of the company's revenue. She notes that Option One, Block's mortgage unit, recently increased the value of its residual interest by $57 million. She also says that the company's underwriting standards are typical of lenders who deal with borrowers lacking pristine credit histories.

Bears contend that Block has limited experience in the mortgage business. It bought Option One in 1997, and Option One in Irvine, Calif., has itself been in business only since 1993. So its track record doesn't extend to the last recession of 1990 to 1991.

On top of that, Block lends to some of the least creditworthy people, known in the trade as "subprime" borrowers. There is no commonly accepted definition of what constitutes a subprime borrower. One shorthand measure is available from credit-reports firm Fair, Isaac & Co. It produces so-called FICO scores that range from 300 to 850, with 850 being perfect. Anything less than 660 is usually considered subprime. Securities and Exchange Commission documents filed by Block's mortgage unit show its borrowers typically score around 600. Moreover, according to the filings, hundreds of recent Block customers, representing about 4% of borrowers, have FICO scores of 500 or less, or no score at all. A score below 500 would place an applicant among the bottom 5% of all U.S. consumers scored by Fair Isaac.

Mr. Dubrish says Block stopped lending to people with FICO scores below 500 some two years ago and says he is puzzled as to why those with scores below 500 still appear in the company's loan pools.

Block says its loans typically don't meet the credit standards set by Fannie Mae or Freddie Mac, which are the lending industry's norms. Block's customers may qualify for loans even if they have experienced a bankruptcy in the previous 12 months, according to underwriting guidelines it lists in the SEC documents.

In many cases, according to Block's SEC filings, an applicant's income isn't verified but is instead taken as stated on the loan application. In other cases, an applicant with a poor credit rating may receive an upgraded rating, depending on factors including "pride of ownership." Most Block mortgages are for single-family detached homes, but Block also makes mobile-home loans, according to the filings.

"We are doing a lot to help people own houses who wouldn't have the chance to do it otherwise," Mr. Dubrish says. "We think we're doing something that's good for the economy and good for our borrowers."

A key figure in the mortgage business is the ratio of loan size to value of the property being mortgaged. Loans with LTV rates above 80% are thought to present a greater risk of loss. The LTV on many of Block's mortgages is just under 80%, according to the SEC filings. The value of these properties can be important if Block is forced to foreclose on the loans and resell the properties. Nationwide, roughly 4.17% of subprime mortgage loans are in foreclosure, according to LoanPerformance, a research firm in San Francisco. As of June 30, only 3.52% of Block's loans, on a dollar basis, were in foreclosure, even though its foreclosure ratio more than tripled between Dec. 31, 1999, and June 30.

The Controversy Over Pro Forma Reporting and HFV

Up Up and Away in My Beautiful Pro Forma

GAAP vs. Non-GAAP Earnings
"Investors Applaud Oracle’s Non-GAAP Earnings," AccountingWeb, July 1. 2005 ---

SOX Regulation G, which went into effect in March 2003, defines non-GAAP (Generally Accepted Accounting Principles) financial measures and creates disclosure standards for them. According to Strategic Finance magazine, the guidelines for non-GAAP financial measures stipulate that they may not:

“The rapid integration of PeopleSoft into our business contributed to the strong growth in both applications sales and profits that we saw in the quarter,” Oracle President Safra Catz said in a written statement. “The combination of increased organic growth plus a carefully targeted acquisition strategy have pushed Oracle’s revenue and profits to record levels.”


"Little Bitty Cisco," by Jesse Eisinger, The Wall Street Journal, November 6, 2003 ---,,SB106806983279057200,00.html?mod=technology%255Ffeatured%255Fstories%255Fhs 

The way Wall Street eyes these things, including the liberal use of the words "pro forma," Cisco had an impressive fiscal first quarter.

Revenue came in better than expected and grew 5.3% compared with a year ago, topping expectations of a flat top-line thanks in part to spending from the federal government (see article). How impressive is this? Well, the country's economy grew at 7.2%, and business spending on equipment and software rose 15%. Microsoft had revenue growth of 6%, IBM 8.6%, and Dell is estimated to come in at 15% growth. So Cisco Systems, one of the big tech dogs, looks like the runt of that particular litter. Is networking a growth industry anymore, or is it doomed to be troubled by overcapacity and a lack of business demand? The next few quarters are crucial.

Earnings per share -- that is, pro forma earnings per share -- easily surpassed estimates, logging in at 17 cents a share, compared with the expectation of 15 cents a share and last year's 14 cents.

The company's shareholder equity fell in the quarter to $27.4 billion from $28 billion a year ago. Cash flow from operations fell to $973 million from $1.1 billion a year earlier. Cash on hand and investments fell from $20.7 billion to $19.7 billion, which is still mountainous but lower year-over-year, nevertheless.

Then there is the gross-margin story. Cisco has had Himalayan gross margins throughout the slowdown, because it was able to squeeze suppliers and find efficiencies. But now that revenue is finally increasing, gross margins fell. Product gross margins came in at 69%, down from 71% in the fourth quarter. Cisco is selling less profitable products, including some from its recent acquisition of Linksys. It also has outsourced much of its production. How much operating leverage does Cisco now have? That is the reason it sports its high valuation, after all.

Then there is the outlook. Deferred revenue and backlog were down. Cisco's book-to-bill ratio, a measure that reflects order momentum, was below one. When book-to-bill is below one, orders are lower than billings, suggesting a slowdown, not acceleration. True, Cisco put out a forecast for modestly higher revenue for the second quarter compared with the first. But some questions should linger.

Question:  How does former Enron CEO Jeff Skilling define HFV?
Home Video Uncovered by the Houston Chronicle, December 19, 2002
Skits for Enron ex-executive funny then, but full of irony now --- 
(The above link includes a "See it Now" link to download the video itself which played well for me.)

The tape, made for the January 1997 going-away party for former Enron President Rich Kinder, features nearly 30 minutes of absurd skits, songs and testimonials by company executives and prominent Houstonians. The collection is all meant in good fun, but some of the comments are ironic in the current climate of corporate scandal.

In one skit, former administrative executive Peggy Menchaca plays the part of Kinder as he receives a budget report from then-President Jeff Skilling, who plays himself, and financial planning executive Tod Lindholm. When the pretend Kinder expresses doubt that Skilling can pull off 600 percent revenue growth for the coming year, Skilling reveals how it will be done.

"We're going to move from mark-to-market accounting to something I call HFV, or hypothetical future value accounting," Skilling jokes as he reads from a script. "If we do that, we can add a kazillion dollars to the bottom line."

Richard Causey, the former chief accounting officer who was embroiled in many of the business deals named in the indictments of other Enron executives, makes an unfortunate joke later on the tape.

"I've been on the job for a week managing earnings, and it's easier than I thought it would be," Causey says, referring to a practice that is frowned upon by securities regulators. "I can't even count fast enough with the earnings rolling in."

Texas' political elite also take part in the tribute, with then-Gov. George W. Bush pleading with Kinder: "Don't leave Texas. You're too good a man."

Former President George Bush also offers a send-off to Kinder, thanking him for helping his son reach the Governor's Mansion.

"You have been fantastic to the Bush family," he says. "I don't think anybody did more than you did to support George."

"Bubble Redux," by Andrew Bary, Barron's, April 14, 2003, Page 17.

Amazon's valuation is the most egregious of the 'Net trio.  It trades for 80 times projected "pro forma" 2003 profit of 32 cents a share.  Amazon's pro forma definition of profit, moreover, is dubious because it excludes re-structuring charges and, more important, the restricted stock that Amazon now is issuing to employees in lieu of stock options.  Amazon's reported profit this year under generally accepted accounting principles (which include restricted-stock costs) could be just 10 cents to 15 cents a share, meaning that Amazon's true P/E arguably is closer to 200.

Yahoo, meanwhile, now commands 70 times estimated 2003 net of 35 cents a share, and eBay fetches 65 times projected 2003 net of $1.35 a share.

What's fair value?  By our calculations, Amazon is worth, at best, roughly 90% of its projected 2003 revenue of $4.6 billion. That translates into $10 a share, or $4.1 billion.  This estimate is charitable because the country's two most successful brick-and-mortar retailers, Wal-Mart Stores and Home Depot, also trade for about 90% of 2003 sales.

Yahoo ought to trade closer to 15.  That's a stiff 43 times projected 2003 earnings and gives the company credit for its strong balance sheet, featuring over $2 a share in cash and another $3 a share for its stake in Yahoo Japan, which has become that country's eBay.

Sure, eBay undoubtedly is the most successful Internet company and the only one that has lived up to the growth projections made during the Bubble.  As the dominant online marketplace in the U.S. and Europe, eBay saw its earnings surge to 87 cents a share last year from three cents in 1998, when it went public at a split-adjusted $3.00 a share.

Why would eBay be more fairly valued around 60, its price just several months ago?  At 60, eBay would trade at 44 times projected 2003 profit of $1.35 a share and 22 times an optimistic 2005 estimate of $2.75.  So confident are analysts about eBay's outlook that they're comfortable valuing the stock on a 2005 earnings estimate.

Fans of eBay believe its profit can rise at a 35% annual clip in the next five years, a difficult rate for any company to maintain, even one, such as eBay, with a "scalable" business model that allows it to easily accommodate more transactions while maintaining its enviable gross margins of 80%.  If the company earns $5 a share in 2007--nearly six times last year's profit--it would still trade at 18 times that very optimistic profit level.

Continued in the article.

The New York Yankees today released their 4th Quarter 2001 pro forma results. Although generally accepted scorekeeping principles (GASP) indicate that the Yankees lost Games 1 and 2 of the 2001 World Series, their pro forma figures show that these reported losses were the result of nonrecurring items, specifically extraordinary pitching performances by Arizona Diamondbacks personnel Kurt Schilling and Randy Johnson. Games 3 and 4 results, already indicating Yankee wins, were not restated on a pro forma basis.
Ed Scribner, New Mexico State

Until recently, pro forma reporting was seen as a useful tool that could help companies show performance when unusual circumstances might cloud the picture. Today it finds itself in bad odour. 
"Pro forma lingo Does the use of controversial non-GAAP reporting by some companies confuse or enlighten?," by Michael Lewis, CA Magazine, March 2002 --- 

For fans of JDS Uniphase Corp., the fibre-optics manufacturer with headquarters in Ottawa and San Jose, Calif., the report for fiscal 2001 provided the icing on a very delicious cake: following an uninterrupted series of positive quarterly earnings results, the corporate giant announced it was set to deliver US$67 million in pro forma profit.

There was only one fly in the ointment. Like all such calculations, JDS's pro forma numbers were not prepared in accordance with generally accepted accounting principles (GAAP), and as such they excluded goodwill, merger-related and stock-option charges, and losses on investments. Once those items were added back into the accounting mix, JDS suddenly showed a staggering US$50.6 billion in red ink - a US corporate record. Even so, many investors remained loyal, placing their trust in the boom-market philosophy that views onetime charges as largely irrelevant. The mantra was simple - operating results rule.

"That was the view at the time," says Jim Hall, a Calgary portfolio manager with Mawer Canadian Equity Fund. "It just goes to show how wrong people can be."

Since then, of course, the spectacular flameout of Houston's Enron Corp. has done much to change that point of view (though it's not a pro forma issue). Once the world's largest energy trader, the company now holds the title for the largest bankruptcy case in US history. The Chapter 11 filing in December came after Enron had to restate US$586 million in earnings because of apparent accounting irregularities. In its submission, the company admitted it had hidden assets and related debt charges since 1997 in order to inflate consolidated earnings. Enron's auditor, accounting firm Arthur Andersen LLP, later acknowledged that it had made "an [honest] error in judgement" regarding Enron's financial statements.

While the Enron saga will continue in various courtrooms for many months to come, regulators on either side of the border have responded to the collapse with uncharacteristic swiftness. Both the Securities and Exchange Commission (SEC) in the United States and the Canadian Securities Administrators (CSA) issued new guidelines on financial reporting just a few weeks after the Enron bust. In each instance, investors were reminded to redirect their focus to financial statements prepared in accordance with GAAP, paying special attention to cash flow, liquidity and the intrinsic value of acquisitions. At the same time, issuers were warned to reduce their reliance on pro forma results and to explain to investors why they were not using GAAP in their reporting.

SEC chairman Harvey Pitt moved furthest and fastest. In mid-January he announced plans to establish a private watchdog to discipline accountants and review company audits. Working with the largest accounting firms and professional organizations such as the American Institute of Certified Public Accountants (AICPA), the SEC wants the new body to be able to punish accountants for incompetence and ethics violations. As Pitt emphasized, "The commission cannot, and in any event will not, tolerate this pattern of growing re-statements, audit failures, corporate failures and investor losses."

The sheer scale of the Enron debacle has brought pro forma accounting under public scrutiny as never before, and, observers say, will provide a powerful impetus for financial reporting reform. "This will send a message to companies and accountants to cut back on some of the games they've been playing," says former SEC general counsel Harvey Goldschmid.

Meanwhile, the CSA (the forum for the 13 securities regulators of Canada's provinces and territories) expressed its concern over the proliferation of non-standard measures, warning that they improve the appearance of a company's financial health, gloss over risks and make it exceedingly difficult for investors to compare issuers.

"Investors should be cautious when looking at non-GAAP measures," says John Carchrae, chair of the CSA Chief Accountants Committee, when the guidelines were released in January. "These measures present only part of the picture and may selectively omit certain expenses, resulting in a more positive portrayal of a company's performance."

As a result, Canadian issuers will now be expected to provide GAAP figures alongside non-standard earnings measures, explain how pro forma numbers are calculated, and detail why they exclude certain items required by GAAP. So far, the CSA has provided guidance rather than rules, but the committee cautions it could take regulatory action if issuers publish earnings reports deemed to be misleading to investors.

Carchrae, who is also chief accountant of the Ontario Securities Commission (OSC), believes "moral suasion" is a good place to start. Nonetheless, he adds, the OSC intends to track press releases, cross-reference them to statutory earnings filings and supplemental information on websites, and monitor continuous disclosure to ensure a company meets its requirements under the securities act.

Although pro forma reporting finds itself in bad odour, until recently it was regarded as a useful tool that could help companies show performance when unusual circumstances might cloud the picture. In cases involving a merger or acquisition, for example, where a company has made enormous expenditures that generate significant non-cash expenses on the income statement, pro forma can be used as a clarifying document, enabling investors to view economic performance outside of such onetime events. Over the years, however, the pro forma route has increasingly involved the selective use of press releases, websites, and other reports to put a favourable spin on earnings, often leading to a spike in the value of a firm's stock. Like management discussion and analysis, such communications are not within the ambit of GAAP, falling somewhere between the cracks of current accounting standards.

"Obviously, this issue is of concern to everyone who uses financial statements," says Paul Cherry, chairman of the Canadian Institute of Chartered Accountants' Accounting Standards Board. "Our worry as standard-setters is whether these non-GAAP, pro forma items confuse or enlighten."

Regulators and standard-setters have agonized over this issue ever since the reporting lexicon began to expand with the rise of the dot-com sector in the late 1990s, a sector with little in the way of earnings that concentrated on revenue growth as a more meaningful performance indicator. New measures, such as "run-through rates" or "burn rates," were deemed welcome additions to traditional methodology because they helped determine how much financing a technology company might require during its risky startup phase.

Critics, however, argued such terms were usurping easily understood language as part of a corporate scheme to hoodwink unwary investors. Important numbers were hidden or left out under a deluge of new and ever-more complex terminology. The new measurements, they warned, fell short of adequate financial disclosure.

An OSC report published in February 2001 appears to support these claims. According to the report, Canadian technology companies have not provided investors with adequate information about how they disclose revenue, a shortcoming that may require some of them to restate their financial results.

"Initial results of the review suggest a need for significant improvement in the nature and extent of disclosure," the report states, adding that the OSC wants more specific notes on accounting policy attached to financial statements. The report also observes that revenue is often recognized when goods are shipped, not when they are sold, despite the fact that the company may be exposed to returns.

David Wright, a software analyst at BMO Nesbitt Burns in Toronto, says dealing with how technology companies record revenue is a perennial issue. The issue has gained greater prominence with the rise of vendor financing, a practice whereby companies act as a bank to buyers, lending customers the cash to complete purchase orders. If the customer is unable to pay for the goods or services subsequent to signing the sales agreement, the seller's revenue can be drastically overstated.

But pro forma still has plenty of advocates - particularly when it comes to earnings before interest, taxes, depreciation and amortization (EBITDA). Such a measure, it is often argued, can provide a pure, meaningful and reliable diagnostic tool, albeit one that should be considered along with figures that accommodate charges to a balance sheet.

Ron Blunn, head of investor relations firm Blunn & Co. Inc. in Toronto and chairperson of the issues committee of the Canadian Investor Relations Institute, says adjusted earnings can serve a legitimate purpose and are particularly helpful to analysts and money managers who must gauge the financial well-being of technology startups.

The debate shows no signs of burning out anytime soon. On the one hand, the philosophy among Canadian and US standard-setters in recent years has appeared to favour removing constraints, rather than imposing them. New rules to apply to Canadian banks this year, for example, will no longer require the amortization of goodwill in earnings figures. On the other hand, it has become abundantly clear that companies will emphasize the reporting method that puts the best gloss on their operations. And while the use of pro forma accounting has remained most prevalent among technology companies, the movement to embrace more and varied language has spread to "old economy" companies such as Enron, gaining steam as the economy stumbled. Blunn theorizes the proliferation of nontraditional reporting and the increasing reliance on supplemental filings simply reflect the state of the North American economy.

Carchrae has a slightly different diagnosis. When asked why pro forma reporting has mushroomed in recent years, he points to investors' slavish devotion to business box scores - that is, a company's ability to meet sales and earnings expectations as set out by equity analysts. Since companies can be severely punished for falling short of the Street's consensus forecast, there is intense pressure, especially in a bear market, to conjure up earnings that appear to satisfy forecasts.

As a result, pro forma terminology has blossomed over the Canadian corporate landscape. Montreal-based telephone utility BCE Inc., for example, coined the term "cash baseline earnings" to describe its operating performance. Not to be outdone, Robert McFarlane, chief financial officer of Telus Corp., Canada's second-largest telecommunications company, cited a "revenue revision" and "EBITDA deficiency" to explain the drop in the Burnaby, BC-based phone service firm's "core baseline earnings" for its third quarter ended September 30, 2001. (According to company literature, core baseline earnings refers to common share income before discontinued operations, amortization of acquired intangible assets net of tax, restructuring and nonrecurring refinancing costs net of tax, revaluation of future tax assets and liabilities and goodwill amortization.)

Meanwhile, IBM Corp. spinoff Celestica Inc. of Toronto neglected to mention the elimination of more than 8,700 jobs from a global workforce of 30,000, alluding to the cuts in its fiscal 2001 third-quarter report through references to "realignment" charges during the period.

Many statements no longer use the term "profit" at all. And while statutory filings must present at least one version of earnings that conforms to GAAP, few rules have been set down by US or Canadian regulators to govern non-GAAP declarations. Accounting bodies in Canada and around the world are charged with policing their members and assuring statutory filings include income and revenue according to GAAP, using supportable interpretations. But pro forma numbers are typically distributed before a company's statutory filing is made.

"Not to pass the buck," says Cherry, "but how can we set standards for something that's not part of GAAP?" Still, Cherry admits the use of non-GAAP terminology has become so widespread that accounting authorities are being forced to take notice. "The matter is gaining some prominence," he says, "because some of the numbers are just so different."

Despite his reservations, Cherry acknowledges "the critical point is when information is released to the marketplace," which nowadays is almost always done via a press release. The duty to regulate such releases, he says, must rest with securities bodies - an opinion shared by Edmund Jenkins, chair of the Financial Accounting Standards Board (FASB) in the United States.

Many authorities view the issue as a matter of education, believing that a high degree of sophistication must now be expected from the retail investing community. Others say the spread of non-GAAP reporting methodology, left unchecked, could distort markets, undermine investor confidence in regulatory regimes and ultimately impede the flow of investment capital. But pro forma devotees insist that introducing tough new measures to govern reporting would do little to protect consumers and encourage retail investment. Instead, new regulations might work to impede growth and limit available, useful financial information.

Continued at 

From The Wall Street Journal Accounting Educators's Review on October 18, 2002

TITLE: Motorola's Profit: 'Special' Again? 
REPORTER: Jesse Drucker 
DATE: Oct 15, 2002 
TOPICS: Special Items, Pro Forma Earnings, Accounting, Earning Announcements, Earnings Forecasts, Financial Analysis, Financial Statement Analysis, Net Income

SUMMARY: Motorola has announced both pro forma earnings and net income as determined by generally accepted accounting principles for 14 consecutive quarters. Ironically, pro forma earnings are always greater than net income calculated using generally accepted accounting principles

1.) Distinguish between a special item and an extraordinary item. How are each reported on the income statement?

2.) Distinguish between pro forma earnings and GAAP based earnings. What are the advantages and disadvantages of allowing companies to report multiple earnings numbers? What are the advantages and disadvantages of not allowing companies to report multiple earnings numbers?

3.) What items were reported as special by Motorola? Are these items special? Support your answer.

4.) Are you surprised that all the special items reduced earnings? What is the likelihood that there were positive nonrecurring items at Motorola? How are positive nonrecurring items reported?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"Pro-Forma Earnings Reporting Persists," by Shaheen Pasha, Washington Post, August 16, 2002 --- 

While many on Wall Street are calling for an end to pro forma financial reporting given widespread jitters over corporate clarity, it's clear from second-quarter reports that the accounting practice is a hard habit to break.

Publicly traded companies are required to report their results according to generally accepted accounting principles, or GAAP, under which all types of business expenses are deducted to arrive at the bottom line of a company's earnings report.

But an ever-increasing number of companies in recent years has taken to also reporting earnings on a pro forma – or "as if" – basis under which they exclude various costs. Companies defend the practice, saying the inclusion of one-time events don't accurately reflect true performance.

There is no universal agreement on which expenses should be omitted from pro forma results, but pro forma figures typically boost results.

Indeed, as the second-quarter reporting season dwindles down with more than 90 percent of the Standard & Poor's 500 companies having reported, only Yahoo Inc., Compuware Corp. and Xilinx Inc. made the switch to reporting earnings under GAAP, according to Thomson First Call.

While a number of S&P 500 companies, including Computer Associates International Inc. and Corning Inc., made the switch to GAAP in the first quarter, that still brings the number to 11 companies in total that have given up on pro forma over the last two quarters.

"It's disappointing that at this stage we haven't seen more companies make the switch to GAAP earnings from pro forma," said Chuck Hill, director of research at Thomson First Call.

Continued at  

A new research report from Bear Stearns identifies the best earnings benchmarks by industry. GAAP earnings are cited as the best benchmarks for a few industries, but not many. The preferred benchmarks are generally pro forma earnings or pro forma earnings per share. 

AccountingWEB US - Oct-1-2002 -  A new research report from Bear Stearns identifies the best earnings benchmarks by industry. GAAP earnings (earnings prepared according to generally accepted accounting principles) are cited as the best benchmarks for a few industries, but not many. Most use pro forma earnings or pro forma earnings per share (EPS).

Examples of the most useful earnings benchmarks for just a few of the 50+ industries included in the report:

EBITDA=Earnings before interest, taxes, depreciation and amortization.
FFO=funds from operations.

The report also lists the most common adjustments made to arrive at pro forma earnings and tells whether securities analysts consider the adjustments valid. Patricia McConnell, senior managing director at Bear Stearns, explains, "Analysts rarely accept managements' suggested 'pro forma' adjustments without due consideration, and sometimes we reject them... We would not recommend using management's version of pro forma earnings without analysis and adjustment, but neither would we blindly advise using GAAP earnings without analysis and adjustment."

From The Wall Street Journal Accounting Educators' Review on July 27, 2002

TITLE: Merrill Changes Methods Analysts Use for Estimates 
REPORTER: Karen Talley DATE: Jul 24, 2002 
TOPICS: Accounting, Earnings Forecasts, Financial Accounting, Financial Analysis, Financial Statement Analysis

SUMMARY: Merrill Lynch & Co. has reported that it will begin forecasting both GAAP based earnings estimates in addition to pro forma earnings measures. To accommodate Merrill Lynch & Co., Thomson First Call will collect and report GAAP estimates from other analysts.

1.) Compare and contrast GAAP earnings and pro forma earnings?

2.) Why do analyst forecast pro forma earnings? Will GAAP earnings forecasts provide more useful information than pro forma earnings forecasts? Support your answer.

3.) Discuss the advantages and disadvantages of analysts forecasting both pro forma and GAAP earnings. Should analysts continue to provide pro forma earnings forecasts? Should analysts also provide GAAP earnings forecasts? Support your answers.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Denny Beresford's Terry Breakfast Lecture
Subtitle:  Does Accounting Still Matter in the "New Economy" 

Every accounting educator and practitioner should read Professor Beresford's Lecture at

Readers might also want to go to 
(Includes an interview with Lynn Turner talking about pro forma reporting.)

Deferred Taxes Related to FAS123 Expense – Accounting and Administrative Issues on New Trends in Stock Compensation Accounting
PWC Insight on FAS 123  --- 
A recent PWC HR Insight discusses the applicable rules and answers questions raised on accounting for income taxes related to FAS 123 expense (for both the pro forma disclosure and the recognized FAS 123 expense). Per PWC, the rules are complex and require that the tax benefits arising from stock options and other types of stock-based compensation be tracked on a grant-by-grant and country-by-country basis

Corporate America's New Math:  Investors Now Face Two Sets of Numbers In Figuring a Company's Bottom Line
By Justin Gillis
The Washington Post
Sunday, July 22, 2001; Page H01   

Cisco Systems Inc., a bellwether of the "new economy," prepared its books for the first three months of this year by slicing and dicing its financial results in the old ways mandated by the rules of Washington regulators and the accounting profession.

Result: a quarterly loss of $2.7 billion.

Cisco did more, though. It sliced and diced the same underlying numbers in ways preferred by Cisco, offering an alternative interpretation of its results to the investing public.

Result: a quarterly profit of $230 million.

That's an unusually large swing in a company's bottom line, but there's nothing unusual these days about the strategy Cisco employed. Across corporate America, companies are emphasizing something called "pro forma" earnings statements. Because there are no rules for how to prepare such statements, businesses have wide latitude to ignore various expenses in their pro forma results that have to be included under traditional accounting rules.

Most of the time, the new numbers make companies look better than they would under standard accounting, and some evidence suggests investors are using the massaged numbers more and more to decide what value to attach to stocks. The pro forma results are often strongly emphasized in news releases announcing a corporation's earnings; sometimes the results computed under traditional accounting techniques are not disclosed until weeks later, when the companies file the official results with the Securities and Exchange Commission, as required by law.

Cisco includes its results under both the pro forma and the traditional accounting methods in its news releases. People skeptical of the practice of using pro forma results worry that investors are being deceived. Karen Nelson, assistant professor of accounting at Stanford University, said some companies were "verging on fraudulent behavior" in their presentation of financial results.

Companies that use these techniques say they are trying to help investors by giving them numbers that more accurately reflect the core operations of their businesses, in part because they exclude unusual expenses. Cisco's technique "gives readers of financial statements a clearer picture of the results of Cisco's normal business activities," the company said in a statement issued in response to questions about its accounting.

Until recently, pro forma results had a well-understood and limited use. Most companies used pro forma accounting only to adjust previously reported financial statements so they could be directly compared with current results. This most frequently happened after a merger, when a company would adjust past results to reflect what they would have been had the merger been in effect earlier. Pro forma, Latin for "matter of form," refers to statements "where certain amounts are hypothetical," according to Barron's Dictionary of Finance and Investment Terms.

What's changed in recent years is that many companies now using the technique also apply it to the current quarter. They include some of the leading names of the Internet age, including Inc., Yahoo Inc. and JDS Uniphase Corp. These companies have received enthusiastic support from many Wall Street analysts for their use of pro forma results. The companies' arguments have also been bolstered by a broader attack on standard accounting launched by some academic researchers and accountants. They believe the nation's financial reporting system, rooted in the securities law reforms of the New Deal, is inadequate to modern needs. In testimony before Congress last year, Michael R. Young, a securities lawyer, called it a "creaky, sputtering, 1930s-vintage financial reporting system."

The dispute over earnings statements has grown in intensity during the recent economic slide. To skeptics, more and more companies appear to be coping with bad news on their financial statements by redefining the concept of earnings. SEC staffers are worried about the trend and are weighing a crackdown.

"People are using the pro forma earnings to present a tilted, biased picture to investors that I don't believe necessarily reflects the reality of what's going on with the business," said Lynn Turner, the SEC's chief accountant.

For the rest of the article (and it is a long article), go to 
The full article is salted with quotes from accounting professors and Bob Elliott (KMPG and Chairman of the AICPA)

The Future of  Unlike Enron, seems to thrive without profits.  How long can it last?

"Economy, the Web and E-Commerce:" An Interview With Jeff Bezos CEO,, The Washington Post,  December 6, 2001 --- is pinning its hopes on pro forma reporting to report the company's first profit in history.  But wait! Plans by U.S. regulators to crack down on "pro forma" abuses in accounting may take a toll on Internet firms, which like the financial reporting technique because it can make losses seem smaller than they really are.  

"When Pro Forma Is Bad Form," by Joanna Glasner, Wired News, December 6, 2001 ---,1367,48877,00.html 

As part of efforts to improve the clarity of information given to investors, the Securities and Exchange Commission warned this week that it will crack down on companies that use creative accounting methods to pump up poor earnings results.

In particular, the commission said it will focus on abuse of a popular form of financial reporting known as "pro forma" accounting, which allows companies to exclude certain expenses and gains from their earnings results. The SEC said the method "may not convey a true and accurate picture of a company's financial well-being."

Experts say the practice is especially common among Internet firms, which began issuing earnings press releases with pro forma numbers en masse during the stock market boom of the late 1990s. The list of new-economy companies using pro forma figures includes such prominent firms as Yahoo (YHOO), AOL Time Warner (AOL), CNET (CNET) and JDS Uniphase (JDSU).

Unprofitable firms are particularly avid users of pro forma numbers, said Brett Trueman, professor of accounting at the University of California at Berkeley's Haas School of Business.

"I can't say for sure why, but I can take a guess: They're losing big time, and they want to give investors the impression that the losses are not as great as they appear," he said.

Trueman said savvy investors tend to know that companies may have self-serving interests in mind when they release pro forma numbers. Experienced traders often put greater credence in numbers compiled according to generally accepted accounting principles (GAAP), which firms are required to release alongside any pro forma numbers.

A mounting concern, however, is the fact that many companies rely almost solely on pro forma numbers in projections for future performance.

Perhaps the best-known proponent of pro forma is the perennially unprofitable, which has a history of guiding investor expectations using an accounting system that excludes charges for stock compensation, restructuring or the declining value of past acquisitions.

Invariably, the pro forma numbers are better than the GAAP ones. In its most recent quarter, for example, Amazon (AMZN) reported a pro forma loss of $58 million. When measured according to GAAP, Amazon's net loss nearly tripled to $170 million.

Things are apt to get even stranger in the last quarter of the year, when Amazon said it plans to deliver its first-ever pro forma operating profit. By regular accounting standards, the company will still be losing money.

Those results might not sit too well with the folks at the SEC, however.

In its statements this week, the SEC noted that although there's nothing inherently illegal about providing pro forma numbers, figures should not be presented in a deliberately misleading manner. Regulators may have been talking directly to Amazon in one paragraph of their warning, which said:

"Investors are likely to be deceived if a company uses a pro forma presentation to recast a loss as if it were a profit."

Neither Amazon nor AOL Time Warner returned phone calls inquiring if they planned to make changes to their pro forma accounting methods in light of the SEC's recent statements.

According to Trueman, few members of the financial community would advocate getting rid of pro forma numbers altogether.

Even the SEC said that pro forma numbers, when used appropriately, can provide investors with a great deal of useful information that might not be included with GAAP results. When presented correctly, pro forma numbers can offer insights into the performance of the core business, by excluding one-time events that can skew quarterly results.

Rather than ditching pro forma, industry groups like Financial Executives International and the National Investor Relations Institute say a better plan is to set uniform guidelines for how to present the numbers. They have issued a set of recommendations, such as making sure companies don't arbitrarily change what's included in pro forma results from quarter to quarter.

Certainly some consistency would make it easier for folks who try to track this stuff, said Joe Cooper, research analyst at First Call, which compiles analyst projections of earnings.

The boom in pro forma reporting has created quite a bit of extra work for First Call, Cooper said, because it has to figure out which companies and analysts are using pro forma numbers and how they're using them.

But the extra work of compiling pro forma numbers doesn't necessarily result in greater financial transparency for investors, Cooper said.

"In days past, before it was abused, it was a way to give an honest apples-to-apples comparison," he said. "Now, it is being used as a way to continually put their company in a good light."

See also:
SEC Fires Warning Shot Over Tech Statements
Earnings Downplay Stock Losses

Change at the Top for AOL
Where's the Money?, Huh?
There's no biz like E-Biz

The bellwether Internet firm says it will stop reporting earnings in pro forma, a controversial accounting method popular in the technology sector ---,1367,51721,00.html 

"Yahoo Gives Pro Forma the Boot." By Joanna Glasner, Wired News, April 11, 2002 --- 

Following the release of its first-quarter results on Wednesday, Yahoo (YHOO) said it will stop reporting earnings using pro forma, a controversial accounting method popular among Internet and technology firms.

Instead, the company said it plans to release all results according to generally accepted accounting principles, or GAAP. Executives said the shift would provide a clearer picture of the Yahoo's financial performance.

"We do not believe the pro forma presentation continues to provide a useful purpose," said Sue Decker, Yahoo's chief financial officer. In the past, the company has used pro forma accounting as a way to separate one-time expenses -- such as the costs of closing a unit or acquiring another firm -- from costs stemming from its core business.

Decker attributed the decision in part to new rules adopted by the U.S. Financial Accounting Standards Board that take effect this year. The new rules require companies to report the amount they overpaid for acquisitions as an upfront charge.

Accounting experts, however, said the rule change was probably not the only reason for Yahoo to drop pro forma. The accounting practice, popularized by technology firms in the late 1990s, has come under fire from regulators in recent months who say some firms have used nonstandard metrics to mask poor financial performance.

The U.S. Securities and Exchange Commission warned in December that it will crack down on companies that use creative accounting methods to pump up poor earnings results.

In particular, the commission said it will focus on abuses of pro forma accounting, which allows companies to exclude certain expenses and gains from their earnings results. The SEC said the method "may not convey a true and accurate picture of a company's financial well-being."

Experts say use of pro forma is especially common among Internet firms. In addition to Yahoo, the list of prominent Internet and technology firms employing pro forma includes AOL Time Warner (AOL), Cnet (CNET) and JDS Uniphase (JDSU).

Although pro forma accounting can be useful in helping to predict a company's future performance, investors have grown increasingly suspicious of the metric following the bursting of the technology stock bubble, said Sam Norwood, a partner at Tatum CFO Partners.

"Once the concept of pro forma became accepted, there were in some cases abuses," Norwood said. "There was a tendency for management to exclude the negative events and to not necessarily exclude the positive events.'

Brett Trueman, an accounting professor at the University of California at Berkeley's Haas School of Business, said he wouldn't be surprised if other firms follow Yahoo's lead in dropping pro forma.

Continued at,1367,51721,00.html 

Bob Jensen's threads on pro forma reporting can be found at the following site: 

Triple Bottom Reporting

While some in the profession may question the long-term viability of audit-only accounting firms, proposed guidelines issued recently by the Global Reporting Initiative may help make the vision more feasible. The GRI's guidelines for "triple-bottom- line reporting" would broaden financial reporting into a three- dimensional model for economic, social and environmental reporting. 

While some in the profession may question the long-term viability of audit-only accounting firms, proposed guidelines issued recently by the Global Reporting Initiative (GRI) may help make the vision more feasible. The GRI's guidelines for "triple-bottom-line reporting" would broaden financial reporting into a three-dimensional model for economic, social and environmental reporting. Each dimension of the model would contain information that is valuable to stakeholders and could be independently verified.

Numbers, Ratios and Explanations

Despite the convenient shorthand reference to bottom lines, many of the GRI indicators are multi-faceted, consisting of tables, ratios and qualitative descriptions of policies, procedures, and systems. Below are examples of indicators within each of the three dimensions:

Economic performance indicators. Geographic breakdown of key markets, percent of contracts paid in accordance with agreed terms, and description of the organization's indirect economic impacts.

Environmental performance indicators. Breakdown of energy sources used, (e.g., for electricity and heat), total water usage, breakdown of waste by type and destination, list of penalties paid for non-compliance with environmental laws and regulations, and description of policies and procedures to minimize adverse environmental impacts.

Social performance indicators. Total workforce including temporary workers, percentage of employees represented by trade unions, schedule of average hours of training per year per employee for all major categories of employee, male/female ratios in upper management positions, and descriptions of policies and procedures to address such issues as human rights, product information and labeling, customer privacy, and political lobbying and contributions. The GRI was formed in 1997 by a partnership of the United Nations Environment Program (UNEP) and the Coalition for Environmentally Responsible Economies (CERES). Several hundred organizations have participated in working groups to help form the guidelines for triple-bottom-line reporting. These organizations include corporations, accounting firms, investors, labor organizations and other stakeholders.


The Controversy Over Fair Value (Mark-to-Market) Financial Reporting

Fair value is the estimated best disposal (exit, liquidation) value in any sale other than a forced sale.  It is defined as follows in Paragraph 540 on Page 243 of FAS 133:

The amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price. If a quoted market price is not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets or similar liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using discount rates commensurate with the risks involved, option- pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis.  Valuation techniques for measuring assets and liabilities should be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. In measuring forward contracts, such as foreign currency forward contracts, at fair value by discounting estimated future cash flows, an entity should base the estimate of future cash flows on the changes in the forward rate (rather than the spot rate). In measuring financial liabilities and nonfinancial derivatives that are liabilities at fair value by discounting estimated future cash flows (or equivalent outflows of other assets), an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction.

This is old news, but it does provide some questions for students to ponder.  The main problem of fair value adjustment is that many ((most?) of the adjustments cause enormous fluctuations in earnings, assets, and liabilities that are washed out over time and never realized.  The main advantage is that interim impacts that “might be” realized are booked.  It’s a war between “might be” versus “might never.”  The war has been waging for over a century with respect to booked assets and two decades with respect to unbooked derivative instruments, contingencies, and intangibles.

As you can see below, the war is not over yet.  In fact it has intensified between corporations (especially banks) versus standard setters versus members of the academy.

From The Wall Street Journal Accounting Educators' Review on April 2, 2004

TITLE: As IASB Unveils New Rules, Dispute With EU Continues 
REPORTER: David Reilly 
DATE: Mar 31, 2004 
PAGE: A2 LINK:,,SB108067939682469331,00.html  
TOPICS: Generally accepted accounting principles, Fair Value Accounting, Insider trading, International Accounting, International Accounting Standards Board

SUMMARY: Despite controversy with the European Union (EU), the International Accounting Standards Board (IASB) is expected to release a final set of international accounting standards. Questions focus on the role of the IASB, controversy with the EU, and harmonization of the accounting standards.

1.) What is the role of the IASB? What authority does the IASB have to enforce standards?

2.) List three reasons that a country would choose to follow IASB accounting standards. Why has the U.S. not adopted IASB accounting standards?

3.) Discuss the advantages and disadvantages of harmonization of accounting standards throughout the world. Why is it important the IASB reach a resolution with the EU over the disputed accounting standards?

4.) What is fair value accounting? Why would fair value accounting make financial statements more volatile? Is increased volatility a valid argument for not adopting fair value accounting? Does GAAP in the United States require fair value accounting? Support your answers.

There are a number of software vendors of FAS 133 valuation software.

One of the major companies is Financial CAD --- 

FinancialCAD provides software and services that support the valuation and risk management of financial securities and derivatives that is essential for banks, corporate treasuries and asset management firms. FinancialCAD’s industry standard financial analytics are a key component in FinancialCAD solutions that are used by over 25,000 professionals in 60 countries.

See software.

Fair value accounting politics in the revised IAS 39

From Paul Pacter's IAS Plus on July 13, 2005 ---
Also see

The European Commission has published Frequently Asked Questions – IAS 39 Fair Value Option (FVO) (PDF 94k), providing the Commission's views on the following questions:
  • Why did the Commission carve out the full fair value option in the original IAS 39 standard?
  • Do prudential supervisors support IAS 39 FVO as published by the IASB?
  • When will the Commission to adopt the amended standard for the IAS 39 FVO?
  • Will companies be able to apply the amended standard for their 2005 financial statements?
  • Does the amended standard for IAS 39 FVO meet the EU endorsement criteria?
  • What about the relationship between the fair valuation of own liabilities under the amended IAS 39 FVO standard and under Article 42(a) of the Fourth Company Law Directive?
  • Will the Commission now propose amending Article 42(a) of the Fourth Company Directive?
  • What about the remaining IAS 39 carve-out relating to certain


What are the advantages and disadvantages of requiring fair value accounting for all financial instruments as well as derivative financial instruments?



  1. Eliminate arbitrary FAS 115 classifications that can be used by management to manipulate earnings (which is what Freddie Mac did in 2001 and 1002.
  2. Reduce problems of applying FAS 133 in hedge accounting where hedge accounting is now allowed only when the hedged item is maintained at historical cost.
  3. Provide a better snap shot of values and risks at each point in time.  For example, banks now resist fair value accounting because they do not want to show how investment securities have dropped in value.




  1. Combines fact and fiction in the sense that unrealized gains and losses due to fair value adjustments are combined with “real” gains and losses from cash transactions.  Many, if not most, of the unrealized gains and losses will never be realized in cash.  These are transitory fluctuations that move up and down with transitory markets.  For example, the value of a $1,000 fixed-rate bond moves up and down with interest rates when at expiration it will return the $1,000 no matter how interest rates fluctuated over the life of the bond.
  2. Sometimes difficult to value, especially OTC securities.
  3. Creates enormous swings in reported earnings and balance sheet values.
  4. Generally fair value is the estimated exit (liquidation) value of an asset or liability.  For assets, this is often much less than the entry (acquisition) value for a variety of reasons such as higher transactions costs of entry value, installation costs (e.g., for machines), and different markets  (e.g., paying dealer prices for acquisition and blue book for disposal).  For example, suppose Company A purchases a computer for $2 million that it can only dispose of for $1 million a week after the purchase and installation.  Fair value accounting requires expensing half of the computer in the first week even though the computer itself may be utilized for years to come.  This violates the matching principle of matching expenses with revenues, which is one of the reasons why fair value proponents generally do not recommend fair value accounting for operating assets. 

"Derivatives and hedging:  An Analyst's Response to US FAS 133," by Frank Will, Corporate Finance Magazine, June 2002, 

However, FAS 133 still needs further clarification and improvement as the example of Fannie Mae shows. Analysts focus more on the economic value of a company and less on unrealised gains and losses.  Much of the FAS 133 volatility in earnings and in equity does not consistently reflect the economic situation.  This makes it difficult to interpret the figures.  Therefore, analysts welcome the decision of some companies voluntarily to disclose a separate set of figures excluding the effect of FAS 133.

For more on Frank Will's analysis of FAS 133, Fair Value Accounting, and Fannie Mae, go to 

Bob Jensen's threads on accounting theory are at 

You can read more about fair value at 

Forwarded on May 11, 2003 by Patrick E Charles [charlesp@CWDOM.DM

Mark-to-market rule should be written off

Richard A. Werner Special to The Daily Yomiuri


Since 1996, comprehensive accounting reforms have been gradually introduced in Japan. Since fiscal 2000, the valuation of investment securities owned by firms has been based on their market value at book-closing. Since fiscal 2001, securities held on a long-term basis also have been subjected to the mark-to-market rule. Now, the Liberal Democratic Party is calling for the suspension of the newly introduced rule to mark investments to market, as well as for a delay in the introduction of a new rule that requires fixed assets to be valued at their market value.

The proponents of so-called global standards are up in arms at this latest intervention by the LDP. If marking assets to market is delayed, they argue, the nation will lag behind in the globalization of accounting standards. Moreover, they argue that corporate accounts must be as transparent as possible, and therefore should be marked to market as often and as radically as possible. On the other hand, opponents of the mark-to-market rule argue that the recent slump in the stock market, which has reached a 21-year low, can at least partly be blamed on the new accounting rules.

What are we to make of this debate? Let us consider the facts. Most leading industrialized countries, such as Britain, France and Germany, so far have not introduced mark-to-market rules. Indeed, the vast majority of countries currently do not use them.

Nevertheless, there is enormous political pressure to utilize mark-to-market accounting, and many countries plan to introduce the standard in 2005 or thereafter.

Japan decided to adopt the new standard ahead of everyone else, based on the advice given by a few accountants--an industry that benefits from the revision of accounting standards as any rule change guarantees years of demand for their consulting services.

However, so far there has not been a broad public debate about the overall benefits and disadvantages of the new standard. The LDP has raised the important point that such accounting changes might have unintended negative consequences for the macroeconomy.

Let us first reflect on the microeconomic rationale supporting mark-to-market rules. They are said to render company accounts more transparent by calculating corporate balance sheets using the values that markets happen to indicate on the day of book- closing. Since book-closing occurs only once, twice or, at best, four times a year, any sudden or temporary move of markets on these days--easily possible in these times of extraordinary market volatility--will distort accounts rather than rendering them more transparent.

Second, it is not clear that marking assets to market reflects the way companies look at their assets. While they know that market values are highly volatile, there is one piece of information about corporate assets that have an undisputed meaning for

firms: the price at which they were actually bought.

The purchase price matters as it reflects actual transactions and economic activity. Marking to market, on the other hand, means valuing assets at values at which they were never transacted. The company has neither paid nor received this theoretical money in exchange for the assets. This market value is hence a purely fictitious value. Instead of increasing transparency, we end up increasing the part of the accounts that is fiction.

While the history of marking to market is brief, we do have some track record from the United States, which introduced mark-to-market accounting in the 1990s.

Did the introduction increase accounting transparency? The U.S. Financial Accounting Standards Board last November concluded that the new rule of marking to market allowed Enron Energy Services Inc. to book profits from long-term energy contracts immediately rather than when the money was actually received.

This enabled Enron executives to create the illusion of a profitable business unit despite the fact that the truth was far from it. Thanks to mark-to-market accounting, Enron's retail division managed to hide significant losses and book billions of dollars in profits based on inflated predictions of future energy prices. Enron's executives received millions of dollars in bonuses when the energy contracts were signed.

The U.S. Financial Accounting Standards Board task force recognized the problems and has hence recommended the mark-to-market accounting rule be scrapped. Since this year, U.S. energy companies will only be able to report profits as income actually is received.

Marking to market thus creates the illusion that theoretical market values can actually be realized. We must not forget that market values are merely the values derived on the basis of a certain number of transactions during the day in case.

Strictly speaking, it is a false assumption to extend the same values to any number of assets that were not actually transacted at that value on that day.

When a certain number of the 225 stocks constituting the Nikkei Stock Average are traded at a certain price, this does not say anything about the price that all stocks that have been issued by these 225 companies would have traded on that day.

As market participants know well, the volume of transactions is an important indicator of how representative stock prices can be considered during any given day. If the index falls 1 percent on little volume, this is quickly discounted by many observers as it means that only a tiny fraction of shares were actually traded. If the market falls 1 percent on record volume, then this may be a better proxy of the majority of stock prices on that day.

The values at which U.S. corporations were marked to market at the end of December 1999, at the peak of a speculative bubble, did little to increase transparency. If all companies had indeed sold their assets on that day, surely this would have severely depressed asset prices.

Consider this: If your neighbor decides to sell his house for half price, how would you feel if the bank that gave you a mortgage argued that, according to the mark-to- market rule, it now also must halve the value of your house--and, as a result, they regret to inform you that you are bankrupt.

We discussed the case of traded securities. But in many cases a market for the assets on a company's books does not actually exist. In this case, accountants use so-called net present value calculations to estimate a theoretical value. This means even greater fiction because the theoretical value depends crucially on assumptions made about interest rates, economic growth, asset markets and so on.

Given the dismal track record of forecasters in this area, it is astonishing to find that serious accountants wish corporate accounts to be based on them.

There are significant macroeconomic costs involved with mark-to-market accounting. As all companies will soon be forced to recalculate their balance sheets more frequently, the state of financial markets on the calculation day will determine whether they are still "sound," or in accounting terms, "bankrupt." While book value accounting tends to reduce volatility in markets to some extent, the new rule can only increase it. The implications are especially far-reaching in the banking sector since banks are not ordinary businesses, but fulfill the public function of creating and providing the money supply on which economic growth depends.

U.S. experts warned years ago that the introduction of marking to market could create a credit crunch. As banks will be forced to set aside larger loan-loss reserves to cover loans that may have declined in value on the day of marking, bank earnings could be reduced. Banks might thus shy away from making loans to small or midsize firms under the new rules, where a risk premium exists and hence the likelihood of marking losses is larger. As a result, banks would have a disincentive to lend to small firms. Yet, for all we know, the small firm loans may yet be repaid in full.

If banks buy a 10-year Japanese government bond with the intention to hold it until maturity, and the economy recovers, thus pushing down bond prices significantly, the market value of the government bonds will decline. Banks would thus be forced to book substantial losses on their bond holdings despite the fact that, by holding until maturity, they would never actually have suffered any losses. Japanese banks currently have vast holdings of government bonds. The change in accounting rules likely will increase problems in the banking sector. As banks reduce lending, economic growth will fall, thereby depressing asset prices, after which accountants will quickly try to mark down everyone's books.

Of course, in good times, the opposite may occur, as we saw in the case of Enron. During upturns, marking to market may boost accounting figures beyond the actual state of reality. This also will boost banks' accounts (similar to the Bank for International Settlements rules announced in 1988), thus encouraging excessive lending. This in turn will fuel an economic boom, which will further raise the accounting values of assets.

Thus does it make sense to mark everything to fictitious market values? We can conclude that marking to market has enough problems on the micro level to negate any potential benefits. On the macro level, the disadvantages will be far larger as asset price volatility will rise, business cycles will be exacerbated and economic activity will be destabilized.

The world economy has done well for several centuries without this new rule. There is no evidence that it will improve anything. To the contrary, it is likely to prove harmful. The LDP must be lauded for its attempt to stop the introduction of these new accounting rules.

Werner is an assistant professor of economics at Sophia University and chief economist at Tokyo-based investment adviser Profit Research Center Ltd.

Measuring the Business Value of Stakeholder Relationships – all about social capital and how high-trust relationships affect the bottom line. Plus a new measurement tool for benchmarking the quality of stakeholder relationships --- 

Trust, shared values and strong relationships aren't typical financial indicators but perhaps they should be. A joint study by CIM and the Schulich School of Business is examining the link between high trust stakeholder relationships and business value creation. The study is sponsored by the Canadian Institute of Chartered Accountants (CICA).

The research team is looking at how social capital can be applied to business. The aim of this project is to better understand corporate social capital, measure the quality of relationships, and provide the business community with ways to improve those relationships and in turn improve their bottom line.

Because stakeholder relationships all have common features, direct comparisons of the quality of relationships can be made across diverse stakeholder groups, companies and industries.

Social capital is “the stock of active connections among people; the trust, mutual understanding, and shared values and behaviors that bind the members of human networks and communities and make cooperative action possible” (Cohen and Prusak, 2000).

So far the research suggests that trust, a cooperative spirit and shared understanding between a company and its stakeholders creates greater coherence of action, better knowledge sharing, lower transaction costs, lower turnover rates and organizational stability. In the bigger picture, social capital appears to minimize shareholder risk, promote innovation, enhance reputation and deepen brand loyalty.

Preliminary results show that high levels of social capital in a relationship can build upon themselves. For example, as a company builds reputation among its peers for fair dealing and reliability in keeping promises, that reputation itself becomes a prized asset useful for sustaining its current alliances and forming future ones.

The first phase of the research is now complete and the study moves into its second phase involving detailed case studies with six companies that have earned a competitive business advantage through their stakeholder relationships. Click here for a full report

Bob Jensen's discussion of valuation and aggregation issues can be found at 

That scenario isn't as farfetched as you might think. It's called a prediction market, based on the notion that a marketplace is a better organizer of insight and predictor of the future than individuals are. Once confined to research universities, the idea of markets working within companies has started to seep out into some of the nation's largest corporations. Companies from Microsoft to Eli Lilly and Hewlett-Packard are bringing the market inside, with workers trading futures contracts on such "commodities" as sales, product success and supplier behavior. The concept: a work force contains vast amounts of untapped, useful information that a market can unlock. "Markets are likely to revolutionize corporate forecasting and decision making," says Robin Hanson, an economist at George Mason University, in Virginia, who has researched and developed markets. "Strategic decisions, such as mergers, product introductions, regional expansions and changing CEOs, could be effectively delegated to people far down the corporate hierarchy, people not selected by or even known to top management."
Barbara Kiviat (See below)

"The End Of Management? by Barbara Kiviat, Time Magazine, July 12, 2004, pp. 88-92 ---,8816,1101040712-660965,00.html 

The end of management just might look something like this. You show up for work, boot up your computer and log onto your company's Intranet to make a few trades before getting down to work. You see how your stocks did the day before and then execute a few new orders. You think your company should step up production next month, and you trade on that thought. You sell stock for the production of 20,000 units and buy stock that represents an order for 30,000 instead. All around you, as co-workers arrive at their cubicles, they too flick on their computers and trade.

Together, you are buyers and sellers of your company's future. Through your trades, you determine what is going to happen and then decide how your company should respond. With employees in the trading pits betting on the future, who needs the manager in the corner office?

That scenario isn't as farfetched as you might think. It's called a prediction market, based on the notion that a marketplace is a better organizer of insight and predictor of the future than individuals are. Once confined to research universities, the idea of markets working within companies has started to seep out into some of the nation's largest corporations. Companies from Microsoft to Eli Lilly and Hewlett-Packard are bringing the market inside, with workers trading futures contracts on such "commodities" as sales, product success and supplier behavior. The concept: a work force contains vast amounts of untapped, useful information that a market can unlock. "Markets are likely to revolutionize corporate forecasting and decision making," says Robin Hanson, an economist at George Mason University, in Virginia, who has researched and developed markets. "Strategic decisions, such as mergers, product introductions, regional expansions and changing CEOs, could be effectively delegated to people far down the corporate hierarchy, people not selected by or even known to top management."

To understand the hype, take a look at Hewlett-Packard's experience with forecasting monthly sales. A few years back, HP commissioned Charles Plott, an economist from the California Institute of Technology, to set up a software trading platform. A few dozen employees, mostly product and finance managers, were each given about $50 in a trading account to bet on what they thought computer sales would be at the end of the month. If a salesman thought the company would sell between, say, $201 million and $210 million worth, he could buy a security — like a futures contract — for that prediction, signaling to the rest of the market that someone thought that was a probable scenario. If his opinion changed, he could buy again or sell.

When trading stopped, the scenario behind the highest-priced stock was the one the market deemed most likely. The traders got to keep their profits and won an additional dollar for every share of "stock" they owned that turned out to be the right sales range. Result: while HP's official forecast, which was generated by a marketing manager, was off 13%, the stock market was off only 6%. In further trials, the market beat official forecasts 75% of the time.

Intrigued by that success, HP's business-services division ran a pilot last year with 14 managers worldwide, trying to determine the group's monthly sales and profit. The market was so successful (in one case, improving the prediction 50%) that it has since been integrated into the division's regular forecasts. Another division is running a pilot to see if a market would be better at predicting the costs of certain components with volatile prices. And two other HP divisions hope to be using markets to answer similar questions by the end of the year. "You could do zillions of things with this," says Bernardo Huberman, director of the HP group that designs and coordinates the markets. "The idea of being able to forecast something allows you to prepare, plan and make decisions. It's potentially huge savings."

Eli Lilly, one of the largest pharmaceutical companies in the world, which routinely places multimillion-dollar bets on drug candidates that face overwhelming odds of failure, wanted to see if it could get a better idea of which compounds would succeed. So last year Lilly ran an experiment in which about 50 employees involved in drug development — chemists, biologists, project managers — traded six mock drug candidates through an internal market. "We wanted to look at the way scattered bits of information are processed in the course of drug development," says Alpheus Bingham, vice president for Lilly Research Laboratories strategy. The market brought together all the information, from toxicology reports to clinical results, and correctly predicted the three most successful drugs.

What's more, the market data revealed shades of opinion that never would have shown up if the traders were, say, responding to a poll. A willingness to pay $70 for a particular drug showed greater confidence than a bid at $60, a spread that wouldn't show if you simply asked, Will this drug succeed? "When we start trading stock, and I try buying your stock cheaper and cheaper, it forces us to a way of agreeing that never really occurs in any other kind of conversation," says Bingham. "That is the power of the market."

The current enthusiasm can be traced in part, oddly enough, to last summer's high-profile flop of a market that was supposed to help predict future terrorist attacks. A public backlash killed that Pentagon project a few months before its debut, but not before the media broadcast the notion that useful information embedded within a group of people could be drawn out and organized via a marketplace. Says George Mason's Hanson, who helped design the market: "People noticed." Another predictive market, the Iowa Electronic Markets at the University of Iowa, has been around since 1988. That bourse has accepted up to $500 from anyone wanting to wager on election results. Players buy and sell outcomes: Is Kerry a win or Bush a shoo-in? This is the same information that news organizations and pollsters chase in the run-up to election night. Yet Iowa outperforms them 75% of the time.

Inspired by such results, researchers at Microsoft started running trials of predictive markets in February, finding the system inexpensive to set up. Now they're shopping around for the market's first real use. An early candidate: predicting how long it will take software testers to adopt a new piece of technology. Todd Proebsting, who is spearheading the initiative, explains, "If the market says they're going to be behind schedule, executives can ask, What does the market know that we don't know?" Another option: predicting how many patches, or corrections, will be issued in the first six months of using a new piece of software. "The pilots worked great, but we had little to compare it to," he says. "You can reason that this would do a good job. But what you really want to show is that this works better than the alternative."

Ultimately, "you may someday see someone in a desk job or a manufacturing job doing day trading, knowing that's part of the job," says Thomas Malone, a management professor at M.I.T. who has written about markets. "I'm very optimistic about the long-term prospects."

But no market is perfect. Economists are still unsure of the human factor: how to get people to play and do their best. In the stock market or even the Iowa prediction market, people put up their own money and trade to make more. That incentive ensures that people trade on their best information. But a company that asks employees to risk their own money raises ethical questions, so most corporate markets use play money to trade and small bonuses or prizes for good traders. "Though this may look like God's gift to business, there are problems with it," says Plott, who ran the first HP experiments. Tokyo-based Dentsu, one of the world's largest advertising firms, is still grappling with incentives for an ad forecasting market it will launch later this year with the help of News Futures, a U.S. consultancy.

And even if companies can figure out how to make their internal markets totally efficient, there are plenty of reasons that corporate America isn't about to jump wholesale onto the markets bandwagon. For one thing, markets, based on individuals and individual interests, could threaten the kind of team spirit that many corporations have struggled to cultivate. Established hierarchies could be threatened too. After all, a market implies that the current data crunching and decision-making process may not be as good as a gamelike system that often includes lower-level employees. In a sense, an internal market's success suggests that if upper managers would just give up control, things would run better. Lilly, which is considering using a market to forecast actual drug success, is still grappling with the potential ramifications. "We already have a rigorous process," says Lilly's Bingham. "So what do you do if you use a market and get different data?" Throw it out? Or say that the market was smarter, impugning the tried-and-true system?

There could be risks to individual workers in an internal trading system as well. If you lose money in the market, does that mean you're not knowledgeable about something you should be? "You have to get people used to the idea of being accountable in a very different way," says Mary Murphy-Hoye, senior principal engineer at Intel, which has been experimenting with internal markets. "I can now tell if planners are any good, because they're making money or they're not making money."

Continued in article

The FASB has released Statement No. 148. 

FAS 148 improves disclosures for stock-based compensation and provides alternative transition methods for companies that switch to the fair value method of accounting for stock options --- 
The transition guidance and annual disclosure provisions of Statement 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances.  .  Fair value accounting is still optional (until the FASB finally makes up its mind on stock options.)

FASB Amends Transition Guidance for Stock Options and Provides Improved Disclosures

Norwalk, CT, December 31, 2002—The FASB has published Statement No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends FASB Statement No. 123, Accounting for Stock-Based Compensation. In response to a growing number of companies announcing plans to record expenses for the fair value of stock options, Statement 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, Statement 148 amends the disclosure requirements of Statement 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation.

Under the provisions of Statement 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a “ramp-up” effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, Statement 148 provides two additional methods of transition that reflect an entity’s full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect.

Statement 148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies—regardless of the accounting method used—by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the Statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. In the past, companies were required to make pro forma disclosures only in annual financial statements.

The transition guidance and annual disclosure provisions of Statement 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002.

As previously reported, the FASB has solicited comments from its constituents relating to the accounting for stock-based compensation, including valuation of stock options, as part of its recently issued Invitation to Comment, Accounting for Stock-Based Compensation: A Comparison of FASB Statement No. 123, Accounting for Stock-Based Compensation, and Its Related Interpretations, and IASB Proposed IFRS, Share-based Payment. That Invitation to Comment explains the similarities of and differences between the proposed guidance on accounting for stock-based compensation included in the International Accounting Standards Board’s (IASB’s) recently issued exposure draft and the FASB’s guidance under Statement 123.

After considering the responses to the Invitation to Comment, the Board plans to make a decision in the latter part of the first quarter of 2003 about whether it should undertake a more comprehensive reconsideration of the accounting for stock options. As part of that process, the Board may revisit its 1995 decision permitting companies to disclose the pro forma effects of the fair value based method rather than requiring all companies to recognize the fair value of employee stock options as an expense in the income statement. Under the provisions of Statement 123 that remain unaffected by Statement 148, companies may either recognize expenses on a fair value based method in the income statement or disclose the pro forma effects of that method in the footnotes to the financial statements.

Copies of Statement 148 may be obtained by contacting the FASB’s Order Department at 800-748-0659 or by placing an order at the FASB’s website at .

From The Wall Street Journal Accounting Educators' Reviews on June 20, 2002

TITLE: And, Now the Question is: Where's the Next Enron? 
REPORTER: Cassell Bryan-Low and Ken Brown 
DATE: Jun 18, 2002 PAGE: C1 LINK:,,SB1024356537931110920.djm,00.html  
TOPICS: off balance sheet financing, Related-party transactions, loan guarantees, Accounting, Fair Value Accounting, Financial Accounting Standards Board, Regulation, Securities and Exchange Commission

SUMMARY: In the wake of the Enron accounting debacle, investors are concerned that another Enron-like situation could occur. The article describes steps taken to improve the quality of financial reporting.


1.) Why is it important that investors and other financial statement users have confidence in financial reporting?

2.) What is a related-party transaction? What accounting issues are associated with related-party transactions? What changes in disclosing and accounting for related party transactions are proposed? Discuss the strengths and weaknesses of the proposed changes.

3.) What is off-balance sheet financing? How was Enron able to avoid reporting liabilities on its balance sheet? What changes concerning special-purpose entities are proposed? Will the proposed changes prevent future Enron-like situations? Support your answer.

4.) When are companies required to report loan guarantees as liabilities? What changes are proposed? Do you agree with the proposed changes? Support your answer.

5.) What is mark to market accounting? How did mark to market accounting contribute to the Enron debacle? Discuss the advantages and disadvantages of proposed changes related to mark to market accounting.

6.) What are pro forma earnings? How can pro forma earnings be used to mislead investors? What changes in the presentation of pro forma earnings are proposed? Will the proposed changes protect investors?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Controversies over revenue reporting are discussed at 

From the Free Wall Street Journal Educators' Reviews for December 6, 2001 

TITLE: Audits of Arthur Andersen Become Further Focus of Investigation
SEC REPORTER: Jonathan Weil
DATE: Nov 30, 2001 PAGE: A3 LINK:
TOPICS: Advanced Financial Accounting, Auditing

SUMMARY: This article focuses on the issues facing Arthur Andersen now that their work on the Enron audit has become the subject of an SEC investigation. The on-line version of the article provides three questions that are attributed to "some accounting professors." The questions in this review expand on those three provided in the article.

1.) The first question the SEC might ask of Enron's auditors is "were financial statement disclosures regarding Enron's transactions too opaque to understand?" Are financial statement disclosures required to be understandable? To whom? Who is responsible for ensuring a certain level of understandability?

2.) Another question that the SEC could consider is whether Andersen auditors were aware that certain off-balance-sheet partnerships should have been consolidated into Enron's balance sheet, as they were in the company's recent restatement. How could the auditors have been "unaware" that certain entities should have been consolidated? What is the SEC's concern with whether or not the auditors were aware of the need for consolidation?

3.) A third question that the SEC could ask is, "Did Andersen auditors knowingly sign off on some 'immaterial' accounting violations, ignoring that they collectively distorted Enron's results?" Again, what is the SEC's concern with whether Andersen was aware of the collective impact of the accounting errors? Should Andersen have been aware of the collective amount of impact of these errors? What steps would you suggest in order to assess this issue?

4.) The article finishes with a discussion of expected Congressional hearings into Enron's accounting practices and into the accounting and auditing standards setting process in general. What concern is there that the FASB "has been working on a project for more than a decade to tighten the rules governing when companies must consolidate certain off-balance sheet 'special purpose entities'"?

5.) In general, how stringent are accounting and auditing requirements in the U.S. relative to other countries' standards? Are accounting standards in other countries set in the same way as in the U.S.? If not, who establishes standards? What incentives would the U.S. Congress have to establish a law-based system if they become convinced that our private sector standards setting practices are inadequate? Are you concerned about having accounting and reporting standards established by law?

6.) The article describes revenue recognition practices at Enron that were based on "noncash unrealized gains." What standard allows, even requires, this practice? Why does the author state, "to date, the accounting standards board has given energy traders almost boundless latitude to value their energy contracts as they see fit"?

Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University

CPA2Biz Unveils Business Valuation Resource Center --- 

The BV Center will include resources and information from the American Institute of Certified Public Accountants (AICPA) and industry experts on various factors affecting the value of a business or a transaction, such as mergers and acquisitions; economic damages due to a patent infringement or breaches of contract; bankruptcy or a reorganization; or fraud due to anti-trust actions or embezzlement. The BV Center will provide a comprehensive combination of solutions that meet the professional needs of CPAs practicing business valuation, including those who have achieved the AICPA's Accredited in Business Valuation credential. The BV Center will also provide networking communities for BV practitioners as well as a public forum for discussion of business valuation trends, developments and issues.

"Tremendous growth in the BV discipline, coupled with a dynamic group of factors affecting business valuation, means that CPAs need a consistent, timely and relevant vehicle through which BV-related information can be disseminated to them," said Erik Asgeirsson, Vice President of Product Management at CPA2Biz. "The BV Center on CPA2Biz will provide them with AICPA books, practice aids, newsletters and software, along with industry expert literature and complementary third-party products and solutions. Because the issues associated with valuation impact CPAs in both public and private sectors -- auditors, tax practitioners, personal financial planners as well as BV specialists -- the BV Center will have a powerful horizontal impact on the profession."

"I think that CPAs who practice in business valuation ought to go to the BV Center for information and tools that are timely, relevant and easy to obtain," said Thomas Hilton, CPA/ABV, Chairman of the AICPA Business Valuation Subcommittee. "The BV Center is a source CPAs can use to offer their clients a higher level of service, as well as to connect with other CPAs who provide valuation services."

The CPA2Biz Website is at 

Selected References on Accounting for Intangibles 
(most of which were published after the above paper was written)

BARUCH LEV'S NEW BOOK Brookings Institution Press has just issued Baruch's new book, Intangibles: Management, Measurement and Reporting. Regardless of the "dot com" collapse, this subject continues to be high on the corporate executive's agenda. Baruch foresees increasing attention being paid to intangibles by both managers and investors. He feels there is an urgent need to improve both the management reporting and external disclosure about intellectual capital. He proposes that we seriously consider revamping our accounting model and significantly broaden the recognition of intangible assets on the balance sheet. The book can be ordered at 

Professor Lev's free documents on this topic can be downloaded from 


SSRN's Top 10 Downloads 
(The abstracts are free, but the downloads themselves are not free,. However, your library may provide you with free SSRN downloads if it subscribes to SSRN)

One approach to finding the “top” papers is to download the Social Science Research Network (SSRN) Top 10 downloads in various categories ---
This database is limited to the selected papers included in the database.

For accounting, SSRN’s Top 10 papers are at 
The average number of downloads of this top accounting research network paper is 227 per month.  In contrast the top economics network research paper has an average of 2,375 downloads per month.  Downloads in other disciplines depend heavily upon the number of graduate students and practitioners in that discipline.

The top ten downloads from the accounting network are as follows (note that some authors like Mike Jensen are not accountants or accounting educators):

16010 A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation
University of Illinois at Urbana-Champaign and Columbia School of Business
Date posted to database:March 31, 1997
10201 Value Based Management: Economic Value Added or Cash Value Added?
Anelda AB
Date posted to database:April 5, 1999
8041 Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure
Michael C. Jensen, A THEORY OF THE FIRM: GOVERNANCE, RESIDUAL CLAIMS AND ORGANIZATIONAL FORMS, Harvard University Press, Dec. 2000, and The Journal Of Financial Economics, 1976.
The Monitor Company and Deceased, University of Rochester Simon School
Date posted to database:July 19, 1998
7607 Evidence on EVA®
Journal of Applied Corporate Finance, Vol. 12, No. 2, Summer 1999
Hong Kong University of Science & Technology, University of Washington and University of California at Irvine
Date posted to database:September 20, 1999
5194 A Generalized Earnings Model of Stock Valuation
Columbia Business School and University of California, Los Angeles
Date posted to database:July 18, 1998
5046 Which is More Value-Relevant: Earnings or Cash Flows?
Brigham Young University
Date posted to database:September 2, 1998
4927 Combining Earnings and Book Value in Equity Valuation
Columbia School of Business
Date posted to database:November 5, 1997
4254 Separation of Ownership and Control
Michael C. Jensen, FOUNDATIONS OF ORGANIZATIONAL STRATEGY, Harvard University Press, 1998, and Journal of Law and Economics, Vol. 26, June 1983
University of Chicago and The Monitor Company
Date posted to database:November 29, 1998
3843 Value Creation and its Measurement: A Critical Look at EVA
Politecnico Grancolombiano
Date posted to database:May 19, 1999
3771 Ratio Analysis and Equity Valuation
Columbia Business School and Columbia School of Business
Date posted to database:May 11, 1999
Other Links on Accounting for Intangibles


"Accounting for Intangibles: The New Frontier" by Baruch Lev (January 11, 2001) --- 

FAS 141 and 142 Summary (October 22, 2001) --- 

New Rules Summary by Paul Evans (February 24, 2002) --- 

ACCOUNTING FOR INTANGIBLES: A LITERATURE REVIEW, Journal of Accounting Literature, Vol. 19, 2000  
by Leandro Cañibano Autonomous University of Madrid Manuel García-Ayuso University of Seville Paloma Sánchez Autonomous University of Madrid --- 


NYU Intangibles Research Project --- 

"Alan Kay talks with Baruch Lev," (June 19, 2001) --- 

International Accounting Standard No. 38 ---{2954EE08-82A0-4BC0-8AC0-1DE567F35613}&sd=928976660&n=982 

IAS 38: Intangible Assets

IAS 38, Intangible Assets, was approved by the IASB Board in July 1998 and became operative for annual financial statements covering periods beginning on or after 1 July 1999.

IAS 38 supersedes:

  • IAS 4, Depreciation Accounting, with respect to the amortisation (depreciation) of intangible assets; and
  • IAS 9, Research and Development Costs.

In 1998, IAS 39: Financial Instruments: Recognition and Measurement, amended a paragraph of IAS 38 to replace the reference to IAS 25, Accounting for Investments, by reference to IAS 39.

One SIC Interpretation relates to IAS 38:

Summary of IAS 38

IAS 38 applies to all intangible assets that are not specifically dealt with in other International Accounting Standards. It applies, among other things, to expenditures on:

  • advertising,
  • training,
  • start-up, and
  • research and development (R&D) activities.

IAS 38 supersedes IAS 9, Research and Development Costs. IAS 38 does not apply to financial assets, insurance contracts, mineral rights and the exploration for and extraction of minerals and similar non-regenerative resources. Investments in, and awareness of the importance of, intangible assets have increased significantly in the last two decades.

The main features of IAS 38 are:

  • an intangible asset should be recognised initially, at cost, in the financial statements, if, and only if:

    (a) the asset meets the definition of an intangible asset. Particularly, there should be an identifiable asset that is controlled and clearly distinguishable from an enterprise's goodwill;

    (b) it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and

    (c) the cost of the asset can be measured reliably.

    This requirement applies whether an intangible asset is acquired externally or generated internally. IAS 38 also includes additional recognition criteria for internally generated intangible assets;


  • if an intangible item does not meet both the definition, and the criteria for the recognition, of an intangible asset, IAS 38 requires the expenditure on this item to be recognised as an expense when it is incurred. An enterprise is not permitted to include this expenditure in the cost of an intangible asset at a later date;


  • it follows from the recognition criteria that all expenditure on research should be recognised as an expense. The same treatment applies to start-up costs, training costs and advertising costs. IAS 38 also specifically prohibits the recognition as assets of internally generated goodwill, brands, mastheads, publishing titles, customer lists and items similar in substance. However, some development expenditure may result in the recognition of an intangible asset (for example, some internally developed computer software);


  • in the case of a business combination that is an acquisition, IAS 38 builds on IAS 22: Business Combinations, to emphasise that if an intangible item does not meet both the definition and the criteria for the recognition for an intangible asset, the expenditure for this item (included in the cost of acquisition) should form part of the amount attributed to goodwill at the date of acquisition. This means that, among other things, unlike current practices in certain countries, purchased R&D-in-process should not be recognised as an expense immediately at the date of acquisition but it should be recognised as part of the goodwill recognised at the date of acquisition and amortised under IAS 22, unless it meets the criteria for separate recognition as an intangible asset;


  • after initial recognition in the financial statements, an intangible asset should be measured under one of the following two treatments:

    (a) benchmark treatment: historical cost less any amortisation and impairment losses; or

    (b) allowed alternative treatment: revalued amount (based on fair value) less any subsequent amortisation and impairment losses. The main difference from the treatment for revaluations of property, plant and equipment under IAS 16 is that revaluations for intangible assets are permitted only if fair value can be determined by reference to an active market. Active markets are expected to be rare for intangible assets;


  • intangible assets should be amortised over the best estimate of their useful life. IAS 38 does not permit an enterprise to assign an infinite useful life to an intangible asset. It includes a rebuttable presumption that the useful life of an intangible asset will not exceed 20 years from the date when the asset is available for use. IAS 38 acknowledges that, in rare cases, there may be persuasive evidence that the useful life of an intangible asset will exceed 20 years. In these cases, an enterprise should amortise the intangible asset over the best estimate of its useful life and:

    (a) test the intangible asset for impairment at least annually in accordance with IAS 36: Impairment of Assets; and

    (b) disclose the reasons why the presumption that the useful life of an intangible asset will not exceed 20 years is rebutted and also the factor(s) that played a significant role in determining the useful life of the asset;


  • required disclosures on intangible assets will enable users to understand, among other things, the types of intangible assets that are recognised in the financial statements and the movements in their carrying amount (book value) during the year. IAS 38 also requires disclosure of the amount of research and development expenditure recognised as an expense during the year; and


  • IAS 38 is operative for annual accounting periods beginning on or after 1 July 1999. IAS 38 includes transitional provisions that clarify when the Standard should be applied retrospectively and when it should be applied prospectively.

To avoid creating opportunities for accounting arbitrage in an acquisition by recognising an intangible asset that is similar in nature to goodwill (such as brands and mastheads) as goodwill rather than an intangible asset (or vice versa), the amortisation requirements for goodwill in IAS 22: Business Combinations are consistent with those of IAS 38.


FASB REPORT - BUSINESS AND FINANCIAL REPORTING, CHALLENGES FROM THE NEW ECONOMY NO. 219-A April 2001 Author: Wayne S. Upton, Jr. Source: Financial Accounting Standards Board --- 
Upton's book challenges Lev's contention that the existing standards are enormously inadequate for the "New Economy."

The Garten SEC Report: A press release and an executive summary are available at  
The Garten SEC Report supports Lev's contention that the existing standards are enormously inadequate for the "New Economy."
(You can request a copy of the full report using an email address provided at the above URL)

Trinity University students may access this report at J:\courses\acct5341\readings\sec\garten.doc 


American Accounting Association (AAA) members may view a replay of a day-long webcast on accounting for business combinations and intangible valuations (SFAS 141 and 142) at half the price that will be charged to other non-FEI members ($149 versus $299). The FEI hopes to use funds generated from AAA members to help the FEI assume sponsorship of a Corporate Accounting Policy Seminar.

The webcast encompassed five presentations by experts with question-and-answer periods: (1) Overview of SFAS 141/142, by G. Michael Crooch, FASB Board Member; (2) Recognition and Measurement of Intangibles, by Tony Aarron of E&Y Valuation Services and Steve Gerard of Standard and Poors's, (3) Impact on Doing Deals: Structure, Pricing and Process, by Raymond Beier of PWC and Elmer Huh, Morgan Stanley Dean Witter, (4) Testing for Goodwill Impairment, by Mitch Danaher of GE, and (5) Transition Issues and Financial Statement Disclosures, by Julie A. Erhardt of Arthur Andersen's Professional Standards Group.

As an example (Digital Island Inc.) of the impact of FAS 142 on impairment testing for goodwill, please print the following document: 

Amortization of intangible assets. Amortization expense increased to $153.7 million for the nine months ended June 30, 2001 from $106.4 million for the nine months ended June 30, 2000. This increase was primarily due to a full period

of amortization of the goodwill and intangibles related to the acquisitions of Sandpiper, Live On Line and SoftAware, which were completed in December 1999, January 2000 and September 2000, respectively. This increase was offset by a decrease in the current quarter's amortization as a direct result of a $1.0 billion impairment charge on goodwill and intangible assets in the quarter ended March 31, 2001. Amortization of intangible assets is expected to decrease in future periods due to this impairment charge.

Impairment of Goodwill and Intangible Assets. Impairment of goodwill and intangible assets was recorded in the amount of $1,039.2 million. The impairment charge was based on management performing an impairment assessment of the goodwill and identifiable intangible assets recorded upon the acquisitions of Sandpiper, Live On Line and SoftAware, which were completed during the year ended September 30, 2000. The assessment was performed primarily due to the significant decline in stock price since the date the shares issued in each acquisition were valued. As a result of this review, management recorded the impairment charge to reduce goodwill and acquisition-related intangible assets. The charge was determined as the excess of the carrying value of the assets over the related estimated discounted cash flows.

Forwarded by Storhaug [storhaug@BTIGATE.COM

To follow up on this list's earlier brief discussion on FASB 141 & 142, below is a bookmark to a site "CFO.COM" which has an excellent compendium of articles and links, all of which help you evaluate these new FASB's. 

"The Goodwill Games How to Tackle FASB's New Merger Rules," by Craig Schneider, --- 

The thrill of victory and the agony of defeat. Chances are senior financial executives will experience a similar range of emotions while wrestling with the Financial Accounting Standards Board's new rules for business combinations, goodwill, and intangibles. Use's special report for tips on tackling the impairment test, avoiding Securities & Exchange Commission inquiries, finding valuation experts, and much more. While accounting is not yet an Olympic sport, with the right training, you'll take home the gold. We welcome your questions and comments. E-mail
Take Your First Steps

How to Survive the SEC's Second Guessing
New rules for recording goodwill and intangibles may inadvertently produce more restatements.

Cramming for the Final
Get up to speed on the latest accounting rule changes for treating goodwill and intangibles.

Pool's Closed
FASB's new merger-accounting rules have already won some fans among deal makers.
(CFO Magazine)

Intangibles Revealed
Once you identify them, how much will the fair value assessments cost?

Four Ways to Say Goodbye to Goodwill Amortization
Expert tips for tackling the impairment test.


Congratulations to Baruch Lev from NYU --- 

Baruch's picture adorns the cover of Financial Executive, March/April 2002 --- 

The cover story entitled "Rethinking Accounting:  Intangibles at a Crossroads:  What Next?" on pp. 34-39 --- 
The concluding passage is quoted below:

The Inertness and Commoditization of Intangibles 

Intangibles are inert - by themselves, they neither create value nor generate growth. In fact, without efficient support and enhancement systems, the value of intangibles dissipates much quicker than that of physical assets. Some examples of inertness: uHighly qualified scientists at Merck, Pfizer, or Ely Lilly (human capital intangibles) are unlikely to generate consistently winning products without innovative processes for drug research, such as the "scientific method," based on the biochemical roots of the target diseases, according to Rebecca Henderson, a specialist on scientific drug research, in Industrial and Corporate Change. Even exceptional scientists using the traditional "random search" methods for drug development will hit on winners only randomly, writes Henderson.

uA large patent portfolio at DuPont or Dow Chemical (intellectual property) is by itself of little value without a comprehensive decision support system that periodically inventories all patents, slates them by intended use (internal or collaborative development, licensing out or abandonment) and systematically searches and analyzes the patent universe to determine whether the company's technology is state-of-the-art and competitive.

uA rich customer database (customer intangibles) at or Circuit City will not generate value without efficient, user-friendly distribution channels and highly trained and motivated sales forces.

Worse than just inert, intangibles are very susceptible to value dissipation (quick amortization) - much more so than other assets. Patents that are not constantly defended against infringement will quickly lose value due to "invention around" them. Highly trained employees will defect to competitors without adequate compensation systems and attractive workplace conditions. Valuable brands may quickly deteriorate to mere "names" when the firm - such as a Xerox, Yahoo! or Polaroid - loses its competitive advantage. The absence of active markets for most intangibles (with certain patents and trademark exceptions) strips them of value on a stand-alone basis.

Witness the billions of dollars of intangibles (R&D, customer capital, trained employees) lost at all the defunct dot-coms, or at Enron, or at AOL Time Warner Co., which in January 2002 announced a whopping write-off of $40-60 billion - mostly from intangibles.

Intangibles are not only inert, they are also, by and large, commodities in the current economy, meaning that most business enterprises have equal access to them. Baxter and Johnson & Johnson, along with the major biotech companies, have similar access to the best and brightest of pharmaceutical researchers (human capital); every retailer can acquire the state-of-the-art supply chains and distribution channel technologies capable of creating supplier and customer-related intangibles (such as mining customer information); most companies can license-in patents or acquire R&D capabilities via corporate acquisitions; and brands are frequently traded. The sad reality about commodities is that they fail to create considerable value. Since competitors have equal access to such assets, at best, they return the cost of capital (zero value added).

The inertness and commoditization of most intangibles have important implications for the intangibles movement. They imply that corporate value creation depends critically on the organizational infrastructure of the enterprise - on the business processes and systems that transform "lifeless things," tangible and intangible, to bundles of assets generating cash flows and conferring competitive positions. Such organizational infrastructure, when operating effectively, is the major intangible of the firm. It is, by definition, noncommoditized, since it has to fit the specific mission, culture, and environment of the enterprise. Thus, by its idiosyncratic nature, organizational infrastructure is the major intangible of the enterprise.

Focusing the Intangibles Efforts 

Following Phase I of the intangibles work, which was primarily directed at documentation and awareness-creation, it's now time to focus on organizational infrastructure, the intangible that counts most and about which we know least. It's the engine for creating value from other assets. Like breaking the genetic code, an understanding of the "enterprise code" - the organizational blueprints, processes and recipes - will enable us to address fundamental questions of concern to managers and investors, such as those raised above in relation to H-P/Compaq and Enron.

Organizational Infrastructure By Example: A company's organizational infrastructure is an amalgam of systems, processes and business practices (its operating procedures, recipes) aimed at streamlining operations toward achieving the company's objectives. Following is a concrete example of a business process, part of the organizational infrastructure, which was substantially modified and thereby created considerable value. This was adopted from "Turnaround," Business 2.0, January 2002.

Nissan Motor Co. Ltd., Japan's third-largest automaker and a perennial loser and debt-ridden producer of lackluster cars, received in March 1999 a new major shareholder, Renault, and a new CEO, Carlos Ghosn, both imported from France. Ghosn moved quickly to transform Nissan into a viable competitor, and indeed, in the fiscal year ending March 2001, the company reported a profit of $2.7 billion, the largest in its 68-year history.

How was this miracle performed? Primarily by cost-cutting, achieved by a drastic change in the procurement process. Here briefly, is the old process: Nissan's buyers were locked into ordering from keiretsu partners, suppliers in which Nissan owned stock. The guaranteed stream of Nissan orders insulated those suppliers from competition. Suppliers can't specialize and can't sell excess capacity elsewhere. Each supplier was assigned a shukotan, Nissan-speak for a relationship manager. It was the shukotan who would negotiate price discounts - but favors got in the way.

Here, in brief, is the new procurement process, as drastically changed by Ghosn: Ghosn gave Itaru Koeda, the purchasing chief, authority to place orders without regard to keiretsu relationships - and, more important, insisted that he use it. Then, a Renault executive and Koeda dumped the shukotan system, instead assigning buyers responsibility by model and part. They formed a sourcing committee to review vendor price quotes on a global basis. "This is the best change in our process," Koeda says. "Suppliers are specializing in what they do best, making them more efficient."

The results? An 18 percent drop in purchasing costs, which was the major contributor to Nissan's transformation from a loss to a profit. Ghosn's next major set of tasks: To change the car design process in order to enhance the top line, sales; to rid Nissan of the myriad design committees and hierarchies that stifle and slow innovation; and to institute an efficient, effective innovative process.

Baruch's cover story is accompanied by "Fixing Financial Reporting:  Financial Statement Overhaul," by  Robert A Howell, pp. 40-42 --- 

Financial reporting is broken and has to be fixed - and fast! If it isn't, we will continue to see more cases such as Xerox, Lucent, Cisco Systems, Yahoo! and Enron. Xerox's market value is down 90 percent, or $40 billion, in the past two years. In the same period other market losses include; Lucent, down more than $200 billion; Cisco Systems, off more than $400 billion; Yahoo!, more than $100 billion; and Enron, down more than $60 billion in the largest bankruptcy of all time.

Some argue that these are extreme examples of "irrational exubuerance." Some in the accounting profession say that such cases represent a small percentage of the aggregate number of statements audited - some 15,000 public company registrants. Perhaps. But a financial reporting framework that permits these companies to suggest that they are doing well, and, by implication, to justify market valuations which, subsequently, cost investors trillions in the aggregate, is unconscionable.

Financial reporting, especially in the U. S., with its very public capital markets, has reached the point where "accrual-based" earnings are almost meaningless. Reported earnings are driven as much by "earnings expectations" as they are by real business performance. Balance sheets fail to reflect the major drivers of future value creation - the research and product, process and software development that fuel high technology companies, and the brand value of leading consumer product companies. And, cash flow statements are such a hodge-podge of operating, investing and financing activities that they obfuscate, rather than illuminate, business cash flow performance.

The FASB, in its Concept No. 1, states, "financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions." This is simply not so.

The primary financial statements - income statement, balance sheet and cash flow statement - which derive their foundation from an industrial age model, need major redesign if they are to serve as the starting point for meaningful financial analysis, interpretation and decision-making in today's knowledge-based and value-driven economy. Without significant redesign, ad hoc definitions such as pro forma earnings, returns and cash flows will continue to proliferate. So will significant reporting "surprises!"

Starting Point: Market Value Creation
The objective of a business is to increase real shareholder value - what Warren E. Buffett would call the "intrinsic value" of the firm. It's a very basic idea: Investors get "returns" from dividends and realized market appreciation. Both investments and returns are measured in cash terms, so individuals and investors invest cash in securities with the objective of realizing returns that meet or exceed their criteria. If their judgments are too high, and that later becomes clear, the market value of the firm will drop. If judgments are too low and cash flows turn out to be stronger, market values increase.

From a managerial viewpoint, the objective of increasing shareholder (market) value really means increasing the net present value (NPV) of the future stream of cash flows. Note, "cash flows," not "profits." Cash is real; profits are anything, within reason, that management wants them to be. If revenues are recognized early - or overstated - and expenses are deferred or, in some cases, accelerated to "clear the decks" for future periods, resulting earnings may show a nice trend, but do not really reflect economic performance.

There are only three ways management may increase the real market, or "intrinsic," value of a firm. First, increase the amount of cash flows expected at any point in time. Second, accelerate cash flows; given the time value of money, cash received earlier has a higher present value. Third, if a firm is able to lower the discount rate that it applies to its cash flows - which it frequently can - it can raise its NPV.

Given that cash flows drive market value, financial statements should put much more emphasis on cash flows. The statement of cash flows now prescribed by the accounting community and presented by management is not easily related to value creation. Derived from the income statement and balance sheet, it's effectively a reconciliation statement for the change in the balance of the cash account. A major overhaul of the cash flow statement would directly relate to market valuations.

Cash Earnings and Free Cash Flows
Managers and investors should focus on "cash earnings" and the reinvestments that are made into the business in the form of "working capital" and "fixed and other (including intangible) investments." The net amount of these cash flows represent the business's "free cash flows."

With negative cash flows - frequently the case for young startups and high-growth companies - a business must raise more capital in the form of debt or equity. The sooner it gets its free cash flows positive, the sooner it'll begin to create value for shareholders. Positive free cash flows provide resources to pay interest and pay down debt, to return cash to shareholders (through stock repurchases or dividends) or to invest in new business areas.

The traditional cash flow statement purportedly distinguishes between operating, investing and financing cash flows, and has as its "bottom line" the change in cash and cash equivalents. In fact, the operating cash flows include the results of selling activities, investing in working capital and interest expense, a financing activity. Investing cash flows include capital expenditures, acquisitions, disposals of assets and the purchase and sale of financial assets. Financing cash flows consist of what's left over.

Indeed, the bottom-line change in cash is not a useful number, other than to demonstrate that it may be reconciled with the change in the cash account. If one wants a positive change in cash, simply borrow more. These free cash flows ultimately drive market value, and should be the focus of managers and investors alike.

Replacing Income With Cash Earnings
The traditional "profit and loss," or "income," statement needs modification in three ways, two of which are touched on above, along with a name-change, to "Operating Statement." That would suggest a representation of the business' current operations, without the emphasis on accrual-based profits.

Interest expense (income) should be eliminated from the statement, as it represents a financing cost rather than an operating cost. A number of companies do this internally to determine "net operating profit after taxes" (NOPAT). Also, NOPAT needs to be adjusted for the various non-cash items, such as depreciation, amortization, gains and losses on the sale of assets, tax-timing differences and restructuring charges - which affect income but not cash flows. The resultant "cash earnings" better represents the current economic performance of a business than accrual income and, very importantly, is much less susceptible to manipulation.

A third adjustment is the order in which the classes of expenses are displayed. Traditional income statements report cost of goods sold or product costs first, frequently focus on product gross margins, and then deduct, as a group, other expenses such as technical, selling and administrative expenses. This order made sense in the industrial age when product costs dominated. It does not for many of today's high-tech or consumer product companies. It would be more useful for companies to report expenses in an order that reflects the flow of the business activities. One logical order that builds on the concept of a business' value chain, is to categorize costs into development costs, product (service) conversion costs, sales and customer support costs and administrative costs.

Reinvesting in the Business
For most companies - especially those with significant investments that are being depreciated or amortized - cash earnings will be significantly higher than NOPAT. Unfortunately, cash earnings are not free cash flows because most businesses have to reinvest in working capital, property, plant and equipment and intangible assets, just to sustain - let alone increase - their productive capabilities.

As a business grows in sales volume, assuming that it offers credit to its customers who pay with the same frequency, accounts receivable will increase proportionately. As sales volumes increase, so, too, will product costs, inventories and accounts payable balances. Working capital - principally receivables, inventories, and payables - will tend to increase proportionately with sales growth, and will require cash to finance it. The degree to which it grows is a function of receivables terms and collection practices, inventory management and payables practices.

Companies such as Dell Computer Corp. collect payments up front, turn inventories in a few days and pay their vendors when due. The net effect is that as Dell grows it actually throws off cash, rather than requiring it to support increases in working capital. Most companies are not as efficient; the amount of cash needed to support increases in working capital can be as much as 20-25 percent of any sales increase. The degree to which working capital increases as sales increase is an important performance metric. Lower is better, which absolutely flies in the face of such traditional measures of liquidity as "working capital" and "quick" ratios, for which higher has been considered better.

Balance sheets ought to reflect investments that represent future value. What drives value for many businesses in today's knowledge-based economy - pharmaceuticals, high technology, software and brand-driven consumer product companies - is the investments in R&D, product, process and software development, brand equity and the continued training and development of the work force. Yet, based on generally accepted accounting principles (GAAP) accounting, these "investments" in the future are not reflected on balance sheets, but, rather, expensed in the period in which they are incurred.

A frequent argument for "expensing" is the unclear nature of the investments' future value. Apparently, investors believe otherwise, evidenced by the ratio of market values to book values having exploded in the past 25 years. In 1978, the average book-to-market ratio was around 80 percent; today it is around 25 percent. In the early 1970s, when accounting policies were established for R&D, product lines were narrower and life cycles longer, resulting in R&D being a much less significant element of cost. Expensing was less relevant. Now, with intangible assets having become so central and significant, expensing - rather than capitalizing and amortizing them over time - results in an absolute breakdown of the principle of "matching," which is at the heart of accrual accounting. The world of business has changed; accounting practices must also change.

Financial Statement Overhaul
Financial statements need marked overhaul to be useful for analysis and decision-making in today's knowledge-driven and shareholder value-creation environment. The proposed changes fall into three categories:

First - Move to a much more explicit shareholder (market) value creation and cash orientation, and away from accrual accounting profits and return on investment calculations predicated on today's accounting policies. Start with a shareholder perspective for cash flows, then reconstruct the statement of cash flows to clearly provide the free cash flows that the business' operations are generating. Cash earnings and reinvestments in the business comprise free cash flows.

Second - Expand the definition of investments to include intangibles, which should be capitalized as assets and amortized according to some thoughtful rules. This will better reflect investments that have potential future value.

Third - Change the title to "operating statement" and other "housekeeping" of financial statements, to include categorizing costs in a more logical "value chain" sequence and aggregating all financial transactions, such as interest and the purchase and sale of securities, as financing activities.

Value creation is ultimately measured in the marketplace, so it stands to reason that if a firm's market value increases consistently, over time, and can be supported by improvements in its cash generation performance, real value is being created. For this to happen, the place to start is by fixing the financial statements. 

Bob Jensen's threads on accounting theory are at 


The Shareholder Action On-Line Handbook (1993) (history, finance, investing, law)--- 

These Web pages are the on-line version of The Shareholder Action Handbook, first published in paperback 1993 by New Consumer. The Handbook aims to give practical advice to individuals about how they may use shares to make companies more accountable. The need for such a guide is now stronger than ever. Public concern in Britain about the accountability of company directors has risen to the extent that the subject makes regular appearances in debates in the House of Commons. While there are many obstacles to taking shareholder action, shareholders can do much to alter the course of corporate behaviour. Indeed, since the original version of the guide appeared there have been a number of successful shareholder action campaigns. However, there is considerable need both for new legislation to make it easier for shareholders to hold companies to account, and for the large institutional shareholders who own much of global industry to take their responsibilities as shareholders rather more seriously.

Online Resources for Business Valuations

Looking for information on valuing your business? Look no further. Or look way further, depending on your point of view. Here is a Web site, produced by Professor William C. Weaver, that provides numerous links to online business valuation resources all assembled in one easy-to-use location. 

Business Valuation Links --- 

Business Valuation References --- 

Understanding the Issues

From The Wall Street Journal's Accounting Educator Reviews on January 22, 2002

TITLE: Deciphering the Black Box 
REPORTER: Steve Liesman 
DATE: Jan 23, 2002 PAGE: C1 LINK:  TOPICS: Accounting, Accounting Theory, Creative Accounting, Disclosure, Disclosure Requirements, Earnings Management, Financial Analysis, Financial Statement Analysis, Fraudulent Financial Reporting, Regulation, Securities and Exchange Commission

SUMMARY: The article discusses several factors that have led to financial reporting that is complex and difficult to understand. Related articles provide specific examples of complicated and questionable financial reporting practices.

1.) What economic factors have led to the complexity of financial reporting? Have accounting standard setters kept pace with the changing economic conditions? Support your answer.

2.) What determines a company's cost of capital? What is the relation between the quantity and quality of financial information disclosed by a company and its cost of capital? Why are companies reluctant to disclose financial information?

3.) Explain the difference between earnings management and fraudulent financial reporting? Is either earnings management or fraudulent financial reporting illegal? Is either unethical? Could earnings management ever improve the usefulness of financial reporting? Explain.

4.) Discuss the advantages and disadvantages of allowing discretion in financial reporting.

5.) Refer to related articles. Briefly discuss the major accounting or economic situation that has caused complexity in the financial reporting of each of these companies. What can be done to make the financial reporting more useful?

SMALL GROUP ASSIGNMENT: How much discretion should Generally Accepted Accounting Principles allow in financial reporting? Support your position.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University


TITLE: GE: Some Seek More Light on the Finances 
REPORTER: Rachel Emma Silverman and Ken Brown 
PAGE: C1 ISSUE: Jan 23, 2002 

TITLE: AIG: A Complex Industry, A Very Complex Company 
REPORTER: Christopher Oster and Ken Brown 
PAGE: C16 ISSUE: Jan 23, 2002 

TITLE: Williams: Enron's Game, But Played with Caution 
REPORTER: Chip Cummins 
PAGE: C16 ISSUE: Jan 23, 2002 

TITLE: IBM: 'Other Income' Can Mean Other Opinions 
REPORTER: William Bulkeley 
PAGE: C16 ISSUE: Jan 23, 2002 

TITLE: Coca-Cola: Real Thing Can Be Hard to Measure 
REPORTER: Betsy McKay 
PAGE: C16 ISSUE: Jan 23, 2002 

Bob Jensen's threads on accounting and securities fraud are at 

From The Wall Street Journal Accounting Educators' Review on June 11, 2004

TITLE: Outside Audit: Goodyear and the Butterfly Effect 
REPORTER: Timothy Aeppel 
DATE: Jun 04, 2004 
TOPICS: Accounting Changes and Error Corrections, Pension Accounting, Restatement

SUMMARY: Goodyear Tire & Rubber has announced the amount of its restatement from problems identified in 2003. The company as well has announced further restatements due to changes in the discount rate it uses for pension liability calculations.

1.) For what reason is Goodyear Tire & Rubber restating earnings for the last five years?

2.) What accounting standards require restatements of past financial results? Under what circumstances are restatements required? What other types of accounting changes are possible? How are these categories of accounting changes presented in the financial statements?

3.) In general, what adjustment is Goodyear Tire & Rubber making to its accounting for defined benefit pension plans?

4.) Discuss the details of the change in accounting for the defined benefit pension plan. Specifically, define the discount rate in question and state how it is used in pension accounting.

5.) Had the company not uncovered the issues identified under question #1, do you think they would be making the changes identified in questions #3 and #4? Why or why not?

6.) Do you think that changes in the discount rate used in pension accounting are made by other companies? When do you think companies might change this rate? In general, what type of accounting treatment would you recommend for such a change? Support your answer.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"Outside Audit: Goodyear And the Butterfly Effect:  A Valuation Rate Is Shaved By Half a Point and Presto, $100.1 Million Goes Poof," by Timothy Aeppel, The Wall Street Journal, June 4, 2004, Page C3 ---,,SB108629544631828261,00.html

There's a costly oddity tucked into Goodyear Tire & Rubber Co.'s recent earnings restatement.

As part of a larger revision reaching back five years, the U.S.'s largest tire maker changed the interest-rate assumptions associated with its domestic retirement plans. The upshot: By slicing half a point off a rate used to value the company's obligations to its pension fund and other post-retirement benefit plans, Goodyear also lopped off a total of $100.1 million in earnings over that period.

This may be the first time a major company has restated earnings for this reason, although it was just one of several accounting issues the Akron, Ohio, tire maker addressed in its restatement announced May 19. Goodyear has identified a series of accounting irregularities over the past year and is the target of a continuing investigation by the Securities and Exchange Commission.

"I have a feeling that while they were scrubbing, they decided to scrub everything," says Jack Ciesielski, publisher of Analyst's Accounting Observer.

Keith Price, a Goodyear spokesman, says the change doesn't mean Goodyear sought to inflate earnings in the past by using an inappropriately high discount rate. Most of the reduction in earnings was the result of Goodyear having to record additional tax expenses, he notes. Mr. Price says Goodyear decided to change its methodology for calculating the rate it uses going forward and, since a broader restatement was already under way, chose to extend the new approach into the past as well.

The root of Goodyear's problem appears to be that it used an uncommon way of calculating the so-called discount rate it assumes for its traditional pension plan. A discount rate is simply an interest rate companies use to convert future values into their present-day terms. Companies calculate the pension-fund discount rate at the end of every year in order to project cash outflows in their retirement plans. The number changes from year to year. But it also tends to get buried in financial footnotes and overlooked.

The higher the discount rate, the less the current value of a company's future obligations to its retirees under its plans. So, in Goodyear's case, the older, higher discount rate lowered the company's projected benefit payments -- which also had the effect of raising its pretax income.

Goodyear's old method of setting the rate was to use a six-month average of corporate-bond rates. That's unusual, though not a violation of generally accepted accounting principles, says Mr. Ciesielski.

The more common and accurate approach is to pick a discount rate based on rates at a point in time near to when the calculations are being done. That provides a better snapshot of reality, especially in an era when rates are falling, as they have in recent years.

Sure enough, Goodyear's old methodology resulted in discount rates that were higher than those used by most other companies during the period in question. For instance, in its restatement, Goodyear cut the rate it used in 2001 to 7.5% from 8%. But a study by Credit Suisse First Boston notes that the median discount rate used by S&P-500 component companies that year was a far lower 7.25%. In fact, the study found only seven companies used rates of 8% or higher in 2001.

Goodyear's numbers are now more in line with other companies' and shouldn't require further adjustment, say analysts. But like many old-line companies with a relatively large cadre of older workers and retirees, Goodyear is expected to face pension problems for years to come, since its plans are underfunded by about $2.8 billion.

While Goodyear's pension concerns are not unique, Mr. Ciesielski says it is unlikely other companies will rush to restate earnings to reflect a new discount-rate assumption. Besides, coming up with the rate is still far from an exact science.

David Zion, CSFB's accounting analyst, says even companies that use identical methodologies can arrive at sharply different discount rates. Those with fiscal years ending in June would have different rates than those with years ending in December, for example. And multinational companies face another complication: "The discount rate for a Japanese pension plan will be different than the discount rate in Turkey," Mr. Zion points out.

In its restatement, Goodyear decreased overall pretax income by $18.9 million for the past five years as a result of its reassessment of the discount rate. And since Goodyear's pension plan is underfunded, the cut in the discount rate also magnified that negative condition. As a result, Goodyear had to add $160.9 million in liabilities to its balance sheet. The new liabilities forced Goodyear to record $81.2 million in additional tax expenses for 2002.

This restatement comes at a time Goodyear's accounting is still under heavy scrutiny. The company launched an internal probe last year after it said it found problems in internal billing and the implementation of a new computer system. It later said it had identified serious misdeeds by top managers in Europe and cases in which U.S. plants understated workers' compensation liabilities.

Hi Robert,

I added your document to 

I would not say that we are so much timid as we are squashed by lobbying pressures from industry.

Bob Jensen


I wish to ask you a favour again. I have written the attached as a submission to a review of the New Zealand Financial Reporting Act 1993. It is currently under review due to the imminent adoption of the IASB's standards. It has thrown New Zealand's application of differential reporting into confusion. My submission deals with the way in which accounting must be the pivot upon which creditor protection functions. What I would hope Americans find interesting is the degree to which we have played out your laws - the corporate solvency test and GAAP - in a way you are too timid to do.

The Government's discussion document to which the submission is a response is on this link: 

The letter is self-contained aside from the specific commentary at the end. Could you find space for it on your web-site?

Robert B Walker

Stock Option Valuation Research Database

From Syllabus News on December 13, 2002

Wharton School Offers Stock Data Via the Web

The University of Pennsylvania's Wharton business school is offering financial analysts access to historical information on stock options over the Internet. The data, supplied by research firm OptionMetrics's Ivy database, covers information on all U.S. listed index and equity options from January1996. The Ivy database adds to the 1.5 terabyte storehouse of financial information from a range of providers now available through Wharton Research Data Services (WRDS). The university said that by making data from the Center for Research in Security Prices, Standard & Poor's COMPUSTAT, the Federal Deposit Insurance Corporation, the New York Stock Exchange, and other data vendors accessible from a simple Web-based interface, WRDS hopes to become the preferred source among university scholars for data covering global financial markets.

Note from Jensen:  the Wharton Research Data Services (WRDS) home page is at 

Wharton Research Data Services, a revolutionary Internet-based research data service developed and marketed by the Wharton School, has become the standard for large-scale academic data research, providing instant web access to financial and business datasets for almost all top-tier business schools (including 23 of the top 25 schools as ranked by Business Week magazine).

Subscribers to Wharton Research Data Services (WRDS) gain instant access to the broadest array of business and economic data now available from a single source on the Web. From anywhere and at any time, WRDS functions as an application service provider (ASP) to deliver information drawn from 1.2 terabytes of comprehensive financial, accounting, management, marketing, banking and insurance data.

Launched in July 1997, the unique data service's client list of over 60 institutions now includes Stanford University, Harvard University, Columbia University, Yale University, Northwestern University, London Business School, INSEAD, University of Chicago, Massachusetts Institute of Technology and dozens of other institutions. Subscribers to WRDS need only PCs or even less-expensive Web terminals to endow their units with supercomputer capabilities and tap a massive, constantly updated source of data. Users click on the WRDS database and interactively select data to extract. The requested information is instantly returned to the web browser, ready to be pasted into a spreadsheet or any other application for analysis.

To learn more about WRDS or to get licensing information, contact: Nicole Carvalho, Marketing Director Wharton Research Data Services 400 Steinberg Hall-Dietrich Hall 3620 Locust Walk Philadelphia, PA 19104-6302

1-877-GET-WRDS (1-877-438-9737)

Knowledge@Wharton is a free source of research reports and other materials in accounting, finance, and business research --- 


Forwarded by Robert B Walker [walkerrb@ACTRIX.CO.NZ

FASB Understanding the Issues: Vol 4 Series 1 --- 

I refer to the monograph on credit standing & liability measurement written by Crooch & Upton. ---  

The article seems to suggest you wish to have feedback on this and other matters. Accordingly, I send my thoughts on this matter.

I would begin by observing that I think Concepts Statement 7 is inconsistent with the earlier 1996 study from which it was derived. I found that study utterly persuasive so I do not now find CS-7 persuasive. In moments of cynicism, I think that Mr Upton’s apparent epiphany is related more to the politics of accountancy than to its conceptual purity.

By this I mean that the measurement of liabilities at risk free interest rate rather than at a rate reflecting credit standing would be so anathema to the generality of accountants that it is futile to suggest it. Indeed the Crooch & Upton begin by stating a basic premise of axiomatic significance to their case – no gain or loss should arise when engaging in simple borrowing. The idea that no sooner one entered a loan agreement than a loss would arise (because it would invariably be a loss) would have most accountants in a state of high dudgeon.

The issue then is one of gain or loss. But then that is only if you perceive the world from an income orientation perspective. I don’t, primarily because of the influence of the conceptual framework. This is reinforced by my work as a liquidator of companies. I see the world purely from a balance sheet perspective and one subject to realisable value at that. In other words, I see the utility of accounting only in terms of solvency determination with all that entails in regard to the going concern assumption.

Unlike the United States, in the jurisdiction in which I live accounting has been rendered central to creditor protection in our corporate law. Central to this law, in turn, is the conceptual framework (at least in my view and to test the hypothesis I have a case before the courts now). I am then caused considerable misgiving as the final consequence of FASB’s view is the effective emasculation of our law built, essentially, on American conceptual development.

The ultimate consequence of what FASB propose is that as a company slides toward insolvency its liability value declines, the value of its net worth increases. Presumably as it has no credit standing at all because it is insolvent, it has no liabilities. This may be practically true when the creditors miss out but in my jurisdiction at least it is not legally true because those responsible for the creditors loss are held accountable, the impediments of the legal system notwithstanding.

I note that Crooch & Upton make reference in a footnote to the theory of Robert Merton in which it is implied that the residual assets are able to be ‘put’ to satisfy the claims of creditors. That may be true in an economist’s fantasy but it is not true in law, a rather more important arena.

I say perceiving a decline in the value of a liability is considerably more counter-intuitive than the problem of accelerating the recognition of cost of debt. This is a mere triviality by comparison. After all the same amount of charge is recognised over time. The advantage of accelerating loss is that it causes an entity to be more inhibited in its distribution policy as it has less equity to draw upon. That is to the advantage of creditors.

It seems to me that there needs to be an objective value at which to determine the value of a liability, this being central to the ability to liquidate. Mr Upton in his 1996 study demonstrates that such a value will represent the price the debtor has to pay to have the liability taken away. That price will be determined by the seller providing sufficient resources to the buyer to ensure that the buyer will avoid any risk. The resources would need to be enough to acquire a risk free asset with the same maturity profile as the liability.

The effect of perceiving the ‘price’ of a liability in this way is to necessitate that it is discounted at a risk free rate.

I note that the only way to make CS-7 coherent is to assume that such transfers of assets are always made between parties of the same credit standing. This pertains to one of the major practical difficulties of reflecting credit standing in accounting measurement – that is knowing what it is. It may be easily determined in the publicly listed world in which Crooch & Upton inhabit. It is not in the small, closely held corporate world in which I operate. For accounting to have long term validity it must be applicable in all circumstances.

I think it fair to note that there is another dimension to this that tends to undermine what I believe. I have a theoretical notion that the world upon consolidation nets to nil. That is to say, my financial asset and your financial liability must have the same value in our respective records. Call this a principle of reciprocity.

Theoretically, so far as I understand it a lender will discount the face value of a zero discount bond at the risk free rate after having adjusted for the probability of receiving nothing at all. The effect of doing that is, at the inception of an advance, to carry the value of the asset at the cash value paid at that time. If the application of the principle of reciprocity was applied when the liability was revalued in the books of the debtor, the creditor would take up a gain that denied any risk existed.

I find this inconvenient as it causes me to abandon a notion in which I fundamentally believe. I will just have to suffer cognitive dissonance, won’t I? But then one should not underestimate the psychology that underlies accounting, particularly in the face of the paradoxes it is capable of generating.

Also see other articles on related topics at 


Pro-Forma Earnings (Electronic Commerce, e-Commerce, eCommerce)

From the Wall Street Journal's Accounting Educators' Reviews, October 4, 2001
Educators interested in receiving these excellent reviews (on a variety of topics in addition to accounting) must firs subscribe to the electronic version of the WSJ and then go to 

Sample from the October 4 Edition:

TITLE: Sales Slump Could Derail Amazon's Profit Pledge 
REPORTER: Nick Wingfield 
DATE: Oct 01, 2001 
TOPICS: Accounting, Creative Accounting, Earnings Management, Financial Analysis, Net Income, Net Profit

SUMMARY: Earlier this year Amazon promised analysts that it will report first-ever operating pro forma operating profit. However, Amazon is not commenting on whether it still expects to report a fourth-quarter profit this year. Questions focus on profit measures and accounting decisions that may enable Amazon to show a profit.


1.) What expenses are excluded from pro forma operating profits? Why are these expenses excluded? Are these expenses excluded from financial statements prepared in accordance with Generally Accepted Accounting Principles?

2.) List three likely consequences of Amazon not reporting a pro forma operating profit in the fourth quarter. Do you think that Amazon feels pressure to report a pro forma operating profit? Why do analysts believe that reporting a fourth quarter profit is important for Amazon?

3.) List three accounting choices that Amazon could make to increase the likelihood of reporting a pro forma operating profit. Discuss the advantages and disadvantages of making accounting choices that will allow Amazon to report a pro forma operating profit.

SMALL GROUP ASSIGNMENT: Assume that you are the accounting department for Amazon and preliminary analysis suggest that Amazon will not report a pro forma operating profit for the fourth quarter. The CEO has asked you to make sure that the company meets its financial reporting objectives. Discuss the advantages and disadvantages of making adjustments to the financial statements. What adjustments, if any, would you make? Why?


By: Judy Beckman, University of Rhode Island Reviewed 
By: Benson Wier, Virginia Commonwealth University Reviewed 
By: Kimberly Dunn, Florida Atlantic University

Bob Jensen's threads on accounting theory can be found at

Bob Jensen's threads on real options for valuing intangibles are at 


Baruch Lev has a very good site on accounting for intangibles at 

Also note Wayne Upton's Special Report for the FASB at 

E-COMMERCE AND AUDITING FAIR VALUES SUBJECTS OF NEW INTERNATIONAL GUIDANCE The International Federation of Accountants (IFAC) invites comments on two new exposure drafts (EDs): Auditing Fair Value Measurements and Disclosures and Electronic Commerce: Using the Internet or Other Public Networks - Effect on the Audit of Financial Statements. Comments on both EDs, developed by IFAC's International Auditing Practices Committee (IAPC), are due by January 15, 2002. See  

The IFAC link is at 

The purpose of this International Standard on Auditing (ISA) is to establish standards and provide guidance on auditing fair value measurements and disclosures contained in financial statements. In particular, this ISA addresses audit considerations relating to the valuation, measurement, presentation and disclosure for material assets, liabilities and specific components of equity presented or disclosed at fair value in financial statements. Fair value measurements of assets, liabilities and components of equity may arise from both the initial recording of transactions and later changes in value.


"Auditing Fair Value Measurements And Disclosures"
in MS Word format.

File Size: 123 Kbytes
"Auditing Fair Value Measurements And Disclosures"
in Adobe Acrobat format.

File Size: 209 Kbytes




External Auditing Combined With Consulting and Other Assurance Services:  Audit Independence?

TITLE:  "Auditor Independence and Earnings Quality"R
Richard M. Frankel MIT Sloan School of Business 50 Memorial Drive, E52.325g Cambridge, MA 02459-1261 (617) 253-7084 
Marilyn F. Johnson Michigan State University Eli Broad Graduate School of Management N270 Business College Complex East Lansing, MI 48824-1122 (517) 432-0152  
Karen K. Nelson Stanford University Graduate School of Business Stanford, CA 94305-5015 (650) 723-0106  
DATE:  August 2001

Stanford University Study Shows Consulting Does Affect Auditor Independence --- 

Academics have found that the provision of consulting services to audit clients can have a serious effect on a firm's perceived independence.

And the new SEC rules designed to counter audit independence violations could increase the pressure to provide non-audit services to clients to an increasingly competitive market.

The study (pdf format), by the Stanford Graduate School of Business, showed that forecast earnings were more likely to be exceeded when the auditor was paid more for its consultancy services.

This suggests that earnings management was an important factor for audit firms that earn large consulting fees. And such firms worked at companies that would offer little surprise to the market, given that investors react negatively when the auditor also generates a high non-audit fee from its client.

The study used data collected from over 4,000 proxies filed between February 5, 2001 and June 15, 2001.

It concluded: "We find a significant negative market reaction to proxy statements filed by firms with the least independent auditors. Our evidence also indicates an inverse relation between auditor independence and earnings management.

"Firms with the least independent auditors are more likely to just meet or beat three earnings benchmarks – analysts' expectations, prior year earnings, and zero earnings – and to report large discretionary accruals. Taken together, our results suggest that the provision of non-audit services impairs independence and reduces the quality of earnings."

New SEC rules mean that auditors have to disclose their non-audit fees in reports. This could have an interesting effect, the study warned: "The disclosure of fee data could increase the competitiveness of the audit market by reducing the cost to firms of making price comparisons and negotiating fees.

"In addition, firms may reduce the purchase of non-audit services from their auditor to avoid the appearance of independence problems."

A Lancaster University study in February this year found that larger auditors are less likely to compromise their independence than smaller ones when providing non-audit services to their clients.

And our sister site, AccountingWEB-UK, reports that research by the Institute of Chartered Accountants in England & Wales (ICAEW) showed that, despite the prevalence of traditional standards of audit independence, the principal fear for an audit partner was the loss of the client. 


External Auditing Combined With Consulting and Other Assurance Services:  The Enron Scandal

One of the most prominent CPAs in the world sent me the following message and sent the WSJ link:

Bob, More on Enron. 
It's interesting that this matter of performing internal audits didn't come up in the testimony Joe Beradino of Andersen presented to the House Committee a couple of days ago

"Arthur Andersen's 'Double Duty' Work Raises Questions About Its Independence," by Jonathan Weil, The Wall Street Journal, December 14, 2001 --- 

In addition to acting as Enron Corp.'s outside auditor, Arthur Andersen LLP also performed internal-auditing services for Enron, raising further questions about the Big Five accounting firm's independence and the degree to which it may have been auditing its own work.

That Andersen performed "double duty" work for the Houston-based energy concern likely will trigger greater regulatory scrutiny of Andersen's role as Enron's independent auditor than would ordinarily be the case after an audit failure, accounting and securities-law specialists say.

It also potentially could expose Andersen to greater liability for damages in shareholder lawsuits, depending on whether the internal auditors employed by Andersen missed key warning signs that they should have caught. Once valued at more than $77 billion, Enron is now in proceedings under Chapter 11 of the U.S. Bankruptcy Code.

Internal-audit departments, among other things, are used to ensure that a company's control systems are adequate and working, while outside independent auditors are hired to opine on the accuracy of a company's financial statements. Every sizable company relies on outside auditors to check whether its internal auditors are working effectively to prevent fraud, accounting irregularities and waste. But when a company hires its outside auditor to monitor internal auditors working for the same firm, critics say it creates an unavoidable conflict of interest for the firm.

Still, such arrangements have become more common over the past decade. In response, the Securities and Exchange Commission last year passed new rules, which take effect in August 2002, restricting the amount of internal-audit work that outside auditors can perform for their clients, though not banning it outright.

"It certainly runs totally contrary to my concept of independence," says Alan Bromberg, a securities-law professor at Southern Methodist University in Dallas. "I see it as a double duty, double responsibility and, therefore, double potential liability."

Andersen officials say their firm's independence wasn't impaired by the size or nature of the fees paid by Enron -- $52 million last year. An Enron spokesman said, "The company believed and continues to believe that Arthur Andersen's role as Enron's internal auditor would not compromise Andersen's role as independent auditor for Enron."

Andersen spokesman David Tabolt said Enron outsourced its internal-audit department to Andersen around 1994 or 1995. He said Enron began conducting some of its own internal-audit functions in recent years. Enron, Andersen's second-largest U.S. client, paid $25 million for audit fees in 2000, according to Enron's proxy last year. Mr. Tabolt said that figure includes both internal and external audit fees, a point not explained in the proxy, though he declined to specify how much Andersen was paid for each. Additionally, Enron paid Andersen a further $27 million for other services, including tax and consulting work.

Following audit failures, outside auditors frequently claim that their clients withheld crucial information from them. In testimony Wednesday before a joint hearing of two House Financial Services subcommittees, which are investigating Enron's collapse, Andersen's chief executive, Joseph Berardino, made the same claim about Enron. However, given that Andersen also was Enron's internal auditor, "it's going to be tough for Andersen to take that traditional tack that 'management pulled the wool over our eyes,' " says Douglas Carmichael, an accounting professor at Baruch College in New York.

Mr. Tabolt, the Andersen spokesman, said it is too early to make judgments about Andersen's work. "None of us knows yet exactly what happened here," he said. "When we know the facts we'll all be able to make informed judgments. But until then, much of this is speculation."

Though it hasn't received public attention recently, Andersen's double-duty work for Enron wasn't a secret. A March 1996 Wall Street Journal article, for instance, noted that a growing number of companies, including Enron, had outsourced their internal-audit departments to their outside auditors, a development that had prompted criticism from regulators and others. At other times, Mr. Tabolt said, Andersen and Enron officials had discussed their arrangement publicly.

Accounting firms say the double-duty arrangements let them become more familiar with clients' control procedures and that such arrangements are ethically permissible, as long as outside auditors don't make management decisions in handling the internal audits. Under the new SEC rules taking effect next year, an outside auditor impairs its independence if it performs more than 40% of a client's internal-audit work. The SEC said the restriction won't apply to clients with assets of $200 million or less. Previously, the SEC had imposed no such percentage limitation.

The Gottesdiener Law Firm, the Washington, D.C. 401(k) and pension class action law firm prosecuting the most comprehensive of the 401(k) cases pending against Enron Corporation and related defendants, added new allegations to its case today, charging Arthur Andersen of Chicago with knowingly participating in Enron's fraud on employees.
Lawsuit Seeks to Hold Andersen Accountable for Defrauding Enron Investors, Employees --- 

Bob Jensen's threads on the Enron scandal are at

Quality of Earnings:  Standard & Poor's Redefines Core Earnings

Bob Jensen's Overview --- Go to 

"Beyond The Balance Sheet Earnings Quality," by  Kurt Badanhausen, Jack Gage, Cecily Hall, Michael K. Ozanian, Forbes, January 28, 2005 --- 

It's not how much money a company is making that counts, it's how it makes its money. The earnings quality scores from RateFinancials aim to evaluate how closely reported earnings reflect the cash that the companies' businesses are generating and how well their balance sheets reflect their true economic position. Companies in the winners table have the best earnings quality (they are generating a lot of sustainable cash from their operations), while companies in the losers table have been boosting their reported earnings with such tricks as unexpensed stock options, low tax rates, asset sales, off-balance-sheet financing and deferred maintenance of the pension fund.

Krispy kreme doughnuts is the latest illustration of the fact that stunning earnings growth can mask a lot of trouble. Not long ago the doughnutmaker was a glamour stock with a 60% earnings-per-share growth rate and a multiple to match-70 times trailing earnings. Now the stock is at $9.61, down 72% from May, when the company first issued an earnings warning. Turns out Krispy Kreme may have leavened profits in the way it accounted for the purchase of franchised stores and by failing to book adequate reserves for doubtful accounts. So claims a shareholder lawsuit against the company. Krispy Kreme would not comment on the suit. 

Investors are not auditors, they don't have subpoena power, and they can't know about such disasters in advance. But sometimes they can get hints that the quality of a company's earnings is a little shaky. In Krispy's case an indication that it was straining to deliver its growth story came three years ago in its use of synthetic leases to finance expansion. Forbes described these leases in a Feb. 18, 2002 story that did not please the company. Another straw in the wind: weak free cash flow from operations. You get that number by taking the "cash flow from operations" reported on the "consolidated statement of cash flows," then subtracting capital expenditures. Solid earners usually throw off lots of positive free cash flow. At Krispy the figure was negative.

 Is there a Krispy Kreme lurking in your portfolio? For this, the fifth installment in our Beyond the Balance Sheet series, we asked the experts at RateFinancials of New York City ( ) to look into earnings quality among the companies included in the S&P 500 Index. The tables at right display the outfits that RateFinancials puts at the top and at the bottom of the quality scale. The ratings are to a degree subjective and, not surprisingly, some of the companies at the bottom take exception. General Motors feels that RateFinancials understates its cash flow. But at minimum RateFinancials' work warns investors to look closely at the financial statements of the suspect companies. 

A lot of factors went into the ratings produced by cofounders Victor Germack and Harold Paumgarten, research director Allan Young and ten analysts. A company that expenses stock options is probably not straining to meet earnings forecasts, so it gets a plus. Overoptimistic assumptions about future earnings on a pension fund artificially prop up earnings and thus rate a minus. A low tax rate is a potential indicator of trouble: Maybe the low profit reported to the Internal Revenue Service is all too true and the high profit reported to shareholders an exaggeration. Other factors relate to discontinued operations (booking a one-time gain from selling a business is bad), corporate governance (companies get black marks for having poison pills), inventory (if it piles up faster than sales, then business may be weakening) and free cash flow (a declining number is bad).

Continued in this section of Forbes

Included in Standard & Poor's definition of Core Earnings are 

  • employee stock options grant expenses, 
  • restructuring charges from on-going operations, 
  • write-downs of depreciable or amortizable operating assets, 
  • pensions costs 
  • purchased research and development. 

Excluded from this definition are 

  • impairment of goodwill charges, 
  • gains or losses from asset sales, pension gains, 
  • unrealized gains or losses from hedging activities, merger and acquisition related fees
  • litigation settlements


From The Wall Street Journal Accounting Educators' Review on May 27, 2004

TITLE: J.C. Penney Profit Hurt by Eckerd 
REPORTER: Kortney Stringer 
DATE: May 19, 2004 
TOPICS: Accounting, Earnings Quality, Financial Accounting, Financial Analysis, Financial Statement Analysis, Income from Continuing Operations, Net Income, Operating Income

SUMMARY: Despite an earnings increase, J.C. Penney reported a 33% decline in net income. Questions focus on the components and usefulness of the income statement.

1.) Describe the primary purpose(s) of the income statement. Distinguish between the single-step and multi-step format for the income statement. Which type of statement is more common? Support your answer.

2.) Explain the components of gross margin, operating income, income from continuing operations, net income, and comprehensive income. What is persistence? Which income statement total is likely to have the greatest persistence? Which income statement total is likely to have the least persistence?

3.) Where are results from discontinued operations reported on the income statement? Why are results from discontinued operations separated from income from continuing operations?

4.) What impact does the loss from the sale of Eckerd have on J.C. Penney's expected future net income? What impact does results from continuing operations have on expected future net income?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

From The Wall Street Journal Accounting Educators' Review on May 23, 2002

TITLE: SEC Broadens Investigation Into Revenue-Boosting Tricks; Fearing Bogus Numbers Are Widespread, Agency Probes Lucent and Others 
REPORTER: Susan Pulliam and Rebecca Blumenstein 
DATE: May 16, 2002 
TOPICS: Financial Accounting, Financial Statement Analysis

SUMMARY: "Securities and Exchange Commission officials, concerned about an explosion of transactions that falsely created the impression of booming business across many industries, are conducting a sweeping investigation into a host of practices that pump up revenue."

1.) "Probing revenue promises to be a much broader inquiry than the earlier investigations of Enron and other companies accused of using accounting tricks to boost their profits." What is the difference between inflating profits vs. revenues?

2.) What are the ways in which accounting information is used (both in general and in ways specifically cited in this article)? What are the concerns about using accounting information that has been manipulated to increase revenues? To increase profits?

3.) Describe the specific techniques that may be used to inflate revenues that are enumerated in this article and the related one. Why would a practice of inflating revenues be of particular concern during the ".com boom"?

4.) "[L90 Inc.] L90 lopped $8.3 million, or just over 10%, off revenue previously reported for 2000 and 2001, while booking the $250,000 [net difference in the amount of wire transfers that had been used in one of these transactions] as 'other income' rather than revenue." What is the difference between revenues and other income? Where might these items be found in a multi-step income statement? In a single-step income statement?

5.) What are "vendor allowances"? How might these allowances be used to inflate revenues? Consider the case of Lucent Technologies described in the article. Might their techniques also have been used to boost profits?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

TITLE: CMS Energy Admits Questionable Trades Inflated Its Volume 
REPORTER: Chip Cummins and Jonathan Friedland 
ISSUE: May 16, 2002 

From The Wall Street Journal Accounting Educators' Review on May 27, 2004

TITLE: SEC Gets Tough With Settlement in Lucent Case
REPORTER: Deborah Solomon and Dennis K. Berman
DATE: May 17, 2004
TOPICS: Criminal Procedure, Financial Accounting, Legal Liability, Revenue Recognition, Securities and Exchange Commission, Accounting

SUMMARY: After a lengthy investigation into the accounting practices of Lucent Technologies Inc., the Securities and Exchange Commission is expected to file civil charges and impose a $25 million fine against the company. Questions focus on the role of the SEC in financial reporting.

1.) What is the Securities and Exchange Commission (SEC)? When was the SEC established? Why was the SEC established? Does the SEC have the responsibility of establishing financial reporting guidelines?

2.) What role does the SEC currently play in the financial reporting process? What power does the SEC have to sanction companies that violate financial reporting guidelines?

3.) What is the difference between a civil and a criminal charge? What is the difference between a class-action suit by investors and a civil charge by the SEC?

4.) What personal liability do individuals have for improper accounting? Why does the SEC object to companies indemnifying individuals for consequences associated with improper accounting?

Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University

Bob Jensen's threads on revenue accounting are at 

Standard & Poor's News Release on May 14, 2002 --- 

Standard & Poor's To Change System For Evaluating Corporate Earnings

Widely-Supported "Core Earnings" Approach to be Applied to Earnings Analyses and Forecasts for US Indices, Company Data and Equity Research

New York, May 14, 2002 -- Standard & Poor's today published a set of new definitions it will use for equity analysis to evaluate corporate operating earnings of publicly held companies in the United States. Release of "Measures of Corporate Earnings" completes a process Standard & Poor's began in August 2001 when the firm began discussions with securities and accounting analysts, portfolio managers, academic research groups and others to build a consensus for changes that will reduce investor frustration and confusion over growing differences in the reporting of corporate earnings. The text of "Measures of Corporate Earnings" may be found at

At the center of Standard & Poor's effort to return transparency and consistency to corporate reporting is a focus on what it refers to as Core Earnings, or the after-tax earnings generated from a corporation's principal business or businesses. Since Standard & Poor's believes that there is a general understanding of what is included in As Reported Earnings, its definition of Core Earnings begins with As Reported and then makes a series of adjustments. As Reported Earnings are earnings as defined by Generally Accepted Accounting Principles (GAAP) which excludes two items - discontinued operations and extraordinary items, both as defined by GAAP.

Included in Standard & Poor's definition of Core Earnings are employee stock options grant expenses, restructuring charges from on-going operations, write-downs of depreciable or amortizable operating assets, pensions costs and purchased research and development. Excluded from this definition are impairment of goodwill charges, gains or losses from asset sales, pension gains, unrealized gains or losses from hedging activities, merger and acquisition related fees and litigation settlements.

"For over 140 years, Standard & Poor's has stood for the investor's right to know. Central to that objective is a clear, consistent, definition of a company's financial position," said Leo O'Neill, president of Standard & Poor's. "The increased use of so-called pro forma earnings and other measures to report corporate performance has generated controversy and confusion and has not served investor interests. Standard & Poor's Core Earnings definition will help build consensus and restore investor trust and confidence in the data used to make investment decisions."

"A number of recent high profile bankruptcies have renewed investors' concerns about the reliability of corporate reporting," said David M. Blitzer, Standard & Poor's chief investment strategist. "From the work we have just completed, our hope is to generate additional public discussion on earnings measures. Once there are more generally accepted definitions, it will be much easier for analysts and investors to evaluate varying investment opinions and recommendations and form their own views of which companies are the most attractive."

Beginning shortly, Standard & Poor's will include the components of its definition for Core Earnings in its COMPUSTAT database for the U.S., the leading source for corporate financial data. In addition, Core Earnings will be calculated and reported for Standard & Poor's U.S. equity indices, including the S&P 500. Finally, Standard & Poor's own equity research team, which provides opinions on over 1100 stocks, will adopt Core Earnings in its analyses.

"Core Earnings is an excellent analytical tool for the individual and professional investor alike," said Kenneth Shea, managing director for global equity research at Standard & Poor's. "It allows investors to better evaluate and compare the underlying earnings power of the companies they are examining. In addition, it enhances an investor's ability to construct and maintain investment portfolios that will adhere to a pre-determined set of investment objectives. With Core Earnings, Standard & Poor's equity analysts will be able to provide our clients with even more insightful forecasts and buy, hold and sell recommendations."

From the outset, Standard & Poor's has sought to achieve agreement surrounding broad earnings measures that address a company's potential for profitability. In addition to emphasizing this approach in its equity analysis, Standard & Poor's will also make Core Earnings a part of its credit ratings analysis. The accuracy of earnings and earnings trends has always been a component of credit analysis and Core Earnings adds value to this process. Earnings are also a major element in cash flow analysis and are therefore a part of Standard & Poor's debt rating methodology.

Standard & Poor's, a division of The McGraw-Hill Companies (NYSE:MHP), provides independent financial information, analytical services, and credit ratings to the world's financial markets. Among the company's many products are the S&P Global 1200, the premier global equity performance benchmark, the S&P 500, the premier U.S. portfolio index, and credit ratings on more than 220,000 securities and funds worldwide. With more than 5,000 employees located in 18 countries, Standard & Poor's is an integral part of the global financial infrastructure. For more information, visit

S&P Main Core Earnings Site (including a Flash Presentation) --- 

          Standard & Poor's Core Earnings Data
          Latest Standard & Poor's Research
          Previous Standard & Poor's Research
          Press Releases
          Media Coverage
          Standard & Poor's Core Earnings Data and Services


S&P PowerPoint Show on Core Earnings 

Other Related Core Earnings Files

Bob Jensen's Overview --- 

Updates, including FAS 133 --- 

Pensions and Pension Interest --- 

What ten companies have the most "inflated" measures of profit?

"Shining A New Light on Earnings, BusinessWeek Editorial, June 21, 2002 --- 

How much does a company truly make? It's hard to tell these days. To boost the performance of their stocks, companies have come up with a slew of self-defined "pro forma" numbers that put their financials in a favorable light. Now ratings agency Standard & Poor's has devised a truer measure known as Core Earnings.

The Goal: to provide a standardized definition of the profits produced by a company's ongiong operations. Of the three main changes from more traditional measures of profits two reduce earmings: Income from pension funds is excluded and the cost of stock options are deducted as an expense. The other big change boosts earnings by adding back in the charges taken to adjust for overpriced acquisitions. Here are the top 10 losers and winners under Core Earnings:


Enhanced Business Reporting

I attended the following CPE Workshop at the AAA Meetings in Orlando

CPE Session 3: Saturday, August 7, 1:00 PM – 4:00 PM 
Value Measurement and Reporting—Moving toward Measuring and Reporting Value Creation Activities and Opportunities

Presenters: William J. L. Swirsky, Canadian Institute of Chartered Accountants  
Paul Herring, AICPA Director Business Reporting Assurance and Advisory Service 

Content – Presentations and dialogue about measuring the activities and opportunities that drive an entity’s value and, once measured, reporting these value creation prospects, in financial or nonfinancial terms, in addition to current financial information. The session will include information about research by the Value Measurement and Reporting Collaborative (VMRC) that will provide the foundation for the development of a framework of market-driven principles that characterize value measurement and reporting on a global basis.

Objectives – To continue the dialogue on more transparent, consistent, and reliable reporting of an entity’s value; to provide participants with information about the research being undertaken by VMRC; to talk about disclosure; and to solicit feedback from the attendees about where they see gaps in the current practices on value measurement and reporting.

Plan – To (1) provide context for value measurement and reporting; (2) describe research to date; and (3) describe reporting initiatives.

The above workshop focused mainly upon the early stages of the Value Measurement and Reporting Collaborative that evolved into the Enhanced Business Reporting (EBR) Consortium)  for providing more structure, uniformity, and measurement of non-financial information reported to managers and other stakeholders --- 
This initiative that began in 2002 with hope that a collaboration between the AICPA, the Canadian CICA, leading consulting firms, and others could initiate a new business reporting model as follows:

The Value Measurement and Reporting Collaborative, in which the AICPA is a participant, will play a crucial role in the new business reporting model. VMRC is a global effort of the accounting profession, along with corporate directors, businesses, business associations and organizations, institutional investors, investment analysts, software companies and academics. The key purpose of the collaborative is to help boards of directors and senior management make better strategic decisions using value measurement and reporting. It is anticipated that the current financial reporting model would, over time, migrate to this new model and would be used to communicate a more complete picture to stakeholders.

Also see Grant Thornton's summary in 2004
Grant Thornton in the US has posted a new publication of Directors Monthly, which focuses on "Business Reporting: New Initiative Will Guide Voluntary Enhancements." The publication discusses how non-financial information offers a better picture of corporate financial health. 
Double Entries, September 9, 2004 --- 

For years researchers and businesses have been attempting to find a better way to report on business performance beyond the traditional financial reporting effort.  Bob Jensen even wrote a 1976 book called Phantasmagoric Accounting --- See Volume 14 at 

Studies of reporting on non-financial business performance over the past 50 years have generally been disappointing.  Numbers attached to such things as cost of pollution and value of human capital were generally derived from overly-simplified models that really did not deal with externalities, interaction effects, non-stationarity, and important missing variables.  There is an immense need, especially by managers and lawmakers, for better business reporting that will help making tradeoffs between stakeholders.  At the Orlando workshop mentioned above, we heard a great deal about the need for a new business reporting model.  But when the presenters got down to what had been accomplished to date, I felt like the presentations lacked scholarship, especially in terms of the history of research on this topic over the past 50 years.  What was presented as "new" really had been hashed over many times in the past.  I left the Enhanced Business Reporting Consortium workshop feeling that this initiative is long on hype and short on hope.

But I do not want to give the impression that the EBR initiative is not important.  Little is gained by the traditional accounting research tradition, especially in academe, of ignoring huge and seemingly intractable problems that seem to defy all known research methodologies.  High on the list of intractable problems are problems of measuring intangibles and human/environmental performance.  If nothing else, the Value Measurement and Reporting Collaborative will help to keep researchers focused on the bigger problems rather than less relevant minutiae.  At a minimum some progress may be made toward standardization of non-financial reporting.  

You can track the progress of the Enhanced Business Reporting Consortium  at 

Economic Theory of Accounting

October 30, 2002 message from JerryFeltham [

Peter Christensen and I are pleased to announce that the first of two volumes on the fundamentals of the economic analysis of accounting has been published by Kluwer. This two volume series is based on two analytical Ph.D. seminars I have taught for several years, and is designed to provide efficient coverage of key information economic models and results that are pertinent to accounting research.

The first volume is entitled:  Economics of Accounting: Volume I - Information in Markets.

The attached file provides the table of contents of this volume, plus the preface - which gives a brief overview of the two volumes. The second volume is

Economics of Accounting: Volume II - Performance Evaluation.

We expect to complete it in the next few months.

The two volumes can be used to provide the foundation for Ph.D. courses on information economic research in accounting. Furthermore, it is our hope that analytical researchers, as well as empiricists and experimentalists who use information economic analysis to motivate their hypotheses, will find our book to be a useful reference.

We plan to maintain a website for the book. It will primarily be used to provide some problems Peter and I have developed in teaching courses based on the two books. In addition, the website will include any errata. The website address is: 

Also attached is a flyer from our publisher Kluwer. It announces a 25% discount in the price if the book is purchased prior to December 31.

The publisher has also informed us that: "If students buy the book through your university bookstore (6 or more copies) they will receive an adoption price of $79.95 US."

Information regarding discounts on this book for course use and bulk purchases can be obtained by sending an e-mail message to  (their customer service department).

Jerry Feltham 
Faculty of Commerce 
University of British Columbia 
2053 Main Mall 
Vancouver, Canada V6T 1Z2 
Tel. 604-822-8397 Fax 604-822-9470 

Bob Jensen's threads on accounting theory are at 




Trinity University students may study more about theory in my Theory02.htm document at J:\courses\acct5341\0assign\theory02.htm