Congressional testimony on the ramifications of the Doty Report show growing political opposition to rules-based, FAS 133-style accounting.

Details of Freddie Mac's attempts to workaround derivatives accounting (FAS 133) are renewing politicians' interests in accounting, in particular-rules based fair value accounting following the model of FAS 133. Recent testimony before a Subcomittee of the US House Committee on Energy and Commerce on Accounting Standards Issues Raised in the Doty Report (the report to Freddie Mac's Board of Directors on the investigation of its reporting conducted by the law firm Baker Botts) will fuel an increasingly heated debate on the efficacy of current GAAP rules. Since this debate is being sparked by a treasury accounting matter, treasurers should be particularly wary of the potential consequences of their actions going forward.

"The transacting around" problem

One of the clear lessons of the report concerning Congress is that GAAP is susceptible to a "transacting-around-the-rules" problem. 

As Rep. Cliff Stearns (R-FL), Chairman of the Commerce, Trade & Consumer Protection Subcommittee that heard the testimony noted in his opening statement: "Although Freddie Mac by its own admission made serious accounting misstatements, had they structured some of these transactions differently, it is possible that GAAP would have permitted the non-disclosure of the fair value of Freddie's derivatives portfolio."

In other words, Freddie Mac's effort to transact around the accounting guidelines could have succeeded, had it had better accounting knowledge on hand.

In his testimony, the author of the Doty Report, James R. Doty, emphasised: "notwithstanding the various accounting errors, we found nothing to suggest that the transactions at issue had the effect of undermining the Company’s risk-management policies and practices." 

On the contrary, these transactions were intended merely to transact around the accounting impact on earnings that was created by Freddie's risk management approach. The transactions did not seek to manufacture profits, per se, but  sought to smooth out the volatile effects introduced by fair value accounting on earnings.

In the main, the transactions described at length in the Doty Report, were designed to defer hedge gains and correct the mismatch of gains/losses on underlyings with the hedge gains/losses for hedging techniques that did not qualify for hedge accounting under FAS 133.

To manage the deferrals, Freddie also entered into, or structured the deferral transactions in such a way (FAS 125), that they could manipulate their reserves (FAS 91) so that current recognized earnings matched their estimates with precision. It was the reserve accounting tricks, by and large, that got them into trouble with GAAP rules, but they had assumed for the most part that they were GAAP compliant.

In sum, the Freddie Mac accounting-driven transactions were designed to achieve results in line with their risk management objectives, and Freddie believed that there was nothing technically wrong with doing this, nor did it believe it was obligated to disclose that this was the purpose of these transactions.

The perceived ability to transact around accounting rules, and ample anecdotal evidence that this not an isolated practice, is precisely what has led Congress (with Sarbanes-Oxley) and the SEC (with its July report) to endorse principles-based accounting. The Doty Report, however, does not see current GAAP necessarily as the problem: it sees corporate governance at fault.

Indeed, the Report falls just short of endorsing the view that Freddie Mac was a victim of a rules-based accounting standard that was inconsistent with the economics of its risk management. Where it is faulted is in how it chose to rectify this: it tried to transact around FAS 133, and in a manner that did not comply with GAAP, to achieve principles-based accounting, in effect, or at least accounting that reflected the economic substance of its risk management. It also failed to diclose these efforts adequately.

By implication, the Doty Report suggests that if FAS 133 were based on the "in line with risk management intent" principle, Freddie Mac would have not have needed to enter into these transactions.

Explicitly, the Doty Report defined the problems at Freddie Mac in terms of: (i) weaknesses in the Company’s internal compliance and governance processes; (ii) disclosure practices that fell below the standards required of a public company; and (iii) weaknesses in Corporate Accounting that resulted in excessive reliance on independent auditors with respect to accounting decisions and policies. 

The last factor can be read as another indictment of current GAAP (again, FAS 133, in particular): it's complexity, and rules-based nature requires too much reliance on external auditors.

Proponents of principles-based accounting would argue that accounting guidance with clearly designed objectives would reduce the need for internal accounting savvy and reliance on external auditors. Knowing that the accounting is supposed to reflect the economic substance of the activity, with the intent to depict the economic reality, there should be less of a need to clarify rules and get an audit opinion, which is usually for an accounting treatment that seeks to do otherwise.

Is GAAP the right compliance benchmark? 

For this reason, Prof. Baruch Lev, the Philips Bardes Professor of Accounting and Finance at NYU's Stern School of Business, wants to move past the rules vs. principles-based GAAP debate. In his view, a move toward a principles-based approach in and of itself does nothing to solve the GAAP's deficiencies.  It also does nothing to reduce complexity."

In his testimony, Prof. Lev singled out fair value accounting: "The current move of accounting regulators toward 'fair value accounting' enhances considerably the role of estimates in financial reports." And as he testified: "The vulnerability of GAAP to manipulation by misusing the multiple estimates underlying accounting is amply demonstrated in the Report. This vulnerability, with its adverse economic and social consequences has not received the required policymakers' attention."

According to Prof. Lev: "For investors and other constituencies, GAAP compliance is of secondary importance," he argued in his testimony. "What these users of financial reports need is information that complies with reality. They need to be assured that the financial reports portray a truthful and unbiased picture of the Company's real earnings, assets, and liabilities, rather than that management's practices conformed with GAAP, known for its wide latitude and ease of manipulation."

That GAAP compliance, at least in its current form, might not be an appropriate benchmark for corporate governance is critica tCorporate Governance reform is thought to be based on it. Sarbanes-Oxley mandates on certification for accuracy and internal control, therefore, should not be presumed to mean that GAAP isgh the SEC rules on Section 404 internal controls do describe them that in the a GAAP context.

That GAAP may not be up to the task is of deep concern to Chairman Stearns. He is leading an effort to get Congress to find ways to improve accounting standards: "I believe Congress should consider appointing a Blue Ribbon Commission of experts to recommend improvements to accounting standards."

If more firms comes out with stories akin to Freddie Mac, that they sought to transact around GAAP, it is likely that this effort will gain transaction. One result may be calls to rework FAS 133. But it is unlikely to stop there. Do you really want Congress meddling with the most complex areas of accounting? So take care in what you transact around, and don't do anything that looks like the transactions in the Doty Report.